You are on page 1of 95

Venture Capital Funds: A Study

Chapter – 1

INTRODUCTION TO VENTURE CAPITAL FUNDS

1.1 Introduction

1.2 The Origin

1.3 Background

1.4 Meaning and Definition

1.5 Characteristics

1.6 Types of VCF

-1-
Venture Capital Funds: A Study

INTRODUCTION to Venture Capital Funds

1.1 VENTURE CAPITAL

Small businesses never seem to have enough money. Bankers and Suppliers, naturally, are
important in financing small business growth through loans and credit, but an equally
important source of long term. Growth Capital is the venture capital firm. Venture Capital
financing may have an extra bonus, for if a small firm has an adequate equity base; banks are
more willing to extend credit.

Venture capital is money provided by professionals who invest alongside management in


young, rapidly growing companies that have the potential to develop into significant
economic contributors. Venture capital is an important source of equity for start-up
companies.

Venture capital is capital typically provided by outside investors for financing of new,
growing or struggling businesses. Venture capital investments generally are high risk
investments but offer the potential for above average returns and/or a percentage of
ownership of the company. A venture capitalist (VC) is a person who makes such
investments. A venture capital fund is a pooled investment vehicle (often a 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.

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.

-2-
Venture Capital Funds: A Study

According to International Finance Corporation (IFC), venture capital is equity or equity


featured capital seeking investment in new ideas, new companies, new production, new
process or new services that offer the potential of high returns on investments.

As defined in Regulation 2(m)of SEBI (Venture Capital Funds) Regulation , 1996 "venture
capital fund means a fund established in the form of a company or trust which raises monies
through loans, donations issue of securities or units as the case may be, and makes or
proposes to make investments in accordance with these regulations.

Thus venture capital is the capital invested in young, rapidly growing or changing companies
that have the potential for high growth. The VC may also invest in a firm that is unable to
raise finance through the conventional means.

Professionally managed venture capital firms generally are private partnerships or closely-
held corporations funded by private and public pension funds, endowment funds,
foundations, corporations, wealthy individuals, foreign investors, and the venture capitalists
themselves.

Venture capitalists generally:

• Finance new and rapidly growing companies;


• Purchase equity securities;
• Assist in the development of new products or services;
• Add value to the company through active participation;
• Take higher risks with the expectation of higher rewards;
• Have a long-term orientation

When considering an investment, venture capitalists carefully screen the technical and
business merits of the proposed company. Venture capitalists only invest in a small
percentage of the businesses they review and have a long-term perspective. Going forward,
they actively work with the company's management by contributing their experience and
business savvy gained from helping other companies with similar growth challenges.

-3-
Venture Capital Funds: A Study

Venture capitalists mitigate the risk of venture investing by developing a portfolio of young
companies in a single venture fund. Many times they will co-invest with other professional
venture capital firms. In addition, many venture partnership will manage multiple funds
simultaneously. For decades, venture capitalists have nurtured the growth of America's high
technology and entrepreneurial communities resulting in significant job creation, economic
growth and international competitiveness. Companies such as Digital Equipment
Corporation, Apple, Federal Express, Compaq, Sun Microsystems, Intel, Microsoft, Yahoo,
Airtel and Genentech are famous examples of companies that received venture capital early
in their development.

Venture Capital is the business of establishing an investment fund in the form of equity
financing via investments in the common stocks, preferred stocks and convertible debentures
of various companies. These companies are seen to have a high growth potential and are able
to be listed on the stock exchange in order to gain the highest returns in dividends and capital
gain.

-4-
Venture Capital Funds: A Study

1.2 The Origin of Venture Capital

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
more famous ventures they financed. Among the early VC funds set up was the one by the
Rockfeller Family which started a special fund called VENROCK in 1950, to finance new
technology companies.

USA is the birth place 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 resources of wealthy families.

In 1946, American Research and Development Corporation (ARD), a publicly traded, closed-
end investment company was formed. ARD's best known investment was the start-up
financing it provided in 1958 for computer maker Digital Equipment Corp. ARD was
eventually profitable, providing its original investors with a 15.8 percent annual rate of return
over its twenty-five years as an independent firm. General Doriot, a professor at Harvard
Business School, set up the ARD, the first firm, as opposed to private individuals, at MIT to
finance the commercial promotion of advanced technology developed in the US Universities.
ARD's approach was a classic VC in the sense that it used only equity, invested for long
term, and was prepared to live with losers. ARD's investment in Digital Equipment
Corporation (DEC) in 1957 was a watershed in the history of VC financing.

The number of such specialized investment firms, eventually to be called venture capital
firms, began to boom in the late 1950s.The growth was aided in large part by the creation in
1958 of the federal Small Business Investment Company program. Hundreds of SBICs were
formed in the 1960s, and many remain in operation today.

Slow Growth in 1960s & early 1970s, and the First Boom Year in 1978

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

-5-
Venture Capital Funds: A Study

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. The industry raised approximately $750 million in 1978.

Highs & Lows of the 1980s

In 1980, legislation made it possible for pension funds to invest in alternative assets classes
such as venture capital firms. 1983 was the boom year - the stock market went through the
roof and there were over 100 initial public offerings for the first time in U.S. history. That
year was also the year that many of today's largest and most prominent firms were founded.

Due to the excess of IPOs and the inexperience of many venture capital fund managers, VC
returns were very low through the 1980s. VC firms retrenched, working hard to make their
portfolio companies successful. The work paid off and returns began climbing back up.

Boom Times in the 1990s

The 1990s have been, by far the best years for the Venture Capital Industry. The engine for
growth has been the favourable economic climate in the US coupled with the advent of the
Internet boom. During this decade, the interest rates were low and the P/Es were very high
compared to historical averages. Finally, the rate of M&A activity has increased dramatically
in the 1990s, creating more opportunities for small, venture-backed companies to exit (cash
out) at high prices.

The advent of the Internet as a new medium for both personal and business communications
and commerce created an avalanche of opportunities for venture capitalists in the mid and
late 1990s. As a result, the industry has experienced extraordinary growth in the past few
years, both in the number of firms, and in the amount of capital they have raised.

-6-
Venture Capital Funds: A Study

1.3 The Background

In September 1995, Government of India issued guidelines for overseas venture capital
investment in India whereas the Central Board of Direct Taxes (CBDT) issued guidelines for
tax exemption purposes. (The Reserve Bank of India governs the investment and flow of
foreign currency in and out of India.) As a part of its mandate to regulate and to develop the
Indian capital markets, Securities and Exchange Board of India (SEBI) framed the SEBI
(Venture Capital Funds) Regulations, 1996.

Pursuant to the regulatory framework, some domestic VCFs were registered with SEBI.
Some overseas investments also came through the Mauritius route. However, the venture
capital industry, understood globally as 'independently managed, dedicated pools of capital
that focus on equity or equity linked investments in privately held, high growth companies'
(The Venture Capital Cycle, Gompers and Lerner, 1999) is still relatively in a nascent stage
in India. Figures from the Indian Venture Capital Association (IVCA) reveal that, till 2000,
around Rs. 2,200 crore (US$ 500 million) had been committed by the domestic VCFs and
offshore funds which are members of IVCA. Figures available from private sources indicate
that overall funds committed are around US$ 1.3 billion.

Funds that can be invested were less than 50 percent of the committed funds and actual
investments were lower still. At the same time, due to economic liberalisation and increasing
global outlook in India, an increased awareness and interest of domestic as well as foreign
investors in venture capital was observed. While only 8 domestic VCFs were registered with
SEBI during 1996-98, more than 30 additional funds have already been registered in 2000-
01.

Institutional interest is growing and foreign venture investments are also on the increase.
Given the proper environment and policy support, there is a tremendous potential for venture
capital activity in India.

-7-
Venture Capital Funds: A Study

The Finance Minister, in the Budget 2000 speech announced, "For boosting high tech sectors
and supporting first generation entrepreneurs, there is an acute need for higher investments in
venture capital activities." He also said that the guidelines for the registration of venture
capital activity with the Central Board of Direct Taxes would be harmonized with those for
registration with the Securities and Exchange Board of India.

SEBI decided to set up a committee on venture capital to identify the impediments and
suggest suitable measures to facilitate the growth of venture capital activity in India. Keeping
in view the need for global perspective, it was decided to associate Indian entrepreneur from
Silicon Valley in the committee. The setting up of this committee was primarily motivated by
the need to play a facilitating role in tune with the mandate of SEBI, to regulate as well as
develop the market. The committee headed by K. B. Chandrasekhar, Chairman, Exodus
Communications Inc., submitted its report on 8 January 2000.

1.4 (a)Meaning of Venture Capital

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 capitalist pools 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.

(b) Definition of the Venture Capital Company

A venture capital company is defined as “a financing institutions which joints an


entrepreneur as a co-promoter in a project and shares the risks and rewards of the
enterprise.”

-8-
Venture Capital Funds: A Study

1.5 Characteristics of Venture Capital

The three primary characteristics of venture capital funds which may them eminently
suitable as a source of risk finance are:
(1) that it is equity or quasi equity investments;
(2) it is long-term investment; and
(3) it is an active from of investment.

First, venture capital is equity or quasi equity because the investor assumes risk. There is no
security for his investment. Venture capital funds by participating in the equity capital
institutionalize the process of risk taking which promotes successful domestic technology
development.

Investors of venture capital have no liquidity for a period of time. Venture capitalist or
funds hope that the company they are backing will thrive and after five to seven years from
making the investment it will be large and profitable enough to sell its shares in the stock
market. But a reward is thee for liquidity and waiting. The venture capitalists hope to sell
their share for many times what they paid for. If the unit fails the venture capitalists losses
everything. The probability distribution of expected returns for most venture capital
investment is highly skewed to the right. The success rate is 10-20 percent.

Secondly, venture capital is long-term investment involving both money and time.

Finally, venture capital investment involves participation in the management of the


company. Venture capitalist participates in the Board and guides the firm on strategic and
policy matters. The features of venture capital generally are, financing new and rapidly
growing companies; purchase of equity shares; assist in transformation of innovative
technology based ideas into products and services; and value to company by active
participation; assume risks in the expectation of large rewards; and possess a long-term
perspective. These features of venture capital render it eminently suitable as a source of risk
capital for domestically developed technologies.

-9-
Venture Capital Funds: A Study

New venture proposals in high technology area are attractive because of the perceived
possibility of substantial growth and capital gains. Although venture capital evolved as a
method of early sage financing it includes development, expansion and buyout financing for
units which are unable to raise funds through normal financing channels. Units in developing
countries need funds for financing various stages of development. Such a broad approach
would help venture funds to diversify their investment and spread risks.

1.6 Types of Venture Capital Firms

Venture Capital can be divided into many different types according to the characteristics of
the shareholders and sources of investment -- such as private equity firms, banks, financial
institutions, private corporations, the government or insurance companies.

Generally there are three types of organized or institutional venture capital funds: venture
capital funds set up by angel investors, that is, high net worth individual investors; venture
capital subsidiaries of corporations and private venture capital firms/ funds. Venture capital
subsidiaries are established by major corporations, commercial bank holding companies and
other financial institutions.

Venture funds in India can be classified on the basis of the type of promoters.

• Financial institutions led by ICICI ventures, ILFS, etc. Private venture funds like
Indus, etc.
• Regional funds: Warburg Pincus, JF Electra (mostly operating out of Hong Kong).
• Regional funds dedicated to India: Draper, Walden, etc.
• Offshore funds: Barings, TCW, HSBC, etc.
• Corporate ventures: venture capital subsidiaries of corporations.
• Angels: high net worth individual investors.
• Merchant bankers and NBFCs who specialize in "bought out" deals also fund
companies.

- 10 -
Venture Capital Funds: A Study

On the basis of geographical focus

• Regional
• Global
On the basis of industry specialty
• IT and IT-enabled services
• Software Products (Mainly Enterprise-focused)
• Wireless/Telecom/Semiconductor
• Banking
• Media/Entertainment
• Bio Technology/Bio Informatics
• Pharmaceuticals
• Contract Manufacturing
• Retail

On the basis of funding stage:


• Seed/early
• Late/mbo
• Pipe

The Venture Capital firms in India can be categorized into the following four groups:

1. All-India DFI-sponsored VCFs such as Technology Development and Information


Company of India Ltd. (TDICI) by ICICI, Risk Capital and Technology Finance Corporation
Ltd. (RCTFC) by IFCI and Risk Capital Fund by IDBI

2. SFC-sponsored VCFs such as Gujarat Venture Capital Ltd. (GVCL) by GIIC and Andhra
Pradesh Venture Capital Ltd. (APVCL) by APSFC

3. Bank-sponsored VCFs such as Canfina and SBI Caps

4. Private VCFs supported by private sector companies such as Indus Venture Capital Fund,
Credit Capital Venture Fund.

- 11 -
Venture Capital Funds: A Study

Chapter – 2

Development of VCF in International Arena and INDIA

2.1 VCF in International Arena

2.2 Venture Capital in India

2.3 Future of Venture Capital in India

- 12 -
Venture Capital Funds: A Study

Development of Venture Capital

2.1 The International arena

The modern venture capital industry began taking shape in the post – World War II years. It
is often said that people decide to become entrepreneurs because they see role models in
other people who have become successful entrepreneurs. Much the same thing can be said
about venture capitalists.

USA

The history of the venture capital in US traces back to the period after World War II when a
few wealthy family groups like Rockefeller, Andrew Carnegie and others took the initiative.
The venture capital industry was started by George Detroit who collaborated in establishing
Corporation at Boston. From 1965 to 1972 nearly 40 venture capital companies were formed
with committed assets of $500 million. It is noted that in the US, the venture capital industry
has been associated with technology development. In the 1980s, the US venture industry
began to establish its business overseas at large.

UK

In the UK, the development of venture capital owes to the professionally managed specialist
fund – Charter House – set up in 1980 for providing risk equity finance for young and
growing small business. In 1983, British Venture Capital Association was established with a
membership of 33 funds, which rose to 115 in 1992.

JAPAN

In 1963, 3 Government assisted companies were established in Tokyo, Osaka and Nagoya, to
provide venture capital t small and medium industries. Leading financial institutions in Japan
started venture capital companies for financing high technology industrial units. The rapid
growth of industry in Japan is credited to the easy availability of venture capital.

- 13 -
Venture Capital Funds: A Study

2.2 VENTURE CAPITAL IN INDIA

This activity in the past was possibly done by the developmental financial institutions like
IDBI, ICICI and State Financial Corporations. 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 Gujarat Venture Finance
Ltd. and APIDC Venture Capital Ltd. were started by state level financial institutions.
Sources of these funds were the financial institutions, foreign institutional investors or
pension funds and high net-worth 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.

- 14 -
Venture Capital Funds: A Study

GROWTH OF FIRMS IN INDIA

Year No. of Funds Year No. of Funds


1995 4 2001 12
1996 7 2002 6
1997 10 2003 2
1998 6 2004 3
1999 5 2005 1
2000 47 2006 2
Source: AVCJ/IVCA

India is prime target for venture capital and private equity today, owing to various factors
such as fast growing knowledge based industries, favourable 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 upto 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
(VCFs) and venture capital companies (VCC) are permitted upto 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.

- 15 -
Venture Capital Funds: A Study

2 India Venture Capital Investment Trend

In contrast to the emerging trend highlighted above, 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.

1,400
1,160 1,220
1,200
1,023
1,000 937 900
774
800
590
600 500
400 250
200 80
20
0
96 97 98 99 '00 '01 '02 '03 '04 '05 '06

Source: IVCA/AVCJ

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-2007.

- 16 -
Venture Capital Funds: A Study

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 2001-2003, 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

- 17 -
Venture Capital Funds: A Study

(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 bio-technology and pharmaceuticals; healthcare and medical
tourism; auto-components; 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.

- 18 -
Venture Capital Funds: A Study

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 earlystage investments further into Seed, Series A and Series B investments
depending upon their value.

Figure 3 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 4 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.

- 19 -
Venture Capital Funds: A Study

Figure 5 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.

- 20 -
Venture Capital Funds: A Study

2.3 Future of Venture Capital in India

Rapidly changing economic environment accelerated by the high technology explosion,


emerging needs of new generation of entrepreneurs in the process and inadequacy of the
existing venture capital funds/schemes are indicative of the tremendous scope for venture
capital in India and pointers to the need for the creation of a sound and broad-based venture
capital movement India.

There are many entrepreneurs in India with a good project idea but no previous
entrepreneurial track record to leverage their firms, handle customers and bankers. Venture
capital can open a new window for such entrepreneurs and help them to launch their projects
successfully.

With rapid international march of technology, demand for newer technology and products in
India has gone up tremendously. the pace of development of new and indigenous technology
in the country has been slack in view of the fact that several process developed in
laboratories are not commercialized because of unwillingness of people to take
entrepreneurial risks, i.e. risk their funds as also undergo the ordeal of marketing the
products and process. In such a situation, venture financing assumes more significance. It
can act not only act as a financial catalyst but also provide strong impetus for entrepreneurs
to develop products involving newer technologies and commercialize them. This will give a
boost to the development of new technology and would go a long way in broadening the
industrial base, creation of jobs, provide a thrust to exports and help in the overall enrichment
of the economy.

Another type of situation commonly found in our country is where the local group and a
multi-national company may be ready to enter into a joint venture but the former does not
have sufficient funds to put up its share of the equity and the latter is restricted to a certain
percentage. For the personal reasons or because of competition, the local group may not be
keen to invite any one in its industry or any major private investor to contribute equity and
may prefer a venture capital company, as a less intimately involved and temporary

- 21 -
Venture Capital Funds: A Study

shareholder. Venture capitalists can also lend their expertise and standing to the
entrepreneurs.

In service sector, which has immense growth prospects in India, venture capitalists can play
significant role in tapping its potentiality to the full. For instance, venture capitalists can
provide capital and expertise to organizations selling antique, remodeled jewellery, builders
of resort hotels, baby and health care market, retirement homes and small houses.

In view of the above, it will be desirable to establish a separate national venture capital fund
tow which the financial institutions and banks can contribute. In scope and content such a
national venture capital fund should cover:

(i) all the aspects of venture capital financing in all the three stages of conceptual,
developmental an exploitation phases in the process of commercialization of the
technological innovation and

(ii) as may of the risk stages-development, manufacturing, marketing, management and


growth as possible under Indian Conditions. The fund should offer a comprehensive package
of technical, commercial, managerial and financial assistance and services to building
entrepreneurs and be a position to offer innovative solutions to the varied problems faced by
them in business promotion, transfer and innovation. To this end, the proposed national
venture capital fund should have at its command multi-disciplinary technical expertise. The
major thrust of this fund should be on the promotion of viable new business in India to take
advantage of the on coming high technology revolution and setting up of high growth
industries so as to take the Indian economy to commanding heights.

- 22 -
Venture Capital Funds: A Study

Chapter – 3

Venture Capital Investment Process

3.1 Investment Procedure

3.2 Investment in VC by Banks

1.3 Angle

1.4 Corporate Venturing

1.5 Consortium Financing

1.6 Favourites of the Investors

1.7 Promotion Strategies

1.8 Incentives

1.9 Initiatives

1.10 Special Purpose Vehicle

- 23 -
Venture Capital Funds: A Study

Venture Capital Investment Process

3.1 Investment Procedure

In generating a deal flow, the venture capital investor creates a pipeline of ‘deals’ or
investment opportunities that he would consider investing in. This is achieved primarily
through plugging into an appropriate network. The most popular network obviously is the
network of venture capital funds/investors. It is also common for venture capitals to develop
working relationships with R&D institutions, academia, etc, which could potentially lead to
business opportunities. Understandably the composition of the network would depend on the
investment focus of the venture capital funds/company. Thus venture capital funds focusing
on early stage technology based deals would develop a network of R&D centers working in
those areas. The network is crucial to the success of the venture capital investor. It is almost
imperative for the venture capital investor to receive a large number of investment proposals
from which he can select a few good investment candidates finally.

Before making any investment, the goal as venture capitalists is to understand virtually every
aspect of the target company: the experience and capabilities of the management team, the
business plan, the nature of its operations, its products and/or services, the methods by which
sales are made, the market for the products and/or services, the competitive landscape, and
other factors that may affect the outcome of the investment. While due diligence
investigations are viewed by many as mundane and irritating tasks, the process enables
venture capitalists to address areas of concern, is an important tool in determining a fair pre-
investment valuation, and may help to avoid significant and otherwise unexpected liability
following the investment.

The venture capitalists view the due diligence process as a means of identifying and
becoming comfortable with the risks to which their capital will be exposed. The due
diligence process involves an assessment of both the microeconomic and macroeconomic
factors that can affect the earnings growth of the target company. The due diligence process
also includes a review of the corporate and legal records, including the documentation
supporting any previous issuances of the company's securities.

- 24 -
Venture Capital Funds: A Study

Only one or two business plans in 100 result in successful financing. And of every 10
investments made, only one or two are successful. But this is enough to recover investments
made by the venture capital (VC) in all 10 start-ups in addition to an average 40-50% return!
Securing an investment from an institutional venture capital fund is extremely difficult. It is
estimated that only five business plans in 100 are viable investment opportunities and only
three in 100 results in successful financing. In fact, the odds could be as low as one in 100.
More than half of the proposals to venture capitalists are usually rejected after a 20-30
minute scanning, and 25 per cent are discarded after a lengthier review. The remaining 15 per
cent are looked at in more detail, but at least 10 per cent of these are dismissed due to
irreconcilable flaws in the management team or the business plan.

A Venture Capitalist looks at various aspects before investing in any venture. First, you need
to work out a business plan. The business plan is a document that outlines the management
team, product, marketing plan, capital costs and means of financing and profitability
statements.

1. Initial Evaluation: This involves the initial process of assessing the feasibility of the
project.

2. Due diligence: In this stage an in-depth study is conducted to analyse the feasibility of the
project.

3. Deal structuring and negotiation: Having established the feasibility, the instruments that
give the required return are structured.

4. Investment valuation: In this stage, final amount for deal is decided.

5. Documentation: This is the process of creating and executing legal documents to protect
the interest of the venture.

6. 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.

7. Exit Policies: There are mainly 3 exit policies followed by VCF’s in general.

- 25 -
Venture Capital Funds: A Study

1. Initial Evaluation:

Before any in depth analysis is done on a project, 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

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 the company and factors affecting it significantly
• Advantages from the deal for the venture capitalist
• Exit options available

2. Due diligence

Due diligence is term used that includes all the activities that are associated with
investigating an investment proposal to assess feasibility. It includes carrying out in-depth
reference checks on the proposal related aspects such as management team, products,
technology and market. Additional studies and collection of project-based data are done
during this stage. The important feature to note is that venture capital due diligence focuses
on the qualitative aspects of an investment opportunity.

- 26 -
Venture Capital Funds: A Study

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 labour

 Recruitment process

• Products/services, technology and process

In this category the type of questions asked will depend on the nature of the industry into
which the company is planning to enter. Some of the areas generally considered are

- 27 -
Venture Capital Funds: A Study

 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

• Market

The questions asked under this head also vary depending on the type of product. Some of the
main questions asked are

 main customers

 future demand for the product

 competitors in the market for the same product category and their strategy

 pricing strategy

 supplier and buyer bargaining power

 channels of distribution

 marketing plan to be followed

 future sales forecasts

- 28 -
Venture Capital Funds: A Study

Market survey could be conducted to gather further more accurate and relevant data.

• 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.

3. Structuring a deal

Structuring refers to putting together the financial aspects of the deal and negotiating with the
entrepreneurs to accept a venture capital’s proposal and finally closing the deal. Also the
structure should take into consideration the various commercial issues (ie what the
entrepreneur wants and what the venture capital would require to protect the investment).

- 29 -
Venture Capital Funds: A Study

The instruments to be used in structuring deals are many and varied. The objective in
selecting the instrument would be to maximize (or optimize) venture capital’s
returns/protection and yet satisfy the entrepreneur’s requirements. The instruments could be
as follows:

Instrument Issues
Equity shares new or vendor shares

par value

partially-paid shares
Preference shares redeemable (conditions under Company Act)

participating

par value

nominal shares
Loan clean vs secured

Interest bearing vs non interest bearing

convertible vs one with features (warrants)

1st Charge, 2nd Charge,

loan vs loan stock

maturity
Warrants exercise price, expiry period
Options exercise price, expiry period, call, put

In India, straight equity and convertibles are popular and commonly used. Nowadays,
warrants are issued as a tool to bring down pricing.

- 30 -
Venture Capital Funds: A Study

A variation that was first used by PACT and TDICI was "royalty on sales". Under this, the
company was given a conditional loan. If the project was successful, the company had to pay
a percentage of sales as royalty and if it failed then the amount was written off.

In structuring a deal, it is important to listen to what the entrepreneur wants, but the venture
capital comes up with his own solution. Even for the proposed investment amount, the
venture capital decides whether or not the amount requested, is appropriate and consistent
with the risk level of the investment. The risks should be analyzed, taking into consideration
the stage at which the company is in and other factors relating to the project. (eg exit
problems, etc).

A typical proposal may include a combination of several different instruments listed above.
Under normal circumstances, entrepreneurs would prefer venture capitals to invest in equity
as this would be the lowest risk option for the company. However from the venture capitals
point of view, the safest instrument, but with the least return, would be a secured loan.
Hence, ultimately, what you end up with would be some instruments in between which are
sold to the entrepreneur. A number of factors affect the choice of instruments, such as -

Categories Factors influencing the choice of Instrument


Company specific Risk, current stage of operation, , expected profitability, future cash
flows, investment liquidity options
Promoter specific Current financial position of promoters, performance track-record,
willingness of promoters to dilute stake
Product/Project specific Future market potential, product life-cycle, gestation period
Macro environment Tax options on different instruments, legal framework, policies
adopted by competition

4. Investment valuation

- 31 -
Venture Capital Funds: A Study

The investment valuation process is an exercise aimed at arriving at ‘an acceptable price’ for
the deal. Typically in countries where free pricing regimes exist, the valuation process goes
through the following steps:

1. Evaluate future revenue and profitability

2. Forecast likely future value of the firm based on experienced market capitalization or
expected acquisition proceeds depending upon the anticipated exit from the investment.

3. Target ownership positions in the investee firm so as to achieve desired appreciation on the
proposed investment. The appreciation desired should yield a hurdle rate of return on a
Discounted Cash Flow basis.

In certainty the valuation of the firm is driven by a number of factors. The more significant
among these are:

• Overall economic conditions: A buoyant economy produces an optimistic long- term


outlook for new products/services and therefore results in more liberal pre-money valuations.

• Demand and supply of capital: when there is a surplus of venture capital of venture capital
chasing a relatively limited number of venture capital deals, valuations go up. This can result
in unhealthy levels of low returns for venture capital investors.

• Specific rates of deals: such as the founder’s/management team’s track record, innovation/
unique selling propositions (USPs), the product/service size of the potential market, etc
affects valuations in an obvious manner.

• The degree of popularity of the industry/technology in question also influences the pre-
money. Computer Aided Skills Software Engineering (CASE) tools and Artificial
Intelligence were one time darlings of the venture capital community that have now given
place to biotech and retailing.

- 32 -
Venture Capital Funds: A Study

• The standing of the individual venture capital Well established venture capitals who are
sought after by entrepreneurs for a number of reasons could get away with tighter valuations
than their less known counterparts.

• Investor’s considerations could vary significantly. A study by an American venture capital,


Venture One, revealed the following trend. Large corporations who invest for strategic
advantages such as access to technologies, products or markets pay twice as much as a
professional venture capital investor, for a given ownership position in a company but only
half as much as investors in a public offering.

• Valuation offered on comparable deals around the time of investing in the deal.

5. Documentation

It is the process of creating and executing legal agreements that are needed by the venture
fund for guarding of investment.

Based on the type of instrument used the different types of agreements are

• Equity Agreement
• Income Note Agreement
• Conditional Loan Agreement
• Optionally Convertible Debenture Agreement etc.

There are also different agreements based on whether the agreement is with the promoters or
the company. The different legal documents that are to be created and executed by the
venture firm are

 Shareholders agreement - This agreement is made between the venture capitalist, the
company and the promoters. The agreement takes into account

 Capital structure

- 33 -
Venture Capital Funds: A Study

 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.

 Appointment of Board of Directors

 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

 Number of shares to be subscribed by the venture capitalist

 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.

- 34 -
Venture Capital Funds: A Study

 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.

6. 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.

- 35 -
Venture Capital Funds: A Study

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 awe entitled to obtain on a regular basis information
about the assisted projects.

Venture capital target companies with superior products or services focussed at fast-
growing or untapped markets. Venture capitalists must be confident that the firm has
the quality and depth in the management team to achieve its aspirations. They will
want to ensure that the investee company has the willingness to adopt modern
corporate governance standards.

Firms strong in factors relating to patents, management, idea, and potential are more likely to
obtain VC financing and willing partners to support commercialisation activities.

7. EXIT strategies adopted by VCF’s:

A venture capital firm enters a relationship with a company with the expectation that a
significant return of investment will result when the firm exits the investment. The firm plans
for that exit to take place within a certain amount of time, usually from three to six years,
depending on the development stage of the company in which it is investing.

Depending on the investment focus and strategy of the venture firm, it will seek to exit the
investment in the portfolio company. While the initial public offering may be the most
glamorous and heralded type of exit for the venture capitalist and owners of the company,
most successful exits of venture investments occur through a merger or acquisition of the
company by either the original founders or another company. Again, the expertise of the
venture firm in successfully exiting its investment will dictate the success of the exit for
themselves and the owner of the company.

- 36 -
Venture Capital Funds: A Study

There are several common exit strategies:

• IPO
• Mergers and Acquisitions
• Redemption

IPO

The initial public offering is the most glamorous and visible type of exit for a venture
investment. In recent years technology IPOs have been in the limelight during the IPO boom
of the last six years.

At public offering, the venture firm is considered an insider and will receive stock in the
company, but the firm is regulated and restricted in how that stock can be sold or liquidated
for several years. Once this stock is freely tradable, usually after about two years, the venture
fund will distribute this stock or cash to its limited partner investor who may then manage the
public stock as a regular stock holding or may liquidate it upon receipt. Over the last twenty-
five years, almost 3000 companies financed by venture funds have gone public.

Mergers and Acquisitions

Mergers and acquisitions represent the most common type of successful exit for venture
investments. In an era of large companies dominating industry landscapes, acquisition is
often the targeted and most common exit strategy. Smaller companies have, in essence,
become the research and development arm of larger companies who often look to buy them
once their innovations can contribute to their own profitability.

In the case of a merger or acquisition, the venture firm will receive stock or cash from the
acquiring company and the venture investor will distribute the proceeds from the sale to its
limited partners.

- 37 -
Venture Capital Funds: A Study

Redemption

Another alternative is that the company may be required to buy back a venture capital firm's
stock at cost plus a certain premium. Often a venture capital firm will put a redemption
clause (sometimes referred to as a "buy-back clause") in the investment terms which allows
them to exit their investment in your company in the event that an IPO or acquisition does
not happen within a designated time period.

2.2 Investment in Venture Capital by Banks

To encourage the flow of finance for venture capital commercial banks are allowed to invest
in venture capital without any limit since April 1999. The monetary and credit policy for the
year 1999-2000 provides that the overall ceiling of investment by banks in ordinary shares,
convertible debentures of corporate and units of mutual funds which is currently at 5 per cent
of their incremental deposits will stand automatically enhanced to the extent of banks’
investments in venture capital. Further, the Monetary and Credit Policy (1999-2000)
provides for the inclusion of investment in venture capital under priority sector lending.

2.3 Angels

Angels are people with less money orientation, but who play an active role in making an
early-stage company work. They are people with enough hands-on experience and are
experts in their fields. They understand the field from an operational perspective. An
entrepreneur needs this kind of expertise. He also needs money to make things happen.
Angels bring both to the table of an entrepreneur.

Angels are important links in the entire process of venture capital funding. This is because
they support a fledging enterprise at a very early stage – sometime even before
commercialization of the product or service offering. Typically, an angel is an experienced
industry-bred individual with high net worth.

Angels provide funding by "first round" financing for risky investments – risky because they
are a young /start-up company or because their financial track record is unstable. This

- 38 -
Venture Capital Funds: A Study

venture capital financing is typically used to prepare the company for "second round"
financing in the form of an initial public offering (IPO). Example – A company may need
"first round" financing to develop a new product line, (viz a new drug which would require
significant research & development funding) or make a strategic acquisition to achieve
certain levels of growth & stability.

It is important to choose the right Angel because they will sit on your Board of Directors,
often for the duration of their investment and will assist in getting "second round" financing.
When choosing an 'Angel', it is imperative to consider their experience in a relevant industry,
reputation, qualifications and track record.

Corporate Venturing

Even though corporate venturing is an attractive alternative, most companies find it difficult
to establish systems, capabilities and cultures that make good venture capital firms.
Corporate managers seldom have the same freedom to fund innovative projects or to cancel
them midstream. Their skills are honed for managing mature businesses and not nurturing
start up companies. If a firm is to apply the venture capital model, it must understand the
characteristics of the model and tailor its venture capital program to its own circumstances
without losing sight of these essentials.

Success of venture capital firms rest on the following characteristics:

Focus on specific industry niches

• Although corporate managers have a clear focus in their business, they run into ambiguity
with venture programs. Their biggest challenge is to establish clear, prioritized objectives.
Simply making a good financial return is not sufficient.

• Manage portfolios ruthlessly; abandon losers, whereas abandoning ventures has never been
easy for large corporations, whose projects are underpinned by personal relationships,
political concerns.

- 39 -
Venture Capital Funds: A Study

• Venture capital firms share several attributes with start up they fund. They tend to be small,
flexible and quick to make decisions. They have flat hierarchies and rely heavily on equity
and incentive pay.

Apple Computers established a venture fund in 1986 with the dual objectives of earning high
financial return and supporting development of Macintosh software. They structured
compensation mechanisms, decision criteria and operating procedures on those of top venture
capital firms. While they considered Macintosh as an initial screening factor, its funding
decisions were aimed at optimizing financial returns. The result was an IRR of 90 per cent
but little success in improving the position of Macintosh.

New ventures can be powerful source of revenues, diversification and flexibility in rapidly
changing environments. The company should create an environment that encourages
venturing. An innovative culture cannot be transplanted but must evolve within the company.
Venture investing requires different mindset from typical corporate investors.

How relevant is corporate venturing in the Indian scenario?

The firms, which launched the successful corporate ventures had created new products in the
market operating at the higher end of the value chain and had attained a certain size in the
market. Most Indian companies are yet to move up the value chain and consolidate their
position as players in the global market. Corporate venturing models would probably benefit
Indian companies who are large players in the Indian market in another five to 10 years by
enabling them to diversify and at the same time help start up companies. Multinationals led
by Intel are the best examples of corporate venturing in an Indian context.

Consortium Financing

Where the project cost is high (Rs 100 million or more) and a single fund is not in a position
to provide the entire venture capital required then venture funds may act in consortium with
other funds and take a lead in making investment decisions. This helps in diversifying risk
but however it has not been very successful in the India case.

- 40 -
Venture Capital Funds: A Study

In 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 Rs50bn, according to industry estimates!

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 Rs14.24bn. 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.

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

• 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

2.6 Favourites of the Investors

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.

- 41 -
Venture Capital Funds: A Study

However, recent developments have shown that India is maturing into a more developed
marketplace; 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
Rs1.5bn (up from Rs40mn today).

2.7 Promotion Strategies

There is inadequate flow of applications for venture financing in India. The need is
promotional efforts not only to increase the flow of applications but also to popularize the
generic idea of venture financing. The promotion efforts of venture capital funds in India
could be classified as

- 42 -
Venture Capital Funds: A Study

• Contacting R&D organisations


• Conducting seminars and industrial meets where the salient features of venture capital
schemes can be presented to prospective entrepreneurs
• Creation of information services
• Promotion of entrepreneurial activities
• Venture Fairs in which the members of the VC industry listen to entrepreneurs about
their new ideas and business propositions
• Venture Capital Networks and Associations

2.8 Incentives

Recognizing the importance of venture capital, the government introduced major


liberalisation of tax treatment for venture capital funds and simplification of procedures.
These included the following:

• SEBI was recognized as the single nodal agency.

• A new clause (23FB) in Section 10 of Income Tax Act was introduced with effect
from 1st March 2000. This clause stated that any income, of a venture capital
company or a venture capital fund, from any investments made in venture capital
undertaking, would not be included in computing the total income.

• Section 115U was also introduced in the Income Tax Act with effect from the
assessment year 2001-02 to establish a VC pass through. This means that the VC
profits will not be taxed twice. The regulated VC Fund (with SEBI) would be
exempted from tax (subject to certain conditions) but the VC investor will have to pay
tax.

- 43 -
Venture Capital Funds: A Study

• Earlier on, if a VCF wished to avail certain tax benefits, the VCF had to exit from
investments made in a venture capital undertaking (VCU) within twelve months of
the VCU obtaining a listing. However, this requirement was done away around
November 2000. The Finance Bill 2001, proposes to amend section 10 (23 FB) so as
to provide that a VCC / VCF will continue to be eligible for exemption under section
10 (23 FB), even if the shares of the VCU, in which the VCC / VCF has made the
initial investment, are subsequently listed in a recognized stock exchange in India.

2.9 Initiatives

There have been a number of initiatives by the Government as well as the industry to pave
way for a business and regulatory environment that is conducive to new venture development
and to innovation at the user end. Some of the initiatives in the past have included those by
the Ministry of Finance, the Securities, Exchange Board of India (SEBI), Ministry of
Information Technology (formerly Department of Electronics), State Governments, Financial
Institutions, the Indian Venture Capital Association. These initiatives resulted in the
availability of more than US$ 500 million of venture funds for Indian ventures during 1999-
2000. With the growing realisation of the immense potential offered by Indian technology
companies, funding opportunities are rapidly increasing.
The Government of India has already taken laudable steps to facilitate the creation of an
environment that is conducive for venture capital funds and start-ups in India. These include:

• introduction of sweat equity,


• allowing venture capital funds to offset losses incurred in one company against profits
from another and establishment of government facilitated venture capital funds.

However, the present regulatory framework is still not enough to provide for an environment
that lays stress on
• encouraging the flow of venture funds,
• easy exit options (for either party),

- 44 -
Venture Capital Funds: A Study

• mentoring,
• non-qualified availability of funds,
• and flow of public funds for enterprise building in India.
India needs to encourage the growth of risk capital by acting on three fronts:

1. The Government of India and Indian financial institutions should catalyse the process
by creating Israel's Yozma-like funds. This will stimulate competition but also protect
entrepreneurs from inevitable risks.
2. India should amend its regulatory framework so that the VC funds can earn a
reasonable return on their risk capital.
3. India should actively promote the infusion of VC skills and capabilities, either by
attracting global VC funds or attracting managers from these funds.

However, the above moves need to be substantiated with the earliest implementation of the
recommendations of the SEBI Committee on Venture Capital.

- 45 -
Venture Capital Funds: A Study

2.10 SPECIAL PURPOSE VEHICLE

The Definition
An account, administered by a third party that holds shares bought back by the management

in trust.

THE ADVANTAGES THE DISADVANTAGES

Greater security for lenders Less control over cash flows generated by project

improves credit rating


Lowers the cost of capital Tax treatment of SPV still unclear

Better management of debt repayment Administration fees can be high

Enables new ventures to raise funds. Requires intensive monitoring by trustee

- 46 -
Venture Capital Funds: A Study

Chapter – 4
Venture Capitalist – A key player

4.1 Role of Venture Capitalist

4.2 Difference between VC and money


managers/bankers.

- 47 -
Venture Capital Funds: A Study

VENTURE CAPITALISTS – A key player

4.1 Role of venture Capitalists

Conventional financing generally extends loans to companies, while VC financing invests in


equity of the company. Conventional financing looks to current income i.e. dividend and
interest, while in VC financing returns are by way of capital appreciation. Assessment in
conventional financing is conservative i.e. lower the risk, higher the chances of getting loan.
On the other hand VC financing is a risk taking finance where potential returns outweigh risk
factors.

Venture Capitalists also lend management support and provide entrepreneurs with many
other facilities. They even participate in the management process. VCs generally invest in
unlisted companies and make profit only after the company obtains listing. VCs extend need
based support in a number of stages of investments unlike single round financing by
conventional financiers. VC’s are in for long run and rarely exit before 3 years. To sustain
such commitment VC and private equity groups seek extremely high returns… a return of
30% in rupee terms. A bank or an FI will fund a project as long as it is sure that enough cash
flow will be generated to repay the loans. VC is not a lender but an equity partner.

Venture capitalists take higher risks by investing in an early-stage company with little or no
history, and they expect a higher return for their high-risk equity investment. Internationally,
VCs look at an internal rate of return (IRR) north of 40% plus. In India, the ideal benchmark
is in the region of an IRR of 25% for general funds and more than 30% for IT-specific funds.
With respect to investing in a business, institutional venture capitalists look for average
returns of at least 40 per cent to 50 per cent for start-up funding. Second and later stage
funding usually requires at least a 20 per cent to 40 per cent return compounded per annum.
Most firms require large portions of equity in exchange for start-up financing.

The VC Philosophy
As against Bought out deals (BODs), VCs carry out very detailed due diligence and make 2-7
year investments. The VCs also hand-hold and nurture the companies they invest in besides

- 48 -
Venture Capital Funds: A Study

helping them reach IPO stage when valuations are favourable. VCFs help entrepreneurs at
four stages: idea generation, start-up, ramp-up and finally in the exit.
According to Indian Venture Capital Association, almost 41% (Rs 5146.40 m) of the total
venture capital investment is in start-up projects followed by Rs 4478.60 m in later stage
projects and only Rs 82.95 in turnaround projects . Majority have invested in only three
stages of investment, indicating that most VCs in India have not started developing niches for
investing with regard to the stages of projects.

The main difficulty in early stage funding are related to lack of exit opportunities as
probability of an IPO or buy out by of VC stake is less due to lack of understanding for
evaluation of the knowledge based companies compared to the companies in the traditional
sectors. Some such VCs are: ICICI ventures, Draper, SIDBI and Angels. Apart from finance,
venture capitalists provide networking, management and marketing support as well. The
venture capitalist is a business partner, sharing the risks and rewards and provides strategic,
operational and financial advice to the company based on experience with other companies in
similar situations.

- 49 -
Venture Capital Funds: A Study

Management of investee firms

The venture funds add value to the company by active involvement in running of enterprises
in which they invest. This is called "hands on" or "pro-active" approach. Draper falls in this
category. Incubator funds like e-ventures also have a similar approach towards their
investment. However there can be "hands off" approach like that of 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.

4.2 Difference between a venture capitalist and bankers/money managers

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

• Obtain bank and other debt financing

• Access to international markets and technology

• Introduction to strategic partners and acquisition targets in the region

- 50 -
Venture Capital Funds: A Study

• Regional expansion of manufacturing and marketing operations

• Obtain a public listing

Differences

Points Venture Finance Debt Finance


Objective Maximize return Interest payment

Holding period 2-5 years Short/long term

Instruments Common shares, convertible bonds,Loan, factoring, leasing


options, warrants
Pricing Price earnings ratio, net tangible assets Interest spread

Collateral Very rare Yes

Ownership Yes No

Control Minority shareholders, rights protection,Covenants


board members
Impact on Balance sheetReduced leverage Increased leverage
of financed

Exit Mechanism Public offering, sale to third party, sale toLoan repayment
entrepreneur

- 51 -
Venture Capital Funds: A Study

Chapter – 5

Pro’s and Quo’s of VCF

5.1 Success factors

5.2 Critical factor


5.3 Problems faces by VCF

- 52 -
Venture Capital Funds: A Study

5.1 Success factors of VCFs

1. Industry-specific concentration of investments yields better returns than geographically


concentrated investments.

2. Networking with industrial partners is important since these target companies are potential
clients and exit partners.

3. Networking with universities and research institutes helps identify new technologies and
investment targets.

4. Concentrating investments in carefully selected companies showing international promise


will yield better returns than distributing the capital across several smaller investments. It
is crucial that venture capitalists actively support the growth and internationalisation of the
companies through their industry-specific know-how and international contacts.

5. With respect to the returns from the fund, it is vital that adequate capital is reserved for
further investment in the best investment targets and for maintaining the holdings until the
exit.

6. Joint investments with partners providing added value contribute to the success of the
target companies and improve the returns from the fund.

- 53 -
Venture Capital Funds: A Study

5.2 Critical Factors

In 1999, SEBI (Securities and Exchange Board of India) had set up a committee under the
Chairmanship of Mr. K. B. Chandrasekhar to look into the issues of venture capital in India.
The Report of the K. B. Chandrasekhar Committee on venture capital identified the
following as critical factors for the success of VC industry in India:

• The regulatory, tax and legal environment should play an enabling role. This
emphasizes the facilitating and promotional role of regulation. Internationally,
venture funds have evolved in an atmosphere of structural flexibility, fiscal neutrality
and operational adaptability. And we need to provide regulatory simplicity and
structural flexibility on the same lines. There is also the need for a level playing field
between domestic and offshore venture capital investors. This has already been done
for the mutual fund industry in India.

• Investment, management and an exit option should provide flexibility to suit the
business requirements and should also be driven by global trends. Venture capital
investments have typically come from high net worth individuals who have risk
taking capacity. Since high risk is involved in venture financing, venture investors
globally seek investment and exit on very flexible terms, which provides them with
certain levels of protection. Such exit should be possible through IPOs and mergers /
acquisitions on a global basis and not just within India.

• There is also the need for identifying and increasing the domestic pool of funds for
venture capital investment. In US, apart from high net worth individuals and angel
investors, pension funds, insurance funds, mutual funds etc. provide a very big source
of money. The share of corporate funding is also increasing and it was as high as 25.9
percent in the year 1998 as compared to 2 percent in 1995. Corporations are also
setting up their own venture capital funds. Similar avenues need to be identified in
India also.

- 54 -
Venture Capital Funds: A Study

• With increasing global integration and mobility of capital it is important that Indian
venture capital firms as well as venture financed enterprises be able to have
opportunities for investment abroad. This would not only enhance their ability to
generate better returns but also add to their experience and expertise to function
successfully in a global environment. We need our enterprises to become global and
create their own success stories. Therefore, automatic, transparent and flexible norms
need to be created for such investments by domestic firms and enterprises.

• Venture capital should become an institutionalised industry financed and managed by


successful entrepreneurs, professional and sophisticated investors. Globally, venture
capitalists are not merely finance providers but are also closely involved with the
investee enterprises and provide expertise by way of management and marketing
support. This industry has developed its own ethos and culture. Venture capital has
only one common aspect that cuts across geography i.e. it is risk capital invested by
experts in the field. It is important that venture capital in India be allowed to develop
via professional and institutional management

• Infrastructure development also needs to be prioritised using government support and


private management. This involves creation of technology as well as knowledge
incubators for supporting innovation and ideas. R&D also needs to be promoted by
government as well as other organisations.

The above report was well received by the Government and few issues have already been
resolved.

- 55 -
Venture Capital Funds: A Study

5.3 Problems generally associated with Venture Capital

1. The risk associated with true venture capital is greater than when providing capital to an
established business. Despite the best efforts and intentions, some start-ups will not succeed.
That is simply part of the game. In today's market, though, especially if dealing with highly
leveraged corporations, we have seen there is substantial risk associated with well established
businesses as well as with start-ups. The risk is different, though, and people providing true
venture capital recognizes this risk-reward trade-off.

2. Most investors have an unrealistic view of venture capital. They expect the high returns
publicized with respect to successful new ventures but do not want to take the attendant risk.
Consequently, such investors go into the marketplace looking for opportunities, claiming to
offer venture capital, but never finding an investment that meets their requirements.

3. Most venture fund managers come from banking, professional money management or
corporate management; while some come directly from business school and have been
employees of venture capital firms for their entire career. Consequently, the vast majority of
venture capital company employees - at any level - have no actual "venture" or
entrepreneurial experience, particularly with start-ups. A lack of experience and
understanding translates into a lack of comfort with the creation phase of a business and a
reluctance to invest in such deals.

4. Entrepreneurs, in general, have different goals, motivations and personalities than bankers
or corporate executives, who may expect to see people like themselves as clients. These
differences can often create a gap between the venture capitalist and the entrepreneur
sufficient to result in a rejection of the business proposal irrespective of the merits of the
business.

5. The principal source of capital for most entrepreneurs is friends and family. Once that
source runs out (if it exists at all), venture capital companies may be the only alternative to
obtain funding which, most likely, are small or insufficient in comparison to the cost of, for
instance, building a factory or buying a profitable going concern. Few venture capital

- 56 -
Venture Capital Funds: A Study

companies want to spend the time evaluating small deals when, within the constraints of their
investing limits and in the same amount of time, they could participate in fewer but larger
deals.

6. Three key elements to a successful new venture are (not in order of priority): a good idea,
adequate capital and good management. A failure of any one of these elements can doom the
enterprise. Due primarily to a lack of experience in the creation or start-up phase, venture
capital companies are often lacking in their ability to evaluate and recognize:

(a) a "good idea" because ideas and the projections associated with them are so intangible,
unlike - so they think - the projections of an established company;

(b) "adequate capital" for a start-up because traditional venture capital companies may not
have the experience to understand whether the entrepreneur's goals can be achieved with the
capital requested or to help the entrepreneur determine the appropriate capital requirements
for a start-up;

(c) the presence or absence of adequate entrepreneurial management, which can be different
than that of a large established corporation; a good example of which was the changing need
of Apple Computers when it replaced Steven Jobs with John Sculley.

7. Despite the fact that many fund managers will say that inadequate management is the
primary reason for business failure, they will rarely devote time to assist management to help
achieve a greater likelihood of success. Consequently, some investments are destined to fail
from the start; and many firms use everyone else's failures as a reason for them to avoid start-
ups.

8. Many companies and individuals complain that they have money to invest in "good"
projects, but none can be found. First, what is "good" for one person or firm may not be
"good" for another. That definition is guided by goals and requirements of the individual
investor. An older investor may be looking for income while a younger investor may be
looking for appreciation. Often, those goals are unrealistic as applied to venture capital.

- 57 -
Venture Capital Funds: A Study

Chapter-6

Case Studies

6.1 Case study-1


6.2 Case study-2
6.3 Case study-3

- 58 -
Venture Capital Funds: A Study

Case Studies

6.1 Case Study-1: Rise of UK economy

The economic impact of private equity and venture capital on the UK: Keeping London and
the UK the centre of the European industry

Private Equity and venture capital makes a valuable contribution to the economy generally
by having a positive effect on the companies in which private equity is invested. In addition,
the industry makes a very significant contribution to the financial services industry and in
particular plays an important role in maintaining the City of London as Europe's premier
financial centre and helping to build it as the world's premier financial centre.

The industry has shown incredible growth over the last few years, both in terms of the funds
it has raised and the capital it manages and in the level of investment that is made, with
growth comes responsibility as well as opportunity. The growth of the industry has increased
its profile and with that profile comes a legitimate interest in what the industry is doing from
the public, the press and of course the regulatory authorities.

The industry is currently facing two major reviews - by the FSA in the Discussion paper they
recently published and by the Treasury focusing on the taxation, not just of capital gains
made by the industry, but also the capital gains made by the risk-taking entrepreneurs and
management team that as an industry VCF back.

Achieving the right outcome for the industry from the tax review and continuing to ensure
regulation is appropriate and not burdensome are two vital tasks the British Venture Capital
Association (BVCA) and the industry faces.

The BVCA and its work

The BVCA is the industry body that represents the UK private equity and venture capital
industry.

- 59 -
Venture Capital Funds: A Study

Private equity means the equity financing of companies at many stages in the life of a
company from start-up through expansion all the way through to buy-outs of established
companies that in today's world can be very significant and large transactions.

Venture capital as a term typically covers early stages of start-up or growth funding or
expansion capital. The term buy-outs (MBO, MBI, etc) refers to using - private equity to
finance the change in ownership of a company.

The common threads - and hence the term private equity - is that the investments made in
unquoted equity (i.e. not publicly quoted equity) and into companies that have real growth
potential which can be turned around or transformed under private equity ownership as
opposed to being constantly in the spotlight that having a quoted share price means for a
public company.

The BVCA represents the whole cross section of the private equity industry in the UK - from
small seed stage venture funds all the way through to the large private equity firms who focus
almost exclusively on buy-outs and who are almost becoming household names today.

BVCA membership comprises well over 90% of all UK-based private equity and venture
capital funds and their advisors.

The role of the BVCA is to ensure that the UK industry is properly represented to politicians
and policy makers here at Westminster, across the UK and in Brussels.

The industry's economic impact

The survey shows once again that private equity-backed companies are a significant driver in
the UK economy and its global competitiveness.

Key findings of this report show once again that in the five years to 2005/2006:

• The growth of employment in private equity-backed companies was faster than both FTSE
100 and FTSE 250 companies (9% pa vs 1% and 2% respectively)

- 60 -
Venture Capital Funds: A Study

• Sales grew faster in private equity-backed companies compared with FTSE 100 and 250
companies (9% vs. 7% and 5%)

• Exports from private equity-backed companies grew at a faster rate than the national
growth rate (6% vs. 2%)

• Investment grew faster than the national average (18% vs 1%)

It is now well established that the performance of private equity-backed companies


significantly strengthens the UK economy and improves international competitiveness and
creates jobs at a considerably faster rate than other private sector companies. It is now
estimated that companies that have received private equity funding account for the
employment of around 2.8 million people in the UK, equivalent to 19% of UK private sector
employees.

It is also significant to note that 92% of companies that responded to the survey said that
without private equity the business would not have existed at all or would have developed
less rapidly.

The reason for this is that private equity investment is more than just the provision of capital.
Respondents to the survey noted that strategic direction, financial advice and help with
contacts were key ways in which private equity firms had helped with the development of
their businesses.

It is estimated that companies which have been private equity-backed generated total sales of
£424 billion, exports of £48 billion and contributed over £26 billion in taxes.

The figures in the Economic Impact Survey demonstrate clearly that private equity-backed
businesses are active across all regions of the UK and are valuable contributors to the wealth
of these regions.

- 61 -
Venture Capital Funds: A Study

The impact of the private equity industry as a UK financial service

The UK private equity industry is playing an increasingly significant role as a source of


revenue for firms operating within the broader financial and professional services industry,
contributing to the overall impetus that these industries provide to the UK economy.

2005 data shows that:

• Private equity-related activities generated estimated fee revenue for financial and
professional services firms of over £3.3 billion, representing around 7% of the total annual
turnover of the UK financial services industry.

• There are more than 5,500 individuals (3,500 of which are investment professionals)
employed in some 260 private equity, venture capital, funds-of-funds and secondaries
investment firms in the UK.

• The UK has a network of around 750 financial, professional and business services firms
providing advisory and financial support to private equity and venture capital firms. They
employ a full time equivalent pool of close to 6,700 executives engaged in private equity-
related activities.

• Taken together, there are over 10,000 highly skilled professionals employed across over
1,000 firms engaged either directly or indirectly in private equity-related activities.

• For every private equity executive investing directly in UK companies, there are 2.3 full
time equivalent advisors or finance executives providing specialist advice and services.

• Financial, professional and other business services executives working on private equity-
related mandates in 2005 generated an average of £500,000 per head in fees.

• Private equity-backed transactions account for a significant proportion of total M&A


activity in the UK with almost 30% of all UK investment banking fees from M&A and
loan financing being derived from private equity backed transactions in 2005.

- 62 -
Venture Capital Funds: A Study

• The UK private equity industry has long attracted capital investment from outside its own
shores, with almost £50 billion of foreign investment into UK private equity funds over the
past six years.

• Furthermore, two-thirds of the total capital invested by UK firms over the same period was
committed to companies within the UK, demonstrating a positive net inflow of capital into
the UK economy.

Investment activity

BVCA are an industry that invests across all sectors, from start-ups to buy-outs, all around
the UK, across continental Europe and around the world.

In 2005, UK private equity activity increased to its highest ever levels, in terms of funds
raised, private equity investments made and also divestments.

Here are a few key figures that illustrate the scale of what we do:

• Funds raised from investors reached £27.3 billion.

• 1,535 companies were financed.

• Worldwide investment by UK private equity firms increased by 21% in 2005 to £11.7


billion from £9.7 billion in 2004.

• Companies financed at start-up stage increased by 9% to 208.

By any measure, the UK private equity and venture capital industry is a UK success story.
And yet it is disappointing that despite the fact that the benefits of private equity as an asset
class are so clear that last year 80% of BVCA investors came from overseas, with 45%
coming from the US.

The primary objective of the private equity industry is to drive returns to its investors and
while it is a good thing that we can attract inward investment, it is a pity that the beneficiaries
of the capital gains created by this industry predominantly accrue to overseas investors.

- 63 -
Venture Capital Funds: A Study

UK private equity and venture capital industry is a good strong British success story.

Major investment attract into the UK from overseas, BVCA make major investment around
the UK investing in companies, creating jobs and building businesses, and they invest across
continental Europe and around the world bringing returns home for the benefit of their
investors. This industry has benefited from a strong cross Party consensus that understands
the important role BVCA play in keeping the UK economy competitive and dynamic. This
support is much appreciated.

Private equity investment should not be regarded as an end in itself, but rather as part of a life
cycle of a business. The private equity model brings together absolute alignment of interest
between investor and management.

This enables absolute focus on agreed purpose, the ability to achieve change swiftly and
efficiently and a complete concentration on the direction of the business.

- 64 -
Venture Capital Funds: A Study

6.2 Case Study- 2: Silicon Valley's success.

Venture capitalists supply the funds to budding entrepreneurs who want to start their own
companies - and 40% of such deals in the US take place in Silicon Valley.

Venture capitalists also help nurture those companies to success, supplying introductions to
potential customers or partners, assistance with raising more funds, and even management
support.

And venture capital has been one of the extraordinary growth industries in the Valley, with
the amount of money invested in venture capital funds rising in the decade from $1bn in
1990 to $20bn in 1999 - and nearly doubling again to $35bn in 2000.

Dot.com fall-out

Ann Winblad, founder of venture capital firm Hummer Winblad, with $1bn in funds under
management, was one of the victims of the dot.com fall-out.

Her company had backed one of the biggest and most well-known internet companies selling
to consumers, Pets.com, which stopped trading despite millions of dollars in private
investment and an enthusiastic stock market flotation.

In her sleek, wooden-beamed offices in San Francisco's newly fashionable SoMo district,
which has become a beacon for dot.com companies, she explained what went wrong.

In her view, the increasing frenzy in the stock market for internet companies - whatever their
business plan or chances of profitability - had meant that too many companies had been
funded and brought to the stock market too quickly.

Too many inexperienced people came into the venture capital marketplace, with financiers,
bankers, and big companies all prepared - even desperate - to back internet ventures.

Fund raising difficulties

- 65 -
Venture Capital Funds: A Study

At one point, she says, $1bn a week was being offered to entrepreneurs - attracting too many
people who were "mercenaries not missionaries" to the world of enterprise.

But when the market woke up, and dot.com and tech stocks crashed in April, it became
impossible for even well-managed internet companies to raise additional money. Pets.com
and other e-tailers needed more capital to grow - and that was no longer available at any
price.

Now, she says, it is unlikely that anyone would fund any internet company for at least the
next two years, and e-tailers, or dot.com companies selling to consumers, are the "mad cow
disease" of the venture capital world - no one will touch them at all.

And in future, the pace of investment will be slower and more measured, taking 3-5 years to
bring companies to the stage at which they can be floated on the stock market - and that
venture capitalists will resume their role of "company coach" rather than pure deal-makers.

Profit hopes dimmed

And now, one of the factors limiting the further expansion of venture capital firms is their
need to spend more time managing their existing portfolio - "tending to the sick and needy"
in the words of the chief of one dot.com that has survived, Obongo's John Hunt.

Mr Knoblauch says that in the height of the euphoria one year ago, venture capitalists began
to believe that they could make a profit on nearly any company they backed.

But now, they expect only about one in five of the companies they back to become a major
success - but those successes, with returns of 10-20 times investment, will still make the
whole fund profitable.

Vital role

Venture capitalists will still play a vital role as catalysts for Silicon Valley's future.

- 66 -
Venture Capital Funds: A Study

It was the presence of the world's most sophisticated venture capital industry that attracted
John Hunt of Obongo from the UK to San Francisco. Venture capitalists have played a
crucial part in launching his company, which provides the software for electronic wallets
used for shopping on the internet.

Obongo was created in the offices of venture capital firm Sequoia, who introduced the UK
based company, then called Smartport, to its Silicon Valley rival, Chabi - and they agreed to
merge with each other 30 minutes into the meeting.

Sunny outlook

And Obongo's other venture capital partner, Atlas, played a central role in helping them
secure their first customer, the large US bank Citibank. It is networks like these which will
secure the future of the Valley, according to historian and city planner Anna Lee Saxenian.
Nowhere else have venture capitalists such a close connection with their industry, she argues,
with most moving from being entrepreneurs themselves. Their understanding of the
technology, the markets, and the competition means that entrepreneurial knowledge is shared
and is transferred more quickly here than anywhere else.

It is that culture that will ensure that, despite the sharp change in market sentiment, Silicon
Valley will remain the world's high-tech incubator.

- 67 -
Venture Capital Funds: A Study

Case Study-3: Failure of Analog Devices Enterprises

In 1980, Analog Devices established a corporate venture program, Analog Devices


Enterprises (ADE), to generate both attractive financial returns and strategic benefits in the
form of licensing agreements and acquisitions. Funding was provided by Amoco, and ADE
had invested $26 million in 11 firms by 1985.

That very year Amoco ceased contributing capital, and the ADE program was suspended.
Around this time, Analog Devices took a $7 million charge against earnings; in 1990, with
most of the portfolio liquidated, it took another $12 million charge. Of the 11 firms in ADE’s
portfolio, 10 were terminated, acquired by other companies at unattractive valuations, or
relegated to the "living dead." Only one firm ultimately went public. In this case, ADE’s
stake was so diluted by a merger that it was worth only about $2 million at the time of the
offering.

What went wrong? Clearly, the ADE program exhibits all three of the classic structural
failings:

1. Program managers were hampered by the lack of a clear objective. Instead, they had a
threefold mission: to invest in firms pursuing technologies relevant to the ongoing business
of Analog Devices and Amoco, to obtain options to acquire firms of interest to Analog’s
management, and to generate high financial returns.

2. Analog Devices’ researchers, seeing scarce resources being devoted to ADE, resented the
program. Also, Amoco only committed to fund the program for five years, considerably less
time than was needed to grow the early-stage companies.

3. Incentives of the various parties appear to have been improperly aligned. The management
of Analog Ventures believed that they were insufficiently rewarded, and Amoco did not
share in the profits generated.

- 68 -
Venture Capital Funds: A Study

Chapter - 7
SURVEY AND CONCLUSION

 Survey:
For getting about practical knowledge of working of VCFs, survey was conducted in 3 firms
namely SIDBI (Small Industrial Development Bank of India), JM Equity Fund, IDFC Equity
Fund. Following questions were asked and some of the answers given were:

1) What do VCF looks for in evaluating a new company? Most critical element VCF
looks for.
A- Business potential, Company background, core plan, Promoter details.
B- Growth, management, value, Business model, valuation expectation, return expected.
C- Promoter – very careful, understanding, profile and background.
Interpretation- VCF looks for good profile and background of promoter, business
potential and management for evaluating in a new company.

2) How is business plan presented?


A - Presentation, calling, executive, e-mail, advisors.
B – Presentation, Financial model, mgmt meeting, matter of convenience to both
Promoter and VCF.
C – Based on business plan and industry in relation to its growth, potential, growth,
returns. Presentation is done in front of Investment banker (middleman between VCF and
Promoter).
Interpretation- Business plan is presented through various ways like presentation,
financial model, etc. whichever is more convenient for both parties.

3) How do VCFs define their contribution?


A- By providing facilities through schemes like Started Investment and Smart Money.
B- Best practices, Advice for approaching to financial market, etc.

- 69 -
Venture Capital Funds: A Study

C- Appointment, issues, tie ups with government, tie up with portfolio company,
equipments, training, venturing in new areas, broader view and thinking.
Interpretation- VCFs defines their contributions by showing the Promoters correct way
for taking appropriate steps.

4) What are the milestones in achieving whether the company will achieve their goal?
A – Milestones are laid down during agreement in top line and bottom line revenue. Term
sheet documentation is signed by promoter.
B – Through companies profit numbers and total sales.
C – All the milestones are noted down in shareholder’s agreement.
Interpretation- The landmarks are decided by the VCFs and Promoter during signing of
agreement between them.

5) What are the major trends in VCF industry?


A – Latest trend is interest in Bio-tech sector.
B – Upcoming sectors like Logistics, BPO, Financial Services, Real Estate.
C – All upcoming sectors especially Transport and Logistics.
Interpretation- The trends in VCFs industry depends upon type of firms, as all of them
have interests in different sectors for financing.

6) What companies in VCF might make interesting investments.


A - Depends upon the sector which is booming at that time.
B – Same as above said sectors.
C – The best sector in today’s scenario is IT sector which will be backbone for economy.
Interpretation- The companies themselves shows as interested investing sectors to VCFs
by their performance.

7) How long does it take to make investment or participation decision?


A – Taken after a long procedure of investigation gets over from 6-8 weeks.
B – It takes 10 days sometimes and also get extent up to 3-4 months.

- 70 -
Venture Capital Funds: A Study

C – Lengthy process as investigation about promoter is done. Then too it takes 3-5
months.
Interpretation- Time taken by VCFs for investment decision is from 10 days till 3-4
months. It also sometime extents till 6 months.

8) Critical features of an agreement between VCF and Promoter.


A – Exit options, Right to appoint a BOD, Internal Auditor, Projects. Even main steps
taken by promoter should be consulted by VCF.
B – Liquidity event, seat in BOD, Minority protection rights, big decisions to be
consulted.
C – Rights and Obligations of Promoter, Board seat, Rights to see committee, Veto Right.
Interpretation- The most critical features are selecting exit options, rights and obligations
of venture capitalists, and major decisions should be consulted with VCF.

9) Exit policies followed by VCFs.


A- IPO, Selling stake to 3rd party, Promoter’s buyback from VCF, Drag-along & Tag-
along.
B- Selling to strategic, Block deal, IPO.
C- IPO, Promoter’s buyback, Selling stake, Combination of promoter’s buyback and
selling stake.
Interpretation- There are 3 basic exit options been followed by VCFs all over the world.

10) Risk analysis.


A – Risk depends upon type of company, market, exit risk, proper investment done or
not, cultural risk, competition.
B – If valuation does not grow as per expectation then business plan fails.
C – Scenario building. Risk in terms of promoter, revenue, cost (as operating expenses).
Even on potential of promoter.
Interpretation- The risk analysis varies as per depending on the situation.

- 71 -
Venture Capital Funds: A Study

Note: As per the answers given for the following questions, A presents SIDBI, B presents
JM Equity Fund and C – IDFC Equity Funds. Interpretation is short conclusion of all
answers.

Conclusion:

Earlier patterns of growth or failure in venture capital industries in other countries and
regions indicate that the evolution of venture capital seems to be either entry into a self
reinforcing spiral, such as occurred in Silicon Valley and Israel, or growth and stagnation, as
occurred in Minnesota in the 1980s or the United Kingdom until recently. Given India’s wish
to develop a high-technology industry funded by venture capital, it is necessary to keep
improving the environment by simplifying the policy and regulatory structure (including
eliminating regulations that do not perform necessary functions such as consumer
protection).

The World Bank, with its agenda of decreasing government regulation, funded the creation
of the first venture capital funds. Though these funds experienced little success, they were the
beginnings of a process of legitimitizing venture investing and they were a training ground
for venture capitalists who later established private venture capital funds. It is unlikely that
the venture capital industry could have been successful without the development of the
software industry and a general liberalization of the economy. Of course, this is not entirely
surprising, because an institution as complicated as venture capital could not emerge without
a minimally supportive environment. This environment both permitted the evolution of the
venture capital industry and simultaneously allowed it to begin changing that environment
and initiating a co-evolutionary dynamic with other institutions.

India still remains a difficult environment for venture capital. Even in 2006 the Indian
government remains bureaucratic and highly regulated. To encourage the growth of venture
capital will require further action, and it is likely that the government will continue and even
accelerate its efforts to encourage venture capital investing. The role of the government
cannot be avoided: it must address tax, regulatory, legal, and currency exchange policies,

- 72 -
Venture Capital Funds: A Study

since many of these affect both venture capital firms and the companies that they finance.
More mechanisms need to be developed to reduce risk if funds for venture capital must come
from publicly held financial institutions managed by highly risk-averse managers. In short,
“VCF is next engine for economical growth for all countries in the World”.

- 73 -
Venture Capital Funds: A Study

Suggestions for growth of VCF:

Venture capital industry is at the take off stage in India. It can play a catalytic role in the
development of entrepreneurship skill that remains unexploited among the young and
energetic technocrats and other professionally qualified talents. It can help promote new
technology and hi-tech industries, which involve high risk but promises attractive rate of
return. In order to ensure success of venture capital in India, the following suggestions are
offered:

(i) Exemption/Concession for Capital Gains:


Capital gains law represents a hurdle to the success of venture capital financing. The
earnings of the funds depend primarily on the appreciation in stock values. Further, the
capital gains may arise only after 3 to 4 years, of investment and that the projects, being in
new risky areas, may not even succeed. Capital gains by corporate bodies in India are taxed
at a much investment risk and long gestation period this is a deterrent to the development of
VCFs.

The benefit of the capital gains, under section 48 of the Act is not significant. Hence, it
would be advisable that all long term capital gains earned by VCCs should be exempted
from tax or subject to concessional flat rate. Further, capital gains reinvested in new venture
should also be exempted from tax. Section 52(E) of the Act should be amended to give effect
to this.

(ii) Development of Stock Markets:


Guidelines issued by finance ministry provides for the sale of investment by way of public
issue at the price to be decided on the basis of book value and earning capacity. However,
this method may not give the best available prices to venture fund as it will not be able to
consider future growth potential of the invested company.

One of the major factors which contributed to the success of venture funds in the West is
development of secondary and tertiary stock markets. These markets do not have listing

- 74 -
Venture Capital Funds: A Study

requirements and are spread over all important cities and towns in the country. These stock
markets provide excellent disinvestments mechanism for venture funds. In India, however,
stock market is not developed beyond a few important cities.
Success of venture capital fund depends very much upon profitable disinvestments of the
capital contributed by it. In US and UK secondary and tertiary markets helped in
accomplishing the above. However, in India, promotion of such maker is not feasible in the
prevailing circumstances as such laissez faire policy may attack persons with ulterior motives
in the business to the determent of general public. However, stock market operation may be
started at man by more big cities where, say, the number of stock exchanges can be increased
to 50. Further, permission to transact in unlisted securities with suitable regulation will
ensure firsthand contact between venture fund and investors.

(iii) Fiscal Incentives:


Fiscal incentives may be given in the form of lowering the rate of income tax. It can be
accomplished by:
(i) Application of provisions applicable to non-corporate entities for taxing long term capital
gains.
(ii) An allowance to funds similar to section 80-CC of Income Tax Act, say 20 percent of the
investment in new venture which can be allowed as deduction from the income.

(iv) Private Sector Participation


In US and UK where the economy is dominated by private sector, development of venture
fund market was possible due to very significant role played by private sector which is often
willing to put money in high risk business provided higher returns are expected. The
guidelines by finance ministry provide that non- institutional promoter’s share in the capital
of venture fund cannot exceed 20 percent of total capital; further they cannot be the single
largest equity holders. The private sector, because of this provision, may not like to promote
venture fund business.

Promotion of venture funds by private sector, in addition to public financial institution and
banks, is recommended as:

- 75 -
Venture Capital Funds: A Study

Private sector is in advantageous position as compared to financial institutions and banks to


provide managerial support to new ventures as leading industrial house have a pool of
experienced professional managers in all fields of management viz. marketing, production
and finance. The leading business houses will be able to raise funds from the investing
public with relative ease.

(v) Review the Existing Laws


Today’s need is to review the constrains under various laws of the country and resolve the
issue that could come in the way of growth of the innovative mode of financing. Suitable
exemption should be given from Section 43 A of the companies Act to venture capital
finance companies so that they are not required to comply with several provisions of the Act
applicable to public limited companies.

Amendment of Section 77 of the Companies Act is required to enable the new venture
capital companies to buy back their shares at the time of disinvestments by VC Finance
Companies.

Ceiling on interoperate loans and investment as specified in Section 370 and 372 of the
companies Act should be relaxed in case of VC Finance Companies and Venture Capital
Companies to enable them to invest suitable in newly promoted companies. The only
investment available to the VC Finance company for investment is equity shares. This
restriction should be relaxed so that VC Finance Company can finance through preferential
issues and conditional loans. The scope of VC should not only be confirmed to start up
finance but also be broadened to development finance, expansion and growth, buyouts,
mergers and amalgamation. The restriction on investment of 80% of the entire funds within a
period of 3 years should be removed.

(vi) Limited Partnership


The Practice of the limited partnership as in vogue in UK should be permitted in order to
promote integration of object between the managers and contributors for the success of
venture capital projects.

- 76 -
Venture Capital Funds: A Study

Chapter – 8

Annexure

8.1 SEBI Guidelines and Regulations

8.2 Certificate of Registration

8.3 Tax Aspects

8.4 Investment conditions and restrictions

8.5 Indian Statistical Data

8.6 Report of IVCA

- 77 -
Venture Capital Funds: A Study

Annexure
8.1 SEBI Guidelines and Regulations:

In the absence of an organised Venture Capital industry till almost 1998, individual investors
and development financial institutions played the role of venture capitalists in India.
Entrepreneurs have largely depended upon private placements, public offerings and lending
by the financial institutions.

In 1973 a committee on Development of Small and Medium Enterprises highlighted the need
to foster venture capital as a source of funding new entrepreneurs and technology. Thereafter
some public sector funds were set up but the activity of venture capital did not gather
momentum as the thrust was on high-technology projects funded on a purely financial rather
than a holistic basis.

Later, a study was undertaken by the World Bank to examine the possibility of developing
Venture Capital in the private sector, based on which the Government of India took a policy
initiative and announced guidelines for Venture Capital Funds (VCFs) in India in 1988.

However, these guidelines restricted setting up of VCFs by the banks or the financial
institutions only. Thereafter, the Government of India issued guidelines in September 1995
for overseas investment in Venture Capital in India. For tax-exemption purposes, guidelines
were also issued by the Central Board of Direct Taxes (CBDT) and the investments and flow
of foreign currency into and out of India have been governed by the Reserve Bank of India's
(RBI) requirements. Further, as a part of its mandate to regulate and to develop the Indian
capital markets, the Securities and Exchange Board of India (SEBI) framed the SEBI
(Venture Capital Funds) Regulations, 1996. These guidelines were further amended in Apr
2000 with the objective of fuelling the growth of Venture Capital activities in India.

In the late 1990s, the Indian government became aware of the potential benefits of a healthy
venture capital sector. Thus in 1999 a number of new regulations were promulgated. Some of
the most significant of these related to liberalizing the regulations regarding the ability of

- 78 -
Venture Capital Funds: A Study

various financial institutions to invest in venture capital. Perhaps the most important of these
went into effect in April 1999 and allowed banks to invest up to 5 percent of their new funds
annually in venture capital.

The main statutes governing venture capital in India included the SEBI’s 1996 Venture
Capital Regulations, the 1995 Guidelines for Overseas Venture Capital Investments issued by
the Department of Economic Affairs in the Ministry of Finance, and the Central Board of
Direct Taxes’ (CBDT) 1995 Guidelines for Venture Capital Companies (later modified in
1999). In early 2000, domestic venture capitalists were regulated by three government
bodies: the Securities and Exchange Board of India (SEBI), the Ministry of Finance, and the
CBDT. For foreign venture capital firms there was even greater regulation in the form of the
Foreign Investment Promotion Board (FIPB), which approves every investment, and the
Reserve Bank of India (RBI), which approves every disinvestment.

Since SEBI is responsible for overall regulation and registration of VCF, multiple regulatory
requirements should be harmonized and consolidated within the framework of SEBI
Regulations to facilitate uniform, hassle-free, single window clearance.

Registration of a venture capital fund

Applicant should follow the procedure given below so as to expedite the registration process.
However, SEBI will also guide the applicant step by step after getting application for
registration as a venture capital fund. Normally, all replies are sent within 21 working days
from the date of getting each communication from the applicant during the process of
registration. Thus, the total time period for registration depends on how fast the requirements
are compiled with by the applicant.

Main requirements under SEBI (Venture Capital Funds) Regulations, 1996:

The following are the eligibility criteria for grant of a certificate of registration as per regulation
4 of SEBI (Venture Capital Funds) Regulations 1996. For the purpose of grant of a certificate of
registration, the applicant has to fulfil the following, namely:-

- 79 -
Venture Capital Funds: A Study

(a) If the application is made by a company, -

(i) Memorandum of association has as 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.

- 80 -
Venture Capital Funds: A Study

(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,
is 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 under regulation 30 or cancelled under regulation 31.

Application for Registration:

An applicant should apply for registration in form a prescribed under First Schedule of SEBI
(Venture Capital Funds) Regulations 1996 along with requisite fees. All documents should be
enclosed as specified in the form.

Additional information:

1. A complete list of your associate companies registered with SEBI, and also indicate the
capacity in which they are registered along with the SEBI Registration number;

- 81 -
Venture Capital Funds: A Study

2. State whether the applicant is registered with SEBI in any capacity.

3. A complete list of your group companies registered with SEBI, and also indicate the
capacity in which they are registered with SEBI along with their SEBI Registration
number.

4. Whether the applicant or the intermediary, as the case may be or its whole time director
or managing partner has been convicted by a Court for any offence involving moral
turpitude, economic offence, securities laws or fraud

5. Whether any winding up orders have been passed against the applicant or the
intermediary.

6. Whether any orders under the Insolvency Act have been passed against the applicant or
any of its directors, or person in management and have not been discharged.

7. Whether any order restraining prohibiting or debarring the applicant or its whole time
director from dealing in securities in the capital market has been passed by SEBI or any
other regulatory authority and a period of three years from the date of the expiry of the
period specified in the order has not elapsed;

8. Whether any order canceling the certificate of registration of the applicant on the ground
of its indulging in insider trading, fraudulent and unfair trade practices or market
manipulation has been passed by SEBI and a period of three years from the date of the
order has not elapsed ;

9. Whether any order, withdrawing or refusing to grant any license/ approval to the applicant
or its whole time director which has a bearing on the capital market, has been passed by
SEBI or any other regulatory authority and a period of three years from the date of the
order has not elapsed.

9. Whether the applicant or its group/associate companies are listed on any of the recognised
stock exchange(s) in India. If so, please furnish the details.

- 82 -
Venture Capital Funds: A Study

10. (a) Details of registration of your company/associate/group companies (to be given


separately), which are registered/ required to be registered with Reserve Bank of India
(RBI) as a Banking company or Non Banking Finance Company or in any other
capacity and address(es) of concerned branch office(s) of RBI.

(b) Details of disciplinary action taken by RBI against you or any of your group/associate
companies. Please also inform us in case there is any default in repayment of deposits
by you or any of your group / associate companies.

Applicant can submit ‘no objection certificate’ from RBI for getting registered with SEBI, to
expedite the registration process.

Other Documents to be submitted to SEBI

1) Memorandum and Articles of Association of applicant company, executed copy of


trust deed if the fund is being set up as a trust and main objective of constitution in
case of body corporate.

2) Executed copy of Investment Management Agreement, if applicable.

3) Disclose in detail the investment strategy as required under regulation 12(a) of the
SEBI (Venture Capital Funds) Regulations, 1996. Also state the target size of the
fund along with the profile of the investors of the fund.

4) An undertaking to the effect that the fund will not enter into any venture capital
activity if it fails to raise a commitment of at least Rs. five crore as required under
Regulation 11(3) of SEBI (Venture Capital Funds) Regulations, 1996.

5) Copies of letters of commitment from investors in support of the target amount


proposed to be raised by the fund.

6) Undertaking that the venture capital fund will not make investment in any area listed
under Third Schedule to SEBI (Venture Capital Funds) Regulations, 1996.

- 83 -
Venture Capital Funds: A Study

7) Venture Capital Fund shall disclose the duration/ life cycle of the fund.

Grant of Certificate of Registration

Once all above requirements have been complied with and requisite fees as per Second
Schedule to Regulations have been paid, SEBI will grant certification of registration as a
venture capital fund.

- 84 -
Venture Capital Funds: A Study

8.2 Certificate of Registration

2006
Certificate of registration as venture capital fund

I. In exercise of the powers conferred by sub-section (1) of section 12 of the securities


And exchange Board of India Act, 1992, (15 of 1992) read with the regulation made
There under, the board hereby grants a certificate of registration to -------------------------
------------------------------------------------as a venture capital fund subject to the
conditions specified in the Act and in the regulations made there under.
II. The Registration Number of the venture capital fund is IN/VC/ /

Date:
Place: MUMBAI

By order

Sd/-

For and on behalf of

Securities and Exchange Board of India

Income Tax benefits

In order to encourage the development of venture capital funds, the income Tax Act, 1961
exempts the income of a venture capital fund from Income Tax.

Income of a venture capital fund [section 10(23FB)] (on and from Financial Year 1999-
2000)

Any income of a venture capital fund (VCF) or a venture capital company (VCC) set up to
raise funds for investment in a venture capital undertaking (VCU) is exempt.

- 85 -
Venture Capital Funds: A Study

VCC means a company which has been granted a certificate of registration by SEBI and
which fulfils the conditions laid down by SEBI with the approval of the Central Government.

VCU means a domestic company whose share are not listed in a recognized stock exchange
in India and which is engaged in the business for producing services, production or
manufacture of an article or thing but does not include activities or sectors which are
specified by SEBI with a approval of the Central Government.

8.3. Tax Aspects:

VCFs have been provided complete income tax relaxation (July 1995) and exemption from
long-term capital gains tax after they are listed on stock exchanges. Shares have to be held
for at least 12 months to enjoy tax exemption. A lock-in period of three years is however
applicable for unlisted shares.

The Finance Act, 1995 provided [Section 10 (23 F) of the IT Act] income tax exemption on
any income by way of dividends or long-term capital gains of a venture capital fund or a
venture capital company from investments made by way of equity shares in a venture
proposal. To enjoy tax exemption the venture capital company has to obtain approval and
satisfy prescribed conditions. The Central Board of Direct Taxes (CBDT) issued guidelines,
on 18-7-1995 specifying that the prescribed authority for approval for exemption under
Section 10 (23F) of Income Tax Act is Director of Income Tax (Exemption). The conditions
for approval are:

• it is registered with the SEBI (guidelines of 13.2.1996 discussed below);


• it invests 80 percent of its total monies by acquiring equity shares of venture
capital undertakings;
• it invest 80 percent of its total paid-up capital in acquiring equity share of the
venture capital undertakings;
• it shall not invest more than 20 percent (Budget for 1997-8 raised it from 5 to 20
percent.)

- 86 -
Venture Capital Funds: A Study

• it shall not invest more than 40 percent in the equity capital of one venture
undertakings;
• it shall maintain books of account, and submit audited accounts to the
Director, Income Tax (Exemption).

8.4. Investment conditions and restrictions

A venture capital fund may raise money from any source, whether Indian, foreign or non
resident Indian by way of issue of units. No venture capital fund shall accept any investment
from any investor less than Rs5,00,000. However this condition is not applicable to:-

8.2.1 employees or the principal officer or directors of the venture


capital fund has been established as a trust
8.2.2 employees of the fund manager or asset management company
for the purpose of the se regulations, fund raised means actual
money raised from investors for subscribing to the securities of
the venture capital fund and includes money that is raised
from the author of the trust (in case the venture capital fund
has been established as a trust) but does not include the paid up
capital of the trustee company, if any.
8.2.3 Each scheme launched or fund set up by a venture capital
fund shall have firm commitment from the investors for
contribution by the venture capital fund.

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 ;

- 87 -
Venture Capital Funds: A Study

shall not invest in the associated companies; and


d. venture capital fund shall make investment in the venture capital
undertaking as enumerated below:-

(i). at least 75% of the investible funds shall be invested in unlisted equity shares or equity
linked instruments. However, if the venture capital und seeks avail of benefits under the
relevant provisions of the Income Tax Act applicable to a venture capital fund, it shall be
required to disinvest from such investments within a period of one year from the Date on
which the shares of the venture capital undertaking are listed. In a recognized stock
Exchange.

(ii). Not more than 25% of the investible fund may be invested by way of:

a. subscription to initial public offer of a venture capital undertaking


whose shares are proposed o be listed subject to lock-in period of one
year;
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.

8.5 Indian Statistical Data

Contributors of funds Contributors (Rs mn) Per cent

Foreign Institutional Investors 13,426.47 52.46

All India Financial Institutions 6,252.90 24.43

Multilateral Development Agencies 2,133.64 8.34

Other Banks 1,541.00 6.02

Foreign Investors 570.00 2.23

Private Sector 412.53 1.61

- 88 -
Venture Capital Funds: A Study

Public Sector 324.44 1.27

Nationalized Banks 278.67 1.09

Non Resident Indians 235.50 0.92

State Financial Institutions 215.00 0.84

Other Public 115.52 0.45

Insurance Companies 85.00 0.33

Mutual Funds 4.5 0.0

Total 25,595.17 100.00%

Source: IVCA

Financing by investment stage

Investment Stages Rs million Number

Start-up 3,813.00 297

Later stage 3,338.99 154

Other early stage 1,825.77 124

Seed stage 963.2 107

Turnaround financing 59.5 9

Total 10,000.46 691

Source: IVCA

- 89 -
Venture Capital Funds: A Study

Financing by industry

Industry Rs million Number

Industrial products, machinery 2,599.32 208

Computer Software 1,832.0 87

Consumer Related 1,412.74 58

Medical 623.8 44

Food, food processing 500.06 50

Other electronics 436.54 41

Tel & Data Communications 385.09 16

Biotechnology 376.46 30

Energy related 249.56 19

Computer Hardware 203.36 25

Miscellaneous 1,380.85 113

Total 10,000.46 691

Source: IVCA

- 90 -
Venture Capital Funds: A Study

Financing by states

Investment Rs million Number

Maharashtra 2,566 161

Tamil Nadu 1531 119

Andhra Pradesh 1372 89

Gujarat 1102 49

Karnataka 1046 93

West Bengal 312 22

Haryana 300 22

Delhi 294 21

Uttar Pradesh 283 29

Madhya Pradesh 231 2

Kerala 135 15

Goa 105 16

Rajasthan 87 11

Punjab 84 6

Orissa 35 5

Himachal Pradesh 28 3

Pondicherry 22 2

Bihar 16 3

Overseas 413 12

Total 9962 690

- 91 -
Venture Capital Funds: A Study

Source: IVCA

- 92 -
Venture Capital Funds: A Study

8.6. India Venture Capital Report-2006

Venture Capital firms invested into 92 companies and exited 14 investments in India during
2006. The US-IVCA/Venture Intelligence India Venture Capital Report-2006 report captures
all the action in facts and figures.

With the help of illustrative charts and tables, the India Venture Capital Report-2006
classifies VC investments during the year by industry, sectors (within IT & ITES), stage of
company development and region.

Some interesting facts from the report:

The $20 million raised by electric car maker Reva is the largest reported investment during
the year.

28% of all investments fall in the $5-10 million category, followed by at 26% in the $2-5
million category.

IT & ITES companies corner over 70% of VC investments.

Early-stage deals account for almost 60% of all investments.

Sequoia Capital India is the most active investor.

VC firms and SME-focused PE firms raised over $1 Billion for investments.

VC firms obtain exit routes in 14 companies, including three via IPOs..

Venture capital firms invested into 92 companies and exited 14 investments in India during
2006, according to the US-IVCA/Venture Intelligence India Venture Capital Report-2006.

- 93 -
Venture Capital Funds: A Study

Some interesting facts from the report:

• Early-stage deals account for almost 60 percent of all investments.


• 28 percent of all investments fall in the US$5-10 million category, followed by 26
percent in the US$2-5 million category.
• IT & ITES companies corner over 70 percent of VC investments.
• The US$20 million raised by electric car maker Reva is the largest reported
investment during the year.
• VC firms and SME-focused PE firms raised over US$1 billion for investments.
• Sequoia Capital India is the most active investor.

Venture capital investments in the country registered a near 4 percent increase in the first
quarter of 2007 calendar as investors pumped in US$130 million (about Rs560 crore)
through 20 deals. VC firms had invested around US$125 million during the same period last
year, whereas in the first quarter of 2005 they invested just US$37 million.

Sudhir Sethi, director of US-IVCA and vice chairman & managing director of IDG Ventures
India, said:
“We are witnessing a significant number of early-stage investments taking place in the
US$1-3 million range, which augurs very well for the VC ecosystem in the country."

VC firms obtained exit routes in three companies via IPOs. The companies, Mind Tree
Consulting, First Source and Global Broadcast News, which had received VC funding prior
to launching their initial public offerings, tapped the market during January-March 2007.

India had missed the VC money bus during the Internet boom. Very little money came into
India, limiting the growth of the Internet and Internet-related companies in the country. It is
good to see VC interest, especially in early-stage companies. The Indian economy is
booming and risk capital will allow innovative companies to ride this growth and propel it.`

- 94 -
Venture Capital Funds: A Study

Bibliography

Books

• Indian venture capital market, 2006 - Evalueserve


• Global venture capital insights report 2006 - Ernst & Young
• Creating an Environment: Developing Venture Capital in India - Rafiq Dossani and
Martin Kenney
• Indian Venture Capital Association - IVCA Venture Activity 1997
• The Securities and Exchange Board of India - SEBI (Venture Capital Funds)
Regulations, 1996

Websites

• www.nvca.org
• www.indiainbusiness.nic.in
• www.indiavca.org
• www.thehindubusinessline.com
• www.altassets.net
• www.sebi.gov.in
• www.wikipedia.com
• www.bvca.co.uk
• www.news.bbc.co.uk
• www.economicstimes.com
• www.venturecapital.com
• www.projectshub.com

Newspapers

• Economic Times
• Times of India

Magazines

• MBA Review, August 2006.


• Business Manager May 2005.

- 95 -