Project Report On A STUDY OF VENTURE CAPITAL IN INDIA

In partial fulfillment of the requirement of MASTER OF MANAGEMENT STUDIES COURSE

Project Guide Mr. C.R.S. Pillai

Submitted By: Anand M. Jain (Roll No- 74)

Pillais Institute of Management Studies and Research (2010- 12)

ACKNOWLEDGEMENT
The project of this magnitude would not have been completed singly. Firstly I want to give my hearty thanks to all mighty who made the world and me also. There are many other people without whom the completion of the project would not have been possible. Some have contributed towards this directly while other have provided indirectly. It gives me immense pleasure to thank Ms.Pooja Patil and Ms. Hema(HR) for providing me summer training in his reputed organization. I am indebted to Mr. Ajay Deshmukh of Genext Venture Capital for their guidance and cooperation in completing this project. Last but not the least I would like to convey my heartiest gratitude to all Members of Genext Venture Capital who helped a lot during my summer training.

DECLARATION
I Anand M. Jain a student of MMS III Semester of PIMSR College, Mumbai hereby declare that the research project report titled Study Of Venture Capital In India is my original work and the same has not been submitted for the award of any other diploma or degree. Place: Navi Mumbai Date: Anand M. Jain

EXECUTIVE SUMMARY
Venture capital is a growing business of recent origin in the area of industrial financing in India. The various financial institution set-ups in India to promote industries have done commendable work. However, these institutions do not come up to benefit risky ventures when they are undertaken by new or relatively unknown entrepreneurs. They contend to give debt finance, mostly in the form of term loans to the promoters and their functioning has been more akin to that of commercial banks. Starting and growing a business always require capital. There are a number of alternative methods to fund growth. These include the owner or proprietors own capital, arranging debt finance, or seeking an equity partner, as is the case with private equity and venture capital. Venture capital is a means of equity financing for rapidly-growing private companies. Finance may be required for the start-up, development/expansion or purchase of a company. Venture Capital firms invest funds on a professional basis, often focusing on a limited sector of specialization (eg. IT, Infrastructure, Health/Life Sciences, Clean Technology, etc.). Indian Venture capital and Private Equity Association(IVCA) is a member based national organization that represents venture capital and private equity firms, promotes the industry within India and throughout the world and encourages investment in high growth companies. IVCA member comprise venture capital firms, institutional investors, banks, incubators, angel groups, corporate advisors, accountants, lawyers, government bodies, academic institutions and other service providers to the venture capital and private equity industry. Members represent most of the active venture capital providers and private equity firms in India. These firms provide capital for seed ventures, early stage companies, later stage expansion, and growth finance for management buyouts/buy-ins of established companies. Venture capitalists have been catalytic in bringing forth technological innovation in USA. A similar act can also be performed in India. As venture capital has good scope in India for three reasons:

First: The abundance of talent is available in the country. The low cost high quality Indian workforce that has helped the computer users worldwide in Y2K project is demonstrated asset. Second: A good number of successful Indian entrepreneurs in Silicon Valley should have a demonstration effect for venture capitalists to invest in Indian talent at home. Third: The opening up of Indian economy and its integration with the world economy is providing a wide variety of niche market for Indian entrepreneurs to grow and prove themselves.

Setting the stage - Venture Capital in India

Phase I - Formation of TDICI in the 80s and regional funds as GVFL & APIDC in the early 90s. Phase II - Entry of Foreign Venture Capital funds (VCF) between 1995-1999 Phase III - (2000 onwards). Emergence of successful India-centric VC firms Phase IV (current) Global VCs and PE firms actively investing in India 150 Funds active in the last 3 years (Government,Overseas, Corporate, Domestic)

The Opportunity High Growth in Technology and Knowledge based Industries (KBI) KBI growing fast and mostly global, less affected bydomestic issues. Several emerging centers of innovation biotech,wireless, IT, semiconductor, pharmaceutical. Ability to build market leading companies in India that serve both global and domestic markets. India moving beyond supplier of low-cost services to higher-value products.

Quality of entrepreneurship on ascending curve.

TABLE OF CONTENTS
SR.NO 1 2 3 4 5 6 7 8 9 10 NAME OF THE CONTENTS INTRODUCTION FEATURES OF VENTURE CAPITAL VENTURE CAPITAL INVESTMENT PROCESS METHODS OF VENTURE FINANCING EVOLUTION OF VENTURE CAPITAL INDUSTRY IN INDIA REGULATORY AND LEGAL FRAMEWORK KEY SUCCESS FACTOR FOR VENTURE CAPITAL INDUSTRY IN INDIA RECOMMENDATIONS FINDINGS CONCLUSION ANNEXTURE (QUESTIONNAIRE BIBLIOGRAPHY PAGE NO. 7 13 30 37 39 47 57 62 67 68

CHAPTER 1 INTRODUCTION:
Gen Next Ventures Private Limited is an early stage venture capital firm focused on IT investing with offices in Mumbai, India. Founded in 1997, as Idealab Capital Partners, Gen Next Ventures is responsible for the early-stage funding of many successful startups including PayPal (IPO, acquired by eBay), Overture.com (IPO, acquired by Yahoo), Internet Brands/CarsDirect (NASDAQ: INET), NetZero/United Online (NASDAQ: UNTD), MP3.com (IPO, acquired by Vivendi), Meru Networks (NASDAQ: MERU), Integrien (acquired by VMware), Ankeena (acquired by Juniper), Kazeon Systems (Acquired by EMC) and Mimosa Systems (acquired by Iron Mountain).

Managing Directors
Mr.Anil Sharma, Founder Mr.Vijay Deshmukh Mr.Avadesh Yadav Mr.Sumant Mandal Ms.Sunita Agrawal risk, growth startup companies. The venture capital fundmakes money by owning equity in the companies it invests in, which usually have a novel technology or business model in high technology industries, such as biotechnology, IT, software, etc. The typical venture capital investment occurs after the seed funding round as growth funding round (also referred as Series A round) in the interest of generating a return through an eventual realization event, such as an IPO or trade sale of the company. Venture capital is a subset of private equity. Therefore all venture capital is private equity, but not all private equity is venture capital.[1]

Venture capital (VC) is financial capital provided to early-stage, high-potential, high

In addition to angel investing and other seed funding options, venture capital is
attractive for new companies with limited operating history that are too small to raise

capital in the public markets and have not reached the point where they are able to secure a bank loan or complete a debt offering. In exchange for the high risk that venture capitalists assume by investing in smaller and less mature companies, venture capitalists usually get significant control over company decisions, in addition to a significant portion of the company's ownership (and consequently value).

Venture capital is also associated with job creation (accounting for 21% of US GDP),
[2]

the knowledge economy, and used as a proxy measure of innovation within an

economic sector or geography. Every year there are nearly 2 million businesses created in the USA, and only 600-800 get venture capital funding. According to the National Venture Capital Association 11% of private sector jobs come from venture backed companies and venture backed revenue accounts for 21% of US GDP. Growth capital (also called expansion capital and growth equity) is a type of private equity investment, most often a minority investment, in relatively mature companies that are looking for capital to expand or restructure operations, enter new markets or finance a significant acquisition without a change of control of the business.[1] Companies that seek growth capital will often do so in order to finance a transformational event in their lifecycle. These companies are likely to be more mature than venture capital funded companies, able to generate revenue and operating profits but unable to generate sufficient cash to fund major expansions, acquisitions or other investments. Because of this lack of scale these companies generally can find few alternative conduits to secure capital for growth, so access to growth equity can be critical to pursue necessary facility expansion, sales and marketing initiatives, equipment purchases, and new product development.[2] Growth capital can also be used to effect a restructuring of a company's balance sheet, particularly to reduce the amount of leverage (or debt) the company has on its balance sheet. Growth capital is often structured as either common equity or preferred equity, although certain investors will use various hybrid securities that include a contractual return (i.e., interest payments) in addition to an ownership interest in the company. Often, companies that seek growth capital investments are not good candidates to borrow additionaldebt, either because of the stability of the company's earnings or because of its existing debt levels.

Origins of modern private equity

Before World War II, money orders (originally known as "development capital") were primarily the domain of wealthy individuals and families. It was not until after World War II that what is considered today to be true private equity investments began to emerge marked by the founding of the first two venture capital firms in 1946: American Research and Development Corporation. (ARDC) and J.H. Whitney & Company.
[4]

ARDC was founded by Georges Doriot, the "father of venture capitalism" (former dean
[5]

of Harvard Business Schooland founder of INSEAD), with Ralph Flanders and Karl Compton (former president of MIT), to encourage private sector investments in businesses run by soldiers who were returning from World War II. ARDC's significance was primarily that it was the first institutional private equity investment firm that raised capital from sources other than wealthy families although it had several notable investment successes as well.
[6]

ARDC is credited with the first trick when its 1957 investment of $70,000 in Digital

Equipment Corporation (DEC) would be valued at over $355 million after the company's initial public offering in 1968 (representing a return of over 1200 times on its investment and an annualized rate of return of 101%).
[7]

Former employees of ARDC went on and established several prominent venture capital firms including Greylock Partners (founded in 1965 by Charlie Waite and Bill Elfers) and Morgan, Holland Ventures, the predecessor of Flagship Ventures (founded in 1982 by James Morgan). ARDC continued investing until 1971 with the retirement of Doriot. In 1972, Doriot
[8]

merged ARDC with Textron after having invested in over 150 companies. J.H. Whitney & Company was founded by John Hay Whitney and his partner Benno Schmidt. Whitney had been investing since the 1930s, founding Pioneer Pictures in 1933 and acquiring a 15% interest in Technicolor Corporationwith his cousin Cornelius Vanderbilt Whitney. By far Whitney's most famous investment was in Florida Foods Corporation. The company developed an innovative method for delivering nutrition to American soldiers, which later came to be known as Minute Maid orange juice and was sold to The Coca-Cola Company in 1960. J.H. Whitney & Company continues to make investments in leveraged buyout transactions and raised $750 million for its sixthinstitutional private equity fund in 2005.re capital (also known as VC or Venture) is provided as seed funding to early-stage,

high-potential, growth companies and more often after the seed funding round as growth funding round (also referred as series A round) in the interest of generating a return through an eventual realization event such as an IPO or trade sale of the company. To put it simply, an investment firm will give money to a growing company. The growing company will then use this money to advertise, do research, build infrastructure, develop products etc. The investment firm is called a venture capital firm, and the money that it gives is called venture capital. The venture capital firm makes money by owning a stake in the firm it invests in. The firms that a venture capital firm will invest in usually have a novel technology or business model. Venture capital investments are generally made in cash in exchange for shares in the invested company. It is typical for venture capital investors to identify and back companies in high technology industries, such as biotechnology and IT (Information Technology).

Venture capital typically comes from institutional investors and high net worth individuals, and is pooled together by dedicated investment firms. Venture capital firms typically comprise small teams with technology backgrounds (scientists, researchers) or those with business training or deep industry experience.

OBJECTIVES OF THE STUDY

Understand the concept of venture capital. Venture Capital funding is

different from traditional sources of financing. Venture capitalists finance innovation and ideas which have potential for high growth but with inherent uncertainties. This makes it a high-risk, high return investment.

Study venture capital industry in India.

Scientific, technology and

knowledge based ideas properly supported by venture capital can be propelled into a powerful engine of economic growth and wealth creation in a sustainable manner. In various developed and developing economies venture capital has played a significant developmental role.

Study venture capital industry in global scenario.

development of technology growth of exports and employment.

Venture capital

has played a very important role in U.K., Australia and Hong Kong also in

Study the evaluation & need of venture capital industry in India.

India is still at the level of knowledge. Given the limited infrastructure, low foreign investment and other transitional problems, it certainly needs policy support to move to the next stage. This is very crucial for sustainable growth and for maintaining Indias competitive edge

Understand the legal framework formulated by SEBI to encourage venture capital activity in Indian economy.
Promoting sound public policy on issues related to tax, regulation and securities through representation to the Securities and Exchange Board of India (SEBI), Ministry of Finance (MoF), Reserve Bank of India (RBI) and other Government departments

Find out opportunities that encourage & threats those hinder venture capital industry in India.

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To know the impact of political & economical factors on venture capital investment.

LIMITATION OF PROJECT
A study of this type cannot be without limitations. It has been observed those venture capitals are very secretive about their investments. This attitude is a major hindrance for data collection. However venture capital funds/companies that are members of Indian venture capital association are to be included in the study.

SCOPE OF THE PROJECT

The scope of the research includes all types of venture capital firms set up as a company & funds irrespective of the fact that they are registered with SEBI of India or not part of this study.

RESEARCH DESIGN AND METHODOLOGY

In India neither venture capital theory has been developed nor are there many comprehensive books on the subject. Even the number of research papers available is very limited. The research design used is descriptive in nature. (The attempt has been made to collect maximum facts and figures available on the availability of venture capital in India, nature of assistance granted, future projected demand for this financing, analysis of the problems faced by the entrepreneurs in getting venture capital, analysis of the venture capitalists and social and environmental impact on the existing framework.) The research is based on secondary data collected from the published material. The data was also collected from the publications and press releases of venture capital associations in India. Scanning the business papers filled the gaps in information. The Economic times, Financial Express and Business Standards were scanned for any article or news item related to venture

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capital. Sufficient amount of data about the venture capital has been derived from this project.

CONCEPT OF VENTURE CAPITAL

The term venture capital comprises of two words that is, Venture and capital. Venture is a course of processing the outcome of which is uncertain but to which is attended the risk or danger of Loss. Capital means recourses to start an enterprise. To connote the risk and adventure of such a fund, the generic name Venture Capital was coined. Venture capital is considered as financing of high and new technology based enterprises. It is said that Venture capital involves investment in new or relatively untried technology, initiated by relatively new and professionally or technically qualified entrepreneurs with inadequate funds. The conventional financiers, unlike Venture capitals mainly finance proven technologies and established markets. However, high technology need not be prerequisite for venture capital. Venture capital has also been described as unsecured risk financing. The relatively high risk of venture capital is compensated by the possibility of high return usually through substantial capital gains in term. Venture capital in broader sense is not solely an injection of funds into a new firm, it is also an input of skills needed to set up the firm, design its marketing strategy, organize and manage it. Thus it is a long term association with successive stages of companys development under highly risky investment condition with distinctive type of financing appropriate to each stage of development. Investors join the entrepreneurs as copartners and support the project with finance and business skill to exploit the market opportunities. Venture capital is not a passive finance. It may be at any stage of business/ production cycle, that is startup, expansion or to improve a product or process, which are associated with both risk and reward. The Venture capital gains through appreciation in the value of such investment when the new technology succeeds. Thus the primary return sought by the investor is essentially capital gain rather than steady interest income or dividend yield. The most flexible Definition of Venture Capital is:The support by investors of entrepreneurial talent with finance and business skills to exploit market opportunities and thus obtain capital gains. Venture capital commonly describes not only the provision of start up finance or seed corn capital but also development capital for later stages of business. A long term commitment of

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funds is involved in the form of equity investments, with the aim of eventual capital gains rather than income and active involvement in the management of customers business.

Growth of PE/VC in India 2004 2010 (US$ millions)

INVESTMENT BY SECTORS

Stage of Company Early Stage Growth stage Late stage PIPE Buyout Others

No. of Deals 59 42 104 61 11 22

Amount (US$M) 236 393 3663 1314 1125 769

*PIPE-Private Investment in public equity

INVESTMENT BY STAGE

VC Investments by stage:2009

2009 VC Trends
US$7.5bn invested in 2009 across 299 deals. IT & ITES retained its status as the favorite industry among PE investors, followed by manufacturing and real estate. Largest PE deal was $900M LBO of Flextronics by Kohlberg Kravis Roberts (KKR). M&A and IPO activity continued to remain strong.

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2009 VC Investments by industry Total US$7.5Bn

Top Cities attracting VC Investment

City
Mumbai Delhi Bangalore Chennai Hyderabad Pune

No. Of Deals
69 41 40 22 17 10

Value(US $M)
1780 395 1525 354 492 1114

CHAPTER2 FEATURES OF VENTURE CAPITAL

High Risk High Tech Equity Participation & Capital Gains Participation In Management Length Of Investment
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 Illiquid Investment

High Risk
By definition the Venture capital financing is highly risky and chances of failure are high as it provides long term start up capital to high risk- high reward ventures. Ventures capital assumes four type of risks, these are:

Management risk

-Inability of management teams to work together.

Market risk -Product may fail in the market. Product risk -Product may not be commercially viable. Operation risk-Operation may not be cost effective resulting in increased cost
decreased gross margin.

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

Equity Participation & Capital Gains

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

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

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

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

THE VENTURE CAPITAL SPECTRUM/STAGES

The growth of an enterprise follows a life cycle as shown in the diagram below. The requirements of funds vary with the life cycle stage of the enterprise. Even before a business plan is prepared the entrepreneur invests his time and resources in surveying the market, finding and understanding the target customers and their needs. At the seed stage the entrepreneur continue to fund the venture with his own fund or family funds. At this stage the

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fund are needed to solicit the consultants services in formulation of business plans, meeting potential customers and technology partners. Next the funds would be required for development of the product/process and producing prototypes, hiring key people and building up the managerial team. This is followed by funds for assembling the manufacturing and marketing facilities in that order. Finally the funds are needed to expand the business and attaint the critical mass for profit generation. Venture capitalists cater to the needs of the entrepreneurs at different stages of their enterprises. Depending upon the stage they finance, venture capitalists are called angel investors, venture capitalist or private equity supplier/investor. Venture capital was started as early stage financing of relatively small but rapidly growing companies. However various reasons forced venture capitalists to be more and more involved in expansion financing to support the development of existing portfolio companies. With increasing demand of capital from newer business, venture capitalists began to operate across a broader spectrum of investment interest. This diversity of opportunities enabled venture capitalists to balance their activities in term of time involvement, risk acceptance and reward potential, while providing ongoing assistance to developing business. Different Venture capital firms have different attributes and aptitudes for different types of Venture capital investments. Hence there are different stages of entry for different venture capitalists and they can identify and differentiate between types of venture capital investments, each appropriate for the given stage of the investee company, these are:-

1. Early stage Finance

Seed capital
Start up Capital Early/First Stage Capital Later/Third Stage capital

1. Later Stage Finance

Expansion/Development Stage Capital Replacement Finance Management Buy Out and Buy Ins Turnarounds Mezzanine/Bridge Finance

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Not all business firms pass through each of these stages in sequential manner. For instance seed capital is normally not required by service based ventures. It applies largely to manufacturing or research based activities. Similarly second round finance does not always follow early stage finance. If the business grows successfully it is likely to develop sufficient cash to fund its own growth, so does not require venture capital for growth.

Seed Capital

It is an idea or concept as opposed to a business. European venture capital association defines seed capital as The financing of the initial product development or capital provided to an entrepreneur to prove the feasibility of a project and to qualify for start up capital.

The characteristics of the seed capital may be enumerated as follows:

Absence of ready product market Absence of complete management team Product/process still in R & D stage Initial period/licensing stage of technology transfer

Broadly speaking seed capital investment may take 7 to 10 year to achieve realization. It is the earliest and therefore riskiest stage of Venture capital investment. The new technology and innovations being attempted have equal chance of success and failure. Such projects, particularly hi-tech, projects sink a lot of cash and need a strong financial support for their adaptation, commencement and eventual success. However, while the earliest stage of financing is fraught with risk, it also provides greater potential for realizing significant gains in long term. Typically seed enterprises lack asset base or track record to obtain finance from conventional sources and are largely dependent upon entrepreneurs personal resources. Seed capital is provided after being satisfied that the entrepreneur has used up his own resources and carried out his idea to a stage of acceptance and has initiated research. The asset underlying the seed capital is often technology or an idea as opposed to human assets (a good management taem0 so often sought by venture capitalists. Volume of Investment Activity It has been observed that Venture capitalist seldom make seed capital investment and these are relatively small by comparison to other forms of Venture finance. The absence of interest in providing a significant amount of seed capital can be attributed to the following three factors:-

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a) Seed capital projects by their very nature require a relatively small amount of capital. The success or failure of an individual seed capital investment will have little impact on the performance of all but the smallest venture capital investments. This is because the small investments are seen to be cost inefficient in terms of time required to analyze structure manage them. b) The time horizon to realization for most seed capital investment is typically 7-10 years which is longer than all but most long-term oriented investors will desire. c) The risk of product and technology obsolescence increases as the time to realization I extended. These types of obsolescence are particularly likely to occur with high technology investments particularly in the fields related to Information Technology.

Start Up Capital

It is stage second in the venture capital cycle and is distinguishable from seed capital investments. An entrepreneur often needs finance when the business is just starting. The start up stage involves starting a new business. Here in the entrepreneur has moved closer towards establishment of a going concern. Here in the business concept has been fully investigated and the business risk now becomes that of turning the concept into product. Start up capital is defined as; Capital needed to finance the product development, initial marketing and establishment of product facility. The characteristics of start-up capital are:-

a) Establishment of company or business: the company is either being organized or is

established recently. New business activity could be based on experts, experience or a spin-off from R & D.

b) Establishment of most but not all the members of the team: the skills and fitness
to the job and situation of the entrepreneurs team is an important factor for start up finance.

c) Development of business plan or idea: the business plan should be fully developed
yet the acceptability of the product by the market is uncertain. The company has not yet started trading. In the start up preposition Venture capitalists investment criteria shifts from idea to people involved in the venture and the market opportunity. Before committing any finance at this stage, venture capitalist however, assesses the managerial ability and the capacity of the entrepreneur, besides the skills, suitability and competence of the managerial team are also

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evaluated. If required they supply managerial skill and supervision for implementation. The time horizon for start up capital will be typically 6 or 8 years. Failure rate for start up is 2 out of 3. Start up needs funds by way of both first round investment and subsequent follow-up investments. The risk tends to be lower relative to seed capital situation. The risk is controlled by initially investing a smaller amount of capital in start-ups. The decision on additional financing is based upon the successful performance of the company. However, the term to realization of a start up investment remains longer than the term of finance normally provided by the majority of financial institutions. Longer time scale for using exit route demands continued watch on start up projects. Volume of Investment Activity Despite potential for secular returns most venture firms avoid investing in start-ups. One reason for the paucity of start up financing may be high discount rate that venture capitalist applies to venture proposals at this level of risk and maturity. They often prefer to spread their risk by sharing the financing. Thus syndicates of investors often participate in start up finance.

Early Stage Finance

It is also called first stage capital is provided to entrepreneur who has a proven product, to start commercial production and marketing, not covering market expansion, de-risking and acquisition costs. At this stage the company passed into early success stage of its life cycle. A proven management team is put into this stage, a product is established and an identifiable market is being targeted. British Venture capital Association has vividly defined early stage finance as: Finance provided to companies that have completed the product development stage and require further funds to initiate commercial manufacturing and sales but may not be generating profits. The characteristics of early stage finance may be: Little or no sales revenue. Cash flow and profit still negative. A small but enthusiastic management team which consists of people with technical and specialist background and with little experience in the management of growing business.

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Short term prospective for dramatic growth in revenue and profits.

The early stage finance usually takes 4 to 6 years time horizon to realization. Early stage finance is the earliest in which two of the fundamentals of business are in place i.e. fully assembled management team and a marketable product. A company needs this round of finance because of any of the following reasons: Project overruns on product development. Initial loss after start up phase.

The firm needs additional equity funds, which are not available from other sources thus prompting venture capitalist that, have financed the start up stage to provide further financing. The management risk is shifted from factors internal to the firm (lack of management, lack of product etc.) to factor external to the firm (competitive pressures, in sufficient will of financial institutions to provide adequate capital, risk of product obsolescence etc.) At this stage, capital needs, both fixed and working capital needs are greatest. Further, since firms do not have foundation of a trading record, finance will be difficult to obtain and so venture capital particularly equity investment without associated debt burden is key to survival of the business. The following risks are normally associated to firms at this stage:a) The early stage firms may have drawn the attention of and incurred the challenge of a larger competition. b) There is a risk of product obsolescence. This is more so when the firm is involved in high-tech business like computer, information technology etc. Second stage Finance It is the capital provided for marketing and meeting the growing working capital needs of an enterprise that has commenced the production but does not have positive cash flows sufficient to take care of its growing needs. Second stage finance, the second trench of Early Stage Finance is also referred to as follow on finance and can be defined as the provision of capital to the firm which has previously been in receipt of external capital but whose financial needs have subsequently exploded. This may be second or even third injection of capital. The characteristics of a second stage finance are:

A developed product on the market A full management team in place 21

Sales revenue being generated from one or more products There are losses in the firm or at best there may be a breakeven but the surplus generated is insufficient to meet the firms needs.

Second round financing typically comes in after start up and early stage funding and so have shorter time to maturity, generally ranging from 3 to 7 years. This stage of financing has both positive and negative reasons. Negative reasons include: Cost overruns in market development Failure of new product to live up to sales forecast. Need to re-position products through a new marketing campaign Need to re-define the product in the market place once the product deficiency is revealed. Positive reasons include:

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

Later Stage Finance

It is called third stage capital is provided to an enterprise that has established commercial production and basic marketing set-up, typically for market expansion, acquisition product development etc. it is provided for market expansion of the enterprise. The enterprises eligible for this round of finance have following characteristics: Established business, having already passed the risky early stage. Expanding high yield, capital growth and good profitability. Reputed market position and an established formal organization structure.

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Funds are utilized for further plant expansion, marketing, working capital or development of improved products. Third stage financing is a mix of equity with debt or subordinate debt. As it is half way between equity and debt in US it is called mezzanine finance. It is also called last round of finance in run up to the trade sale or public offer. Venture capitalists prefer later stage investment vis a Vis early stage investments, as the rate of failure in later stage financing is low. It is because firms at this stage have a past performance data, track record of management, established procedures of financial control. The time horizon for realization is shorter, ranging from 3 to 5 years. This helps the venture capitalists to balance their own portfolio of investment as it provides a running yield to venture capitalists. Further the loan component in third stage finance provides tax advantage and superior return to the investors. There are four sub divisions of later stage finance: Expansion/Development Finance Replacement Finance

Buyout Financing
Turnaround Finance

Expansion/ Development finance

An enterprise established in a given market increases its profit exponentially by achieving the economies of scale. This expansion can be achieved either through an organic growth, that is by expanding production capacity and setting up proper distribution system or by way of acquisitions. Anyhow, expansion needs finance and venture capitalists support both organic growth as well as acquisitions for expansion. At this stage the real market feedback is used to analyze competition. It may be found that the entrepreneur needs to develop his managerial team for handling growth and managing a larger business. Realization horizon for expansion/development investment is one to three years. It is favored by venture capitalist as it offers higher rewards in shorter period with lower risk. Funds are needed for new or larger factories and warehouses, production capacities, developing improved or new products, developing new markets or entering exports by enterprise with established business that has already achieved break even and has started making profits.

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

Buy-out / Buy-in Financing

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

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

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

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CHAPTER 3

VENTURE CAPITAL INVESTMENT PROCESS

Venture capital investment process is different from normal project financing. In order to understand the investment process a review of the available literature on venture capital finance is carried out. Tyebjee and Bruno in 1984 gave model of venture capital investment activity with some variations is commonly used presently. As per this model this activity is a five step process as follows:

1. Deal Organization 2. Screening 3. Evaluation or due Diligence 4. Deal Structuring 5. Post Investment Activity and Exit Deal Origination:
In generating a deal flow, the VC investor creates a pipeline of deals or investment opportunities that he would consider for investing in. deal may originate in various ways. Referral system, active search system, and intermediaries. Referral system is an important source of deals. Deals may be referred to VCFs by their parent organizations, trade partners, industry associations, friends etc. Another deal flow is active search through networks, trade fairs, conferences, seminars, foreign visits etc. intermediaries is used by venture capitalists in developed countries like USA, is certain intermediaries who match VCFs and the potential entrepreneurs.

Screening:
VCFs, before going for an in-depth analysis, carry out initial screening of all projects on the basic of some broad criteria. For example, the screening process may limit projects to areas in which the venture capitalist is familiar in terms of technology, or product, or market scope. The size of investment, geographical location and stage of financing could also be used as the broad screening criteria.

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 Due Diligence:
Due diligence is the industry jargon for all the activities that are associated with evaluating an investment proposal. The Venture capitalists evaluate the quality of entrepreneur before appraising the characteristics of the product, market or technology. Most venture capitalists ask for a business plan to make an assessment of the possible risk and return on the venture. Business plan contains detailed information about the proposed venture. The evaluation of ventures by VCFs in Indian includes; Preliminary evaluation: the applicant required to provide a brief profile of the proposed venture to establish prima facie eligibility.

Detailed evaluation:

once the preliminary evaluation is over, the proposal is evaluated

in greater detail. VCFs in India expect the entrepreneur to have: - integrity, long-term vision, urge to grow, managerial skills, commercial orientation. VCFs in India also make the risk analysis of the proposed projects which includes: product risk, market risk, technological risk and entrepreneurial risk. The final decision is taken in terms of the expected risk-return trade-off as shown in figure.

Deal Structuring:
In this process, the venture capitalist and the venture company negotiate the terms of the deals, that are the amount form and price of the investment. This process is termed as deal structuring. The agreement also include the venture capitalists right to control the venture company and to change its management if needed, buyback arrangement specify the entrepreneurs equity share and the objectives share and the objectives to be achieved.

Post Investment Activities:

Once the deal has been structured and agreement finalized, the venture capitalist generally assumes the role of a partner and collaborator. He also gets involved in shaping of the direction of the venture. The degree of the venture capitalists involvement depends on his policy. It may not, however be desirable for a venture capitalist to get involved in the day-today operation of the venture. If a financial or managerial crisis occurs, the venture capitalist may intervene, and even install a new management team.

Exit:

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Venture capitalists generally want to cash-out their gains in five to ten years after the initial investment. They play a positive role in directing the company towards particular exit routes. A venture may exist in one of the following ways: There are four ways for a venture capitalist to exit its investment: Initial Public Offer (IPO) Acquisition by another company Re-purchase of venture capitalists share by the investee company

Purchase of venture capitalists share by a third party

Promoters Buy-back
The most popular disinvestment route in India is promoters buy-back. This route is suited to Indian conditions because it keeps the ownership and control of the promoter intact. The obvious limitation, however, is that in a majority of cases the market value of the shares of the venture firm would have appreciated so much after some years that the promoter would to be in a financial position to buy them back. In India, the promoters are invariably given the first option to buy back equity of their enterprise. For example, RCTO participates in the assisted firms equity with suitable agreement for the promoter to repurchase it. Similarly, Confina-VCF offers an opportunity to the promoters to buy back the shares of the assisted firm within an agreed period at a predetermined price. If the promoter fails to buy back the shares within the stipulated period, Confine-VCF would have the discretion to divest them in any manner it deemed appropriate. SBI capital Markets ensures through examining the personal assets of the promoters and their associates, which buy back, would be a feasible option. GV would make disinvestment, in consultation with the promoter, usually after the project has settled down, to a profitable level and the entrepreneur is in a position to avail of finance under conventional schemes of assistance from banks or other financial institutions.

Initial Public Offers (IPOs)

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The benefits of disinvestments via the public issue route are improved marketability and liquidity, better prospects for capital gains and widely known status of the venture as well as market control through public share participation. This option has certain limitations in the Indian context. The promotion of the public issue would be difficult and expensive since the first generation entrepreneurs are not known in the capital markets. Further, difficulties will be caused if the entrepreneurs business is perceived to be an unattractive investment proposition by investors. Also, the emphasis by the Indian investors on short-term profits and dividends may tend to make the market price unattractive. Yet another difficulty in India until recently was that the Controller of Capital Issues (CCI) guidelines for determining the premium on shares took into account the book value and the cumulative average EPS till the date of the new issue. This formula failed to give due weight age to the expected stream of earning of the venture firm. Thus, the formula would underestimate the premium. The government has now abolished the Capital Issues Control Act, 1947 and consequently, the office of the controller of Capital Issues. The existing companies are now free to fix the premium on their shares. The initial public issue for disinvestments of VCFs holding can involve high transaction costs because of the inefficiency of the secondary market in a country like India. Also, this option has become far less feasible for small ventures on account of the higher listing requirement of the stock exchanges. In February 1989, the Government of India raised the minimum capital for listing on the stock exchanges from Rs 10 million to Rs 30 million and the minimum public offer from Rs 6 million to Rs 18 million.

Sale on the OTC Market

An active secondary capital market provides the necessary impetus to the success of the venture capital. VCFs should be able to sell their holdings, and investors should be able to trade shares conveniently and freely. In the USA, there exist well-developed OTC markets where dealers trade in share on telephone/terminal and not on an exchange floor. This mechanism enables new, small companies which are not otherwise eligible to be listed on the stock exchange, to enlist on the OTC markets and provides liquidity to investors. The National Association of Securities dealers Automated Quotation System (NASDAQ) in the USA daily quotes over 8000 stock prices of companies backed by venture capital. The OTC Exchange in India was established in June 1992. The Government of India had approved the creation for the Exchange under the Securities Contracts (Regulations) Act in 1989. It has been promoted jointly by UTI, ICICI, SBI Capital Markets, Can Bank Financial Services, GIC, LIC and IDBI. Since this list of market-makers (who will decide daily prices

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and appoint dealers for trading) includes most of the public sector venture financiers, it should pick up fast, and it should be possible for investors to trade in the securities of new small and medium size enterprise. The other disinvestment mechanisms such as the management buy outs or sale to other venture funds are not considered to be appropriate by VCFs in India. The growth of an enterprise follows a life cycle as shown in the diagram below. The requirements of funds vary with the life cycle stage of the enterprise. Even before a business plan is prepared the entrepreneur invests his time and resources in surveying the market, finding and understanding the target customers and their needs. At the seed stage the entrepreneur continue to fund the venture with his own fund or family funds. At this stage the funds are needed to solicit the consultants services in formulation of business plans, meeting potential customers and technology partners. Next the funds would be required for development of the product/process and producing prototypes, hiring key people and building up the managerial team. This is followed by funds for assembling the manufacturing and marketing facilities in that order. Finally the funds are needed to expand the business and attaint the critical mass for profit generation. Venture capitalists cater to the needs of the entrepreneurs at different stages of their enterprises. Depending upon the stage they finance, venture capitalists are called angel investors, Venture capitalist or private equity supplier/investor.

CHAPTER4 METHODS OF VENTURE FINANCING

Venture Capital is typically available in three forms in India, they are:

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 Equity: All VCFs in India provide equity but generally their contribution does not
exceed 49% of the total equity capital. Thus, the effective control and majority ownership of the firm remains with the entrepreneur. They buy shares of an enterprise with an intention to ultimately sell them off to make capital gains.

Conditional Loan: it is repayable in the form of a royalty after the venture is able to
generate sales. No interest is paid on such loans. In India, VCFs change royalty ranging between 2% to 15%; actual rate depends on other factors of the venture such as gestation period, cost flow patterns, riskiness and other factors of the enterprise.

Income Note: it is a hybrid security which combines the features of both

conventional loan and conditional loan. The entrepreneur has to pay both interest and royalty on sales, but at substantially low rates.

Participating Debenture: such security carries charges in 3 phases. In the start up

phase, before the venture attains operations to a minimum level, no interest is charged, after this, low rate of interest is charged, up to a particular level of operation. Once the venture is commercial, a high rate of interest is required to be paid.

Quasi Equity: quasi equity instruments are converted into equity at a later date.
Convertible instruments are normally converted into equity at the book value or at certain multiple of EPS, i.e. at a premium to par value at a later date. The premium automatically rewards the promoter for their initiative and hand work. Since it is performance related, it motivates the promoter to work harder so as to minimize dilution of their control on the company. The different quasi equity instruments are follows: Cumulative convertible preference shares. Partially convertible debentures. Fully convertible debentures.

Other Financing methods: a few venture capitalists, particularly in the private

sector, have started introducing innovative financial securities like participating debentures, introduced by TCFC is an example.

CHAPTER 5

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 EVOLUTION OF VENTURE CAPITAL INDUSTRY IN INDIA

The first major analysis on risk capital for India was reported in 1983. It indicated that new companies often confront serious barriers to entry into capital market for raising equity finance which undermines their future prospects of expansion and diversification. It also indicated that on the whole there is a need to review the equity cult among the masses by ensuring competitive return on equity investment. This brought out the institutional inadequacies with respect to the evolution of venture capital. In India, the Industrial Finance Corporation of India (IFCO) initiated the idea of Venture Capital when it established the Risk Capital Foundation in 1975 to provide seed capital to small and risky projects. However the concept of venture capital financing got statutory recognition for the first time in the fiscal budget for the year 1986-87. The venture Capital companies operating at present can be divided into four groups: Promoted by All-India Development Financial Institutions Promoted by State Level Financial Institutions Promoted by Commercial Banks Private Venture Capitalists. Promoted by all India Development Financial Institutions

The IDBI started a Venture Capital in 1976 as per the long term fiscal policy of government of India, with an initial of Rs. 10 Cr. which raised by imposing a chess of 5% on all payment made for the import of technology know-how projects requiring funds from Rs.5 Lacks to Rs.2.5Cr. Were considered for financing. Promoters contribution ranged from this fund was available at a concessional interest rate of 9% (during gestation period) which could be increased at later stages. The ICICI provided the required impetus to Venture Capital activities in India, 1986 it started providing venture Capital finance in 1998 it promoted, along with the Unit trust of India (UTI) Technology Development and information Company of India (TDICI) as first venture Capital company registered under the companies act, 1956. The TDICI may provide financial assistance to venture capital undertaking which are set up by technocrat entrepreneurs, or technology information and guidance services.

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The risk capital foundation established by the industrial finance corporation of India (IFCI) in 1975, was converted in 1988 into the Risk Capital and Technology Finance Company (RCTC) as a subsidiary company of the IFCI the rate provides assistance in the form of conventional loans, interest free conditional loans on profit and risk sharing basis or equity participation in extends financial support to high technology projects for technological up gradations. The RCTC has been renamed as IFCI Venture Capital Funds Ltd. (IVCF)

Promoted by State Level Financial Institutions

In India, the State Level Financial Institutions in some states such as Madhya Pradesh, Gujarat, Uttar prades, etc., have done an excellent job and have provided venture capital to a small scale enterprise. Several successful entrepreneurs have been the beneficiaries of the liberal funding environment. In 1990, the Gujarat Industrial Investment Corporation, promoted the Gujarat Venture Financial Ltd (GVFL) along with other promoters such as the IDBI, the World Bank, etc., the GVFL provides financial assistance to business in the form of equity, conditional loans or income notes for technologies development and innovative products. It also provides finance assistance to entrepreneurs. The government of Andhra Pradesh has also promoted the Andhra Pradesh Industrial Development Corporation (APIDC) venture capital ltd. to provide venture capital financing in Andhra Pradesh.

Promoted by Commercial Banks

Canbank Venture Capital Fund, State bank Venture Capital Fund and Grindlays bank Venture Capital Fund have been set up the respective commercial banks to undertake venture capital activities. The State bank Venture Capital funds provides financial assistance for bought out deal as well as new companies in the form of equity which it disinvests after the commercialization of the project. Canbank Venture Capital Funds provides financial assistance for proven but yet to be commercially exploited technologies. It provides assistance both in the form of equity and conditional loans.

Private venture Capital Funds

Several private sector venture capital funds have been established in India such as the 20th Centure Venture Capital Company, Indus venture capital Funds, Infrastructure Leasing and financial Services Ltd.

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

Mastek, one of the oldest software house in India

Ruskan software, Pune based software consultancy SQL Star, Hyderabad based training and software development consultancy Satyam Infoway, the first private ISP in India Hinditrom, makers of embedded software Selectia, provider of interaction software selectior Yantra, ITL Infosys US subsidiary, solution for supply chain management Rediff on the Net, India website featuring electronic shopping, news, chat etc.

OBJECTIVE AND VISION FOR VENTURE CAPITAL IN INDIA

Venture capitalists finance innovation and ideas which have potential for high growth but with inherent uncertainties. This makes it a high-risk, high return investment. Apart from finance, venture capitalists provide networking, management and marketing support as well. In the broadest sense, therefore, venture capital connotes financial as well as human capital. In the global venture capital industry, investors and investee firms work together closely in an enabling environment that allows entrepreneurs to focus on value creating ideas and allows venture capitalists to drive the industry through ownership of the levers of control, in return for the provision of capital, skills, information and complementary resources. This very blend of risk financing and hand holding of entrepreneurs by venture capitalists creates an environment particularly suitable for knowledge and technology based enterprises. Scientific, technology and knowledge based ideas properly supported by venture capital can be propelled into a powerful engine of economic growth and wealth creation in a sustainable manner. In various developed and developing economies venture capital has played a significant developmental role. India, along with Israel, Taiwan and the United States, is recognized for its globally competitive high technology and human capital. India has the second largest English speaking scientific and technical manpower in the world. The Indian software sector crossed the Rs 100 billion mark turnover during 1998. The sector grew 58% on a year to year basis and exports accounted for Rs 65.3 billion while the

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domestic market accounted for Rs 35.1 billion. Exports grew by 67% in rupee terms and 55% in US dollar terms. The strength of software professionals grew by 14% in 1997 and has crossed 1, 60000. The global software sector is expected to grow at 12% to 15% per annum for the next 5 to 7 years. Recently, there has also been greater visibility of Indian companies in the US. Given such vast potential not only in IT and software but also in the field of service industries, biotechnology, telecommunications, media and entertainment, medical and health services and other technology based manufacturing and product development, venture capital industry can play a catalytic role to put India on the world map as a success story.

2009 VENTURE CAPITAL INVESTMENT IN INDIA

Venture Capital firms invested $475 million in 92 deals during 2009, down from the $836 million invested across 153 deals in the previous year, according to a study by Venture Intelligence and Global-India Venture Capital Association. Venture capital firms, however, began to increase the pace of their investments in Indian companies in the October-December quarter, making 42 investments worth $265 million, compared to 23 investments worth $102 million in the comparative period a year earlier, the study said. "The strong recovery in investment activity in the last quarter of 2009, as well the rising interest among global investors towards emerging markets like India, is quite encouraging for the growth of the sector," Sudhir Sethi, director of the Global-India Venture Capital Association, said in a statement. "During 2010, we expect significant follow-on investments into companies that raised Series a round (first round) in the past two to three years as well as a rise in exit activity as the global economic recovery gathers pace," he added.

NEED FOR GROWTH OF VENTURE CAPITAL IN INDIA

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People in developing countries are poor in part because they have far less capital than people in industrial countries. Because of this shortage, workers have little in the way of specialized machinery and equipment, and firms lack money to obtain more equipment. As a result, productivity of workers in developing countries is low compared with that of workers in industrial countries. Financial-resource flows from industrial to developing countries are an obvious means to overcome this inequality. But financial resources are not enough. Some developing countries have natural resources such as oil or minerals that, when sold on world markets, have provided large amounts of money. In many cases the money has failed to stimulate sustained economic growth or increased productivity and income for the average person. In part, failure to use capital productively results from the way these resources flow. In some countries the government gets the money, which it uses to perpetuate itself through military spending or through increased consumption spending. In other cases, resources flow to wealthy individuals who use them to maintain high levels of conspicuous consumption. India is still developing country. In India, a revolution is ushering in a new economy, wherein entrepreneurs mind set is taking a shift from risk adverse business to investment in new ideas which involve high risk. The conventional industrial finance in India is not of much help to these new emerging enterprises. Therefore there is a need of financing mechanism that will fit with the requirement of entrepreneurs and thus it needs venture capital industry to grow in India. Few reasons for which active Venture Capital Industry is important for India include:

Innovation: Needs risk capital in a largely regulated, conservation, legacy financial

system

Job Creation: large pool of skilled graduates in the first and second tier cities
Patient capital: Not flighty, unlike FIIs

Creating new Industry Clusters: Media, Retail, Call Centers and back office
processing, trickling down to organized effort of support services like Office services, Catering, Transportation.

CHAPTER 6 REGULATORY AND LEGAL FRAMEWORK

At present, the Venture Capital activity in India comes under the purview of different sets of regulations namely:

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The SEBI (Venture Capital Funds) Regulation, 1996[Regulations] lays down the overall regulatory framework for registration and operations of venture capital funds in India.

The Indian Trust Act, 1882 or the company Act, 1956 depending on whether the fund is set up as a trust or a company.

The foreign investment Promotion Board (FIPB) and the RBI in case of an offshore fund. These funds have to secure the permission of the FIPB while setting up in India and need a clearance from the RBI for any repatriation of income.

The Central Board of Direct Taxation (CBDT) governs the issues pertaining to income tax on the proceed from VC funding activity. The long term capital gain tax is at around 10% in India and the relevant clauses to VC may be found in Section 10(sub section 23)

Overseas venture capital investments are subject to the Government of India Guidelines for Overseas Venture Capital Investment in India dated September 20, 1995.

For tax exemptions purposes venture capital funds also needs to comply with the Income Tax Rules made under Section 10(23FA) of the Income Tax Act.

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SEBI (VCF) Reg. 1996 SEBI(FVCI) Reg.2000 SCR Act.1956 SEBI(SAST) Reg.1997 SEBI(DIP)Guidelines,2000 SEBI Act,1992

FEMA, 1999 Transfe r or issue of security by a person resident outside India regulati on 2000

FDI policy Investment approvals Press Notes

IT Act, 1961 DTAA S i n g a p o r e M a u r i t i u s O t h e r s

MAJOR

REGULATORY

FRAMEWORKS

FOR VENTURE CAPITAL INDUSTRY

Major Regulatory frameworks for venture capital industry In addition to the above, offshore funds also require FIPB/RBI approval for investment in domestic funds as well as in Venture Capital Undertakings (VCU). Domestic funds with offshore contributions also require RBI approval for the pricing of securities to be purchased in VCU likewise, at the time of disinvestment, RBI approval is required for the pricing of the securities. Definition of venture capital fund: The Venture Capital Fund is now defined s a fund established in the form of a Trust, a company including a body corporate and registered with SEBI which:

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Has a dedicated pool of capital; Raised in the manner specified under the regulations; and To invest in venture capital undertaking in accordance with the regulation.

Definition of Venture Capital Undertaking: Venture Capital Undertaking means a domestic company: Whose share are not listed on a recognized stock exchange in India

Which is engaged in business including such activities or sectors which are specified
in the negative list by the Board with the approval of the Central Government by notification in the Official Gazette in this behalf? The negative list includes real estate, non-banking financial services, gold financing, activities not permitted under the Industrial Policy of the Government of India. Minimum contribution and fund size: the minimum investment in a Venture Capital Fund from any investor will not be less than Rs.5 lacks and the minimum corpus of the fund before the fund can start activities shall be at least Rs.5 corers. Investment Criteria: The earlier investment criterion has been substituted by new investment criteria which has the following requirements: Disclosure of investment strategy; Maximum investment in single venture capital undertaking not to exceed 25% of the corpus of the fund; Investment in the associated companies not permitted; At least 75% of the investible funds to be invested in unlisted equity shares or equity linked instruments; Not more than 25% of the investible funds may be invested by way of; Subscription to initial public offer of a venture capital undertaking whose shares are proposed to be listed subject to lack in period of one year; Debt or debt instrument of a venture capital undertaking in which the venture capital funds has already made an investment by way of equity. It has also been provided that Venture Capital Fund seeking to avail benefit under the relevant provisions of the Income Tax Act will be required to divest from the investment within a period of one year from the listing of the Venture Capital Undertaking.

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Disclosure and Information to Investors: in order to simplify and expedite the process of fund raising, the requirement of filing the Placement memorandum with SEBI is dispensed with and instead the fund will be required to submit a copy of Placement Memorandum/ copy of contribution agreement entered to with the investors along with the details of the fund raiser for information to SEBI. Further, the contents of the Placement Memorandum are strengthened to provide adequate disclosure and information to investors. SEBI will also prescribe suitable reporting requirement from the fund on their investment activity. QIB status for Venture Capital funds: the venture capital funds will be eligible to participate in the IPO through book building route as qualified Institutional Buyer subject to compliance with the SEBI (Venture Capital Fund) Regulations. Relaxation in Takeover Code: the acquisition of share by the company or any of the promoters from the Venture Capital Funds under the terms of agreement shall be treated on the same footing as that of acquisition of shares by promoters/companies from the state level financial institutions and shall be exempt from making an open offer to other shareholders. Investment by Mutual Funds in Venture capital Funds: in order to increase the resources for domestic venture capital funds, Mutual Funds are permitted to invest up to 5% of its corpus in the case of open ended schemes and up to 10% of its corpus in the case of close ended schemes. A part from raising the resources for Venture Capital Funds this would provide an opportunity to small investors to participate in venture capital activities through Mutual funds. Government of India Guidelines: the Government of India (MOF) Guidelines for Overseas Venture Capital Investment in India dated September20, 1995 will be repealed by the MOF on notification of SEBI Venture Capital Fund Regulations. The following will be the salient features of SEBI (foreign Venture Capital Investors) Regulations, 2000: Definition of Foreign Venture capital Investor: any entity incorporated and established outside India and proposes to make investment in Venture Capital Fund or Venture Capital Undertaking and registered with SEBI. Eligibility Criteria: entity incorporated and established outside India in the form of Investment Company, Trust, Partnership, Pension Fund, Mutual Fund, University Fund, Endowment Fund, Asset Management Company, Investment Manager, Investment Management Company or other Investment Vehicle Incorporated outside India would be eligible for seeking registration from SEBI. SEBI for the purpose of registration shall

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consider whether the applicant is regulated by an appropriate foreign regulatory authority; or is income tax payer; or submits a certificate from its banker of its or its promoters, track record where the applicant is neither a regulated entity nor an income tax payer. Investment Criteria: Disclosure of investment strategy; Maximum investment in single venture capital undertaking not to exceed 25% of the funds committed for investment to India however it can invest its total fund committed in one venture capital fund;

Atleast 75% of the investible funds to be invested in unlisted equity shares or

equity linked instruments. Not more than 25%of the investible funds may be invested by way of: Subscription to initial offer of a venture capital undertaking whose shares are proposed to be listed subject to lock in period of one year; Debt or debt instrument of a venture capital undertaking in which the venture capital funds has already made an investment by way of equity. Hassle Free Entry and Exit: the Foreign Venture Capital Investors proposing to make venture capital investment under the Regulations would be granted registration by SEBI. SEBI Registered Foreign Venture Capital Investors shall be permitted to make investment on an automatic route within the overall sectoral ceiling of foreign investment under Annexure III of statement of Industrial Policy without any approval from FIPB. Further, SEBI registered FVCIs shall be granted a general permission from the exchange control angle for inflow and outflow of funds and no prior approval of RBI would be required for pricing, however, there would be export reporting requirement for the amount transacted. Trading in Unlisted Equity: the board also approved the proposal to permit OTCEI to develop a trading window for unlisted securities where Qualified Institutional Buyers (QIB) would be permitted to participate.

REGULATION OF THE BUSINESS OF VENTURE CAPITAL FUND IN INDIA

Eligibility conditions for grant of license to a venture capital fund.-

(1) A venture capital fund shall not be granted license unless it fulfills the following conditions, namely:-

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a) It is incorporated as a company under the Companies Ordinance, 1984 (XLVII of 1984); b) It is not engaged in any business other than that of investment in venture projects; c) It has a minimum paid-up capital of fifty million rupees raised through private placement; and d) For the purpose of managing its entire business, it has entered into a contract, in writing, with a venture capital company and a copy of which has been filed with the Commission. (2) The board of venture capital fund shall not have a director, who is on the board of any

venture project being financed by the fund. Condition for grant of license.-

(1) No venture capital fund shall commence business unless a license is granted under these rules. (2) For obtaining a license a venture capital fund shall a. Make an application to the Commission on Form V providing information as sought in Annex therein, along with all the relevant documents; b. Submit a bank draft payable to the Commission evidencing the payment of non-refundable application processing fee amounting to fifty thousand rupees; and c. Submit an undertaking that no change in the memorandum and articles of association and in the directors shall be made without prior written authorization of the Commission and that all conditions for grant of license shall be complied with. (3) On being satisfied that a venture capital fund is eligible for the grant of a license and that it would be in the public interest so to do, the Commission may grant a license in form VI. (4) Without prejudice to any other conditions under these rules, the Commission may while granting license imposes any conditions, as it may deem necessary. Terms and conditions of operation. - Unless granted a general or specific waiver by the Commission, a venture capital fund shall a. Not expose more than forty per cent of its equity to any single group of companies; Explanation. - For the purposes of this rule group of companies shall mean companies managed by the members of one family including

42

spouse, dependent lineal ascendants and descendants and dependent brothers and sisters. b. Disclose in its accounts all investments in companies and group of companies exceeding ten per cent of paid-up capital of venture capital fund; c. ensure that the maximum exposure of the venture capital fund to its directors, affiliated companies and companies in which any of the directors and their family members including spouse, dependent lineal ascendants and descendants and dependent brothers and sisters hold controlling interest shall not exceed ten per cent of the overall portfolio of venture capital; and d. Not accept any investment from any investor, which is less than one million rupees.

Renewal of license.
(1) The license granted to the fund under rule 10 shall be valid for one year and shall be renewable annually on payment of a fee of twenty thousand rupees on an application being made on Form VII. (2) The Commission may, after making such inquiry and after obtaining such further information as it may consider necessary, renew the license of such fund, one year on Form VIII on such conditions as it may deem necessary. Private placement.-

A venture capital fund shall raise and receive monies for investment in venture projects through private placement of such securities as may be notified by the Commission, from time to time. Placement memorandum.-

A venture capital fund shall, before soliciting placement of its securities, file with the Commission a placement memorandum which shall inter alia give details of the terms subject to which monies are proposed to be raised from such placements.

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CHAPTER 7

KEY SUCCESS FACTOR FOR VENTURE CAPITAL INDUSTRY IN INDIA

Knowledge becomes the key factor for a competitive advantage for company. Venture Capital firms need more expert knowledge in various fields. The various key success factors for venture capital industry are as follow: Knowledge about Govt. changing policies: Investment, management and exit 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. In this context the judgment of the judiciary raising doubts on treatment of tax on capital gains made by firms registered in Mauritius gains significance - changing policies with a retrospective effect is undoubtedly acting as a dampener to fresh fund raising by Venture capital firms. Quick Response time :

The companies have flat organization structure results in quicker decision making. The entrepreneur is relieved of the trauma that one normally goes through in an interface with a funding institution or a development agency. They follow a clearly defined decision making process that works with clock like precision, which means that if they agree on a funding schedule entrepreneur can count on them to stick it.

Knowledge about Global Environment

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

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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.

Good Human Resource :

Venture capital should become an institutionalized industry financed and managed by successful entrepreneurs, professional and sophisticated investors. Globally, venture capitalist 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.

Regulatory policy
Minimum contribution and fund size: the minimum investment in a Venture Capital Fund from any investor will not be less than Rs. 5 lacs and the minimum corpus of the fund before the fund can start activities shall be at least Rs. 5 crores. And the foreign players can easily enter in the venture capital industry of India. An offshore venture capital company may contribute 100% of the capital of domestic venture capital fund. There are other hurdles to enter in the industry so there is favorable condition for them to enter in to venture capital industry in India.

CHALLENGES AHEAD FOR VENTURE CAPITAL FINANCING IN INDIA

Venture Capital is money provided by professionals who invest and manage young rapidly growing companies that have the potential to develop into significant economic contributors. According to SEBI regulations, venture capital fund means a fund established in the form of a company or trust, which raises money through loans, donations, issue of securities or units and makes or proposes, to make investments in accordance with these regulations. The funds so collected are available for investment in potentially highly profitable enterprises at a high risk of loss. A Venture Capitalist is an individual or a company who provides. Investment Capital, Management Expertise, Networking & marketing support while funding and running highly innovative & prospective areas of products as well as services. Thus, the investment made by Venture Capitalists generally involves Financing new and rapidly growing companies.

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Purchasing equity securities. Taking higher risk in expectation of higher rewards. Having a long frame of time period, generally of more than 5 - 6 years. Actively working with the company's management to devise strategies pertaining to the overall functioning of the project. Networking and marketing of the product /service being offered.

In an attempt to bring together highly influential Indians living across the United States, a networking society named IND US Entrepreneurs or TiE was set up in 1992. The aim was to get the Indian community together and to foster entrepreneurs for wealth creation. A core group of 10 - 15 individuals worked hard to establish the organization. The group (TiE) has now over 600 members with 20 offices spread across the United States. Some of the famous personalities belonging to this group are Vinod Dham (father of the Pentium Chip), Prabhu Goel, and K.B. Chandrashekhar (Head of $ 200 mn. Exodus Communications, a fibre optic network carrying 30% of all Internet content traffic hosting websites like Yahoo, Hotmail and Amazon.)

PROBLEMS OF VENTURE CAPITAL FINANCING IN INDIA:

VCF is in its nascent stages in India. The emerging scenario of global competitiveness has put an immense pressure on the industrial sector to improve the quality level with minimization of cost of products by making use of latest technological skills. The implication is to obtain adequate financing along with the necessary hi-tech equipments to produce an innovative product which can succeed and grow in the present market condition. Unfortunately, our country lacks on both fronts. The necessary capital can be obtained from the venture capital firms who expect an above average rate of return on the investment. The financing firms expect a sound, experienced, mature and capable management team of the company being financed. Since the innovative project involves a higher risk, there is an expectation of higher returns from the project. The payback period is also generally high (5 7 years). The various problems/ queries can be outlined as follows: Requirement of an experienced management team. Requirement of an above average rate of return on investment. Longer payback period. Uncertainty regarding the success of the product in the market.

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Questions regarding the infrastructure details of production like plant location, accessibility, relationship with the suppliers and creditors, transportation facilities, labor availability etc.

The category of potential customers and hence the packaging and pricing details of the product. The size of the market. Major competitors and their market share. Skills and Training required and the cost of training. Financial considerations like return on capital employed (ROCE), cost of the project, the Internal Rate of Return (IRR) of the project, total amount of funds required, ratio of owners investment (personnel funds of the entrepreneur), borrowed capital, mortgage loans etc. in the capital employed.

CHAPTER 8 RECOMMENDATIONS:
Multiplicity of regulations need for harmonization and nodal Regulator:

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Presently there are three set of Regulations dealing with venture capital activity i.e. SEBI (Venture Capital Regulations) 1996, Guidelines for Overseas Venture Capital Investments issued by Department of Economic Affairs in the MOF in the year 1995 and CBDT Guidelines for Venture Capital Companies in 1995 which was modified in 1999. The need is to consolidate and substitute all these with one single regulation of SEBI to provide for uniformity, hassle free single window clearance. There is already a pattern available in this regard; the mutual funds have only one set of regulations and once a mutual fund is registered with SEBI, the tax exemption by CBDT and inflow of funds from abroad is available automatically. Similarly, in the case of FIIs, tax benefits and foreign inflows/outflows are automatically available once these entities are registered with SEBI. Therefore, SEBI should be the nodal regulator for VCFs to provide uniform, hassle free, single window regulatory framework. On the pattern of FIIs, Foreign Venture Capital Investors (FVCIs) also need to be registered with SEBI. Tax passes through for Venture Capital Funds: VCFs are a dedicated pool of capital and therefore operate in fiscal neutrality and are treated as pass through vehicles. In any case, the investors of VCFs are subjected to tax. Similarly, the investee companies pay taxes on their earnings. There is a well established successful precedent in the case of Mutual Funds which once registered with SEBI are automatically entitled to tax exemption at pool level. It is an established principle that taxation should be only at one level and therefore taxation at the level of VCFs as well as investors amount to double taxation. Since like mutual funds VCF is also a pool of capital of investors, it needs to be treated as a tax pass through. Once registered with SEBI, it should be entitled to automatic tax pass through at the pool level while maintaining taxation at the investor level without any other requirement under Income Tax Act. Flexibility in Investment and Exit:

Allowing multiple flexible structures:

Eligibility for registration as venture capital funds should be neutral to firm structure. The government should consider creating new structures, such as limited partnerships, limited liability partnerships and limited liability corporations. At present, venture capital funds can be structured as trusts or companies in order to be eligible for registration with SEBI.Internationally, limited partnerships, Limited Liability Partnership and limited liability corporations have provided the necessary flexibility in risk-sharing, compensation arrangements amongst investors and tax pass through. Therefore, these structures are

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commonly used and widely accepted globally specially in USA. Hence, it is necessary to provide for alternative eligible structures. Flexibility in the matter of investment ceiling and sectoral restrictions:

70% of a venture capital funds investible funds must be invested in unlisted equity or equitylinked instruments, while the rest may be invested in other instruments. Though sectoral restrictions for investment by VCFs are not consistent with the very concept of venture funding, certain restrictions could be put by specifying a negative list which could include areas such as finance companies, real estate, gold-finance, activities not legally permitted and any other sectors which could be notified by SEBI in consultation with the Government. Investments by VCFs in associated companies should also not be permitted. Further, not more than 25% of a funds corpus may be invested in a single firm. The investment ceiling has been recommended in order to increase focus on equity or equity-linked instruments of unlisted startup companies. As the venture capital industry matures, investors in venture capital funds will set their own prudential restrictions. Changes in buy back requirements for unlisted securities:

A venture capital fund incorporated as a company/ venture capital undertaking should be allowed to buy back up to 100% of its paid up capital out of the sale proceeds of investments and assets and not necessarily out of its free reserves and share premium account or proceeds of fresh issue. Such purchases will be exempt from the SEBI takeover code. A venturefinanced undertaking will be allowed to make an issue of capital within 6 months of buying back its own shares instead of 24 months as at present. Further, negotiated deals may be permitted in unlisted securities where one of the parties to the transaction is VCF.

Relaxation in IPO norms:

The IPO norms of 3 year track record or the project being funded by the banks or financial institutions should be relaxed to include the companies funded by the registered VCFs also. The issuer company may float IPO without having three years track record if the project cost to the extent of 10% is funded by the registered VCF. Venture capital holding however shall be subject to lock in period of one year. Further, when shares are acquired by VCF in a preferential allotment after listing or as part of firm allotment in an IPO, the same shall be subject to lock in for a period of one year. Those companies which are funded by Venture capitalists and their securities are listed on the stock exchanges outside the country; these companies should be permitted to list their shares on the Indian stock exchanges. Relaxation in Takeover Code:

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The venture capital fund while exercising its call or put option as per the terms of agreement should be exempt from applicability of takeover code and 1969 circular under section 16 of SC(R) A issued by the Government of India. Issue of Shares with Differential Right with regard to voting and dividend: In order to facilitate investment by VCF in new enterprises, the Companies Act may be amended so as to permit issue of shares by unlisted public companies with a differential right in regard to voting and dividend. Such flexibility already exists under the Indian Companies Act in the case of private companies which are not subsidiaries of public limited companies. QIB Market for unlisted securities: A market for trading in unlisted securities by QIBs is developed. NOC Requirement: In the case of transfer of securities by FVCI to any other person, the RBI requirement of obtaining NOC from joint venture partner or other shareholders should be dispensed with. RBI Pricing Norms: At present, investment/disinvestment by FVCI is subject to approval of pricing by RBI which curtails operational flexibility and needs to be dispensed with.

CHAPTER 9: Findings:
Is the venture capital concept accepted in India much? Indian market is not critically involved into venture capital. Are the procedures a hurdle and a cause of failure? Yes, certainly.rigid regulations and lengthy procedures are a problem but at the same time these are required in order to avoid default and loss to the countrys economy. How far the investors invest into new firms via v.c? The extent up to which they find it difficult to manage funds from other resources.

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 Has v.c helped the development of Indian technology sector? V.c has encouraged brilliant ideas germinated into practical implementation. Indian technological sector has brilliantly grabbed the v.c opportunity and approach.

Does the development of a country depend on v.c? If yes then to what extent?

Yes to quite an extent it does since the major input of any business which is capital is being provided along with other secondary but equally important inputs. Is there currently any development in Indian v.c sector? Since 2001 reforms, there has been a great development in v.c especially with regard to its norms, promotion of the concept and ease in regulations.

How far the brand of a bank influences promoters? The banks brand plays a major role since the goodwill helps the promoter as
well as the investor largely to have faith in their merchant bankers and to have an assurance on the return of their savings.

CHAPTER 10 CONCLUSION
The study provides that the maturity if the still nascent Indian Venture Capital market is imminent. Venture Capitalists in Indian have notice of newer avenues and regions to expand. VCs have moved beyond IT service but are cautious in exploring the right business model, for finding opportunities that generate better returns for their investors. In terms of impediments to expansion, few concerning factors to VCs include; unfavorable political and regulatory environment compared to other countries, difficulty in achieving successful exists and administrative delays in documentation and approval.

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In spite of few non attracting factors, Indian opportunities are no doubt promising which is evident by the large number of new entrants in past years as well in coming days. Nonetheless the market is challenging for successful investment. Therefore Venture capitalists responses are upbeat about the attractiveness of the India as a place to do the business.

ANNEXTURE (QUESTIONNAIRE)
Is the venture capital concept accepted in India much? Are the procedures a hurdle and a cause of failure? How far the investors invest into new firms via v.c? Has v.c helped the development of Indian technology sector?

Does the development of a country depend on v.c? If yes then to what extent?
Is there currently any development in Indian v.c sector?

How far the brand of a bank influences promoters?

BIBLIOGRAPHY
BOOKS:
Taneja Satish, Venture Capital in India.

Chary T Satyanarayana, Venture Capital Concepts & Applications MAGAZINE: Sharma Kapil, an Analysis of Venture Capital Industry in India. WEBSITE:
www.ivca.org www.indiavca.org. www.vcindia.com www.ventureintelligence.in

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 www.nvca.org www.economictimes.indiatimes.com www.100ventures.com

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