VENTURE CAPITAL

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 ACKNOWLEDGEMENT

One of the pleasant aspects of preparing a project report is the opportunity to thank to
those who have contributed to make the project completion possible.

I am extremely thankful to Mr. Deepak Whose active interest in the project and
insights helped to formulate, redefine and implement our approach towards the project.

We are also thankful to all those seen and unseen hands & heads, which have been of
direct or indirect, help in the completion of this project.

Table Of Contents

Sr.No Particulars Page No.

Acknowledgement

1
1 Preface 3

2 Executive Summary 4

3 Introduction to project 6-9

4 Conceptual framework 10-49

5 Global scenario of venture capital industry 50-67

6 Venture capital in India 68-103

7 Recommendations 104

8 Conclusion 112

9 Bibliography & Webliography 113

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 PREFACE

In India, a revolution is ushering in a new economy, wherein major investment are being
made in the knowledge based industry with substantially low investments in land, building,
plant and machinery. The asset/ collateral- backed lending instruments adopted for the hard
core manufacturing industries, are proving to be inadequate for the knowledge- based
industries that often start with just idea.

The only way to finance such industries is through Venture Capital. Venture Capital is
instrumental in bringing about industrial development, for it exploits the vast and untapped
potentialities and promotes the growth of the knowledge- based industries worldwide.

In India too, it has become popular in different parts of the country. Thus, the role of venture
capitalist is very crucial, different, and distinguishable to the role of traditional finance as it
deals with others’ money. In view of the globalization; venture Capital has turned out to be a
boon to both business and industry.

This report, contains in-depth study of Venture Capital Industry which is made with an
intension to get through all the aspects related to the topic and to become able to make some
suggestion at the industry. This report deals with the concept of Venture Capital. The report
includes facts, rules and regulations regarding Venture Capital.

 EXECUTIVE SUMMARY

Ventu1re 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.

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Starting and growing a business always require capital. There are a number of alternative
methods to fund growth. These include the owner or proprietor’s 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.

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INTRODUCTION TO PROJECT

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  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. Venture capital has played a very
important role in U.K., Australia and Hong Kong also in development of technology
growth of exports and employment.
 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 India’s
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.
 To know the impact of political & economical factors on venture capital
investment.
 STATEMENT OF PROBLEMS

Venture capital 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
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:

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

 The limited infrastructure, low foreign investment and other transitional problems,
because of above three reasons availability of fund is very low in market.

 Uncertainty regarding the success of the product in the market.

 As there is requirement of an experienced management team, Due to unavailability of

experienced and skilled people it is difficult to analyze the future growth of the
product in the market.

 Government has taken all the Initiatives in formulating policies to encourage investors
and entrepreneurs. A government policy has many rules and regulation that can create
problems in allocating the fund to the Organizations.

 Initiatives of the SEBI to develop a strong and vibrant capital market giving the
adequate liquidity and flexibility for investors for entry and exit. Due to many rules
and regulations from SEBI organization face lots of difficulties at the time of entering
in the market.

 Problem regarding requirement of an above average rate of return on investment, also

longer payback period. The returns on investment are high but the probability of fund
return is depending on the product success in future.

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 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

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 CONCEPTUAL FRAMEWOR

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
company’s development under highly risky investment condition with distinctive type of
financing appropriate to each stage of development. Investors join the entrepreneurs as co-
partners 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.

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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
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 customer’s business.

 FEATURES OF VENTURE CAPITAL

 High Risk

 High Tech

 Equity Participation & Capital Gains

 Participation In Management

 Length Of Investment

 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:

o Management risk -Inability of management teams to work together.

o Market risk -Product may fail in the market.

o Product risk -Product may not be commercially viable.

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 o 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.

 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 company’s
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

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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
fund are needed to solicit the consultant’s 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,

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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.

Introduction stage

Growth
Stage
Later Stage

Seed Capital Early Stage

Second Stage

Startup Capital

Venture Capital Spectrum/Stage

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:-

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 1. Early stage Finance

 Seed capital

 Start up Capital

 Early/First Stage Capital

 Later/Third Stage capital

2. Later Stage Finance

 Expansion/Development Stage Capital

 Replacement Finance

 Management Buy Out and Buy Ins

 Turnarounds

 Mezzanine/Bridge Finance

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.

The table below shows risk perception and time orientation for different stages of venture
capital financing.

Financing Stage Period (funds Risk perception Activity to be financed

locked in years)

Early stage finance 7-10 Extreme For supporting a concept or

idea or R & D for product
development

Start up 5-9 Very high Initializing operations or

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 developing prototypes

First stage 3-7 High Start commercial production

and marketing

Second stage 3-5 Sufficiently high Expand market & growing

working capital need

Later stage finance 1-3 Medium Market expansion, acquisition

& product development for
profit making company

Buy out-in 1-3 Medium Acquisition financing

Turnaround 1-3 Medium to high Turning around a sick

company

Mezzanine 1-3 Low Facilitating public issue

Venture Capital- Financing Stages

 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

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  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 entrepreneur’s 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:-

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.

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 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 entrepreneur’s 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
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

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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 investor’s 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.

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  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.

 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

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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

 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 firm’s 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.

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  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.

“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:

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  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

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

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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 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.

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

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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.

 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

Investors

Screening

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Prospective
Exit
Investee Monitoring
Structuring
Selection
 Investment
process

 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

25
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.

 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

26
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-to-
day operation of the venture. If a financial or managerial crisis occurs, the venture capitalist
may intervene, and even install a new management team.

 Exit:

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.

27
In India, the promoters are invariably given the first option to buy back equity of their
enterprise. For example, RCTO participates in the assisted firm’s 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)

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.

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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
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 consultant’s 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,

29
venture capitalists are called angel investors, Venture capitalist or private equity
supplier/investor.

 METHODS OF VENTURE FINANCING

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

 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:

o Cumulative convertible preference shares.

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 o Partially convertible debentures.

o 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.

 DIFFERENCE BETWEEN VENTURE CAPITAL AND OTHER FUNDS

(PRIVATE EQUITY)

 Venture Capital Vs Development Funds

Venture capital differs from development funds as latter means putting up of industries
without much consideration of use of new technology or new entrepreneurial venture but
having a focus on underdeveloped areas (locations). In majority cases it is in the form of loan
capital and proportion of equity is very thin. Development finance is security oriented and
liquidity prone. The criteria for investment are proven track record of company and its
promoters, and sufficient cash generation to provide for returns (principal and interest). The
development bank safeguards its interest through collateral.

They have no say in working of the enterprise except safeguarding their interest by having a
nominee director. They do not play any active role in the enterprise except ensuring flow of
information and proper management information system, regular board meetings, adherence
to statutory requirements for effective management information system, regular board
meetings, adherence to statutory requirements for effective management control where as
Venture capitalist remain interested if the overall management of the project account of high
risk involved I the project till its completion, entering into production and making available
proper exit route for liquidation of the investment. As against this fixed payments in the form
of installment of principal and interest are to be made to development.

 Venture Capital Vs Seed Capital & Risk Capital

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It is difficult to make a distinction between venture capital, seed capital, and risk capital as
the latter two form part of broader meaning of Venture capital. Difference between them
arises on account of application of funds and terms and conditions applicable. The seed
capital and risk funds in India are being provided basically to arrange promoter’s contribution
to the project. The objective is to provide finance and encourage professionals to become
promoters of industrial projects. The seed capital is provided to conventional projects on the
consideration of low risk and security and use conventional techniques for appraisal. Seed
capital is normally in the form low interest deferred loan as against equity investment by
Venture capital. Unlike Venture capital, Seed capital providers neither provide any value
addition nor participate in the management of the project. Unlike Venture capital Seed capital
provider is satisfied with low-normal returns and lacks any flexibility in its approach.

Risk capital is also provided to established companies for adapting for new technologies.
Herein the approach is not business oriented but developmental. As a result on one hand the
success rate of units assisted by seed capital/risk.

Finance has been lower than those provided with venture capital. On the other hand the return
to the seed/risk capital financier had been very low as compared to venture capitalist.

Seed Capital Scheme Venture Capital Scheme

Basic Income or aid Commercial viability

Beneficiaries Very small entrepreneurs Medium and large entrepreneurs are

also covered

Size of assistance Rs. 15 lac(Max) Up to 40 percent of promoters’

equity

Appraisal process Normal Skilled and Specialized

Estimates returns 20 percent 30 percent plus

Flexibility Nil Highly flexible

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Value addition Nil Multiple ways

Exit option Sell back to promoters Several, including public offer

Funding sources Owner funds Outside contribution allowed

Syndication Not done Possible

Tax concession Nil Exempted

Success rate Not good Very satisfactory

Difference between Seed Capital Scheme and Venture Capital Scheme

 Venture Capital Vs Bought Out Deals

The important difference between the venture capital and bought out deals is that bought outs
are not based upon high risk- high reward principal. Further unlike venture capital they do not
provide equity finance at different stages of the enterprise. However both have a common
expectation of capital gains yet their objectives and intents are totally different.

 VENTURE CAPITAL & ALTERNATIVE FINANCING COMPARISON

33
 Venture capital & alternative financing comparison

If we are struggling to find success in our quest for venture capital, maybe we are looking in
the wrong place. Venture capital is not for everybody. For starters, venture capitalists tend to
be very picky about where they invest. They are looking for something to dump a lot of
money into 9usually no less than $1 million) that will pour even more money right back at
them in a short amount of time (typically 3-7 years). We may be planning for a steady growth
rate as opposed to the booming, overnight success that venture capitalists tend to gravitate
toward. We may not be able to turn around as large of a profit as they are looking for in quick
enough time. We may not need the amount of money that they offer or our business may
simply not be big enough.

Simply put, venture capital is not the right fit for our business and there are plenty of other
options available when it comes to finding capital.

 Substitute in Early stage

o Angels

Most venture capital funds will not consider investing in anything under $1 million to $2
million. Angels, however, are wealthy individuals who will provide capital for a startup
business. These investors have usually earned their money as entrepreneurs and business
managers and can serve as a prime resource for advice on top of capital. On the other hand,
due to typically limited resources, angels usually have a shorter investment horizon than
venture capitalists and tend to have less tolerance for losses.

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 o Private Placement

An investment bank or agent may be able to raise equity for our company by placing our
unregistered securities with accredited investors. However, you should be aware that the fees
and expenses associated with this practice are generally higher than those that come with
venture and angel investors. We will likely receive little or no business counsel from private
investors who also tend to have little tolerance for losses and under-performance.

o Initial Public Offering

If we are somehow able to gain access to public equity markets than an initial public offering
(IPO) can be an effective way to raise capital. Keep in mind that, while the public market’s
high valuations, abundant capital and liquidity characteristics make it attractive, the
transaction costs are high and there are ongoing legal expenses associated with public
disclosure requirements.

 Later Stage Financing

o Bootstrap Financing

This method is intended to develop a foundation for your business from scratch. Financial
management is essential to make this work. With bootstrap financing you’re building a
business from nothing, which means there is little to no margin for error in the finance
department. Keep a rigid account of all transactions and don’t stray from your budget.

A few different methods of bootstrapping include:

Factoring, this generates cash flow through the sale of your accounts receivable to a “factor”
at discounted price for’s cash.

Trade Credit is an option if you are able to find a vendor or supplier that will allow you to
order goods on net 30, 60 or 90 day terms. If you can sell the goods before the bill comes due
then you have generated cash flow without spending any money. Customers can pay you up
front our services.

Leasing, your equipment instead of purchasing it outright.

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 o Fund from Operations

Look for ways to tweak your business in order to reduce the cash flowing out and increase
the cash flowing in. Funding found in business operations come free of finance charges, can
reduce future financing charges and can increase the value of your business. Month-by-month
operating and cash projections will show how well we have planned, how you can optimize
the elements of your business that generate cash and allow you to plan for new investments
and contingencies.

o Licensing

Sell licenses to technology that is non-essential to our company or grant limited licensing to
essential technology that can be shared. Throughout licensing we can generate revenue from
up-front fees, access fees, royalties or milestone payments.

o Vendor Financing

Similar to the trade credit related to bootstrap financing, vendors can play a big role in
financing your new business. Establish vendor relationships through our trade association and
strike deals to offer their product and pay for it at a date in the near future. Selling the product
in time is up to us. In hopes of keeping you as a customer, vendors may also be willing to
work out an arrangement if we need to finance equipment or supplies. Just make sure to look
for stability when you research a vendor’s credentials and reputation before you sign any kind
of agreement. And keep in mind that many major suppliers (GE Small Business Solutions,
IBM Global Financing) own financial companies that can help you.

o Self Funding

Search between the couch cushions and in old jacket pockets for whatever extra money you
might have lying around and invest it into your business. Obviously loose change will not be
enough for extra business funding, but take a look at your savings, investment portfolio,
retirement funds and employee buyout options from your previous employer. You won’t have
to deal with any creditors or interest and the return on your investment could be much higher.

36
However, make sure that you consider the risks involved with using your own resources.
How competitive is the market that you are about to enter into? How long will it take to pay
you back? Will you be able to pay yourself back? Can you afford to lose everything that you
are investing if your business were to fail? It’s important that your projected returns are more
than enough to cover the risk that you will be taking.

o SBIR and STTR Programs

Coordinated by the SBA, SBIR (Small Business Innovation Research) and STTR (Small
business Technology Transfer) programs offer competitive federal funding awards to
stimulate technological innovation and provide opportunities for small businesses. You can
learn more about these programs at SBIRworld.com.

o State Funding

If you’re not having any luck finding funding from the federal government take a look at
what your state has to offer. There is a list of links to state development agencies that offer an
array of grants and financial assistance for small businessessonsAbout.com..

o Community Banks

These smaller banks may have fewer products than their financial institution counterparts but
they offer a great opportunity to build banking relationships and are generally more flexible
with payment plans and interest rates.

o Microloans

These types of loans can range from hundreds of dollars to low six-figure amounts. Although
some lenders regard microloans to be a waste of time because the amount is so low, these can
be a real boon for a startup business or one that just needs to add some extra cash flow.

o Finance Debt

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It may be more expensive in the long run than purchasing, but financing your equipment,
facilities and receivables can free up cash in the short term or reduce the amount of money
that you need to raise.

o Friends

Ask your friends if they have any extra money that they would like to invest. Assure them
that you will pay them back with interest or offer those stock options or a share of the profits
in return.

o Family

Maybe you have a rich uncle or a wealthy cousin that would be willing to lend you some
money get your business running or send it to the next level. Again, make it worth their while
by offering interest, stocks or a share of the profits.

o Form a Strategic Alliance

Aligning your business with a corporation can produce funding from upfront or access fees to
your service, milestone payments and royalties. In addition, corporate partners may be able to
provide research funding, loans and equity investments.

o Sell Some Assets

Find an interested party to buy some of your assets (computers, equipment, real estate, etc…)
and then lease them back to you. This provides an instant source of cash and you will still be
able to use whatever assets you need.

o Business Lines of Credit

If your business has positive cash flow and has proven that it will cover its debts then you
may be eligible for a business line of credit. This type of financing is a common service
offered by most business banks and serves as business capital, up to an agreed upon amount,
that you can access at any time.

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 o Personal Credit Cards

Using personal credit cards to finance a business can be risky but, if you take the right
approach, they can also give your business a lift. You should only consider using this type of
financing for acquiring assets and working capital. Never consider this to be a long-term
option. Once your company breaks even or moves into the black, ditch the credit cards and
move toward traditional bank financing or lease agreements.

o Business Credit Cards

Business credit cards carry similar risks as personal credit cards but tend to be a safer
alternative. While the activity on this card goes toward your credit report, a business credit
card can help you to build business credit, keep your business expenses separate from your
personal expenses and can make tax season easier to manage.

 PLAYERS IN VENTURE CAPITAL INDUSTRY

Idea Established the Expansion Troubleshooting

company

Business concept Break Even- Investing In IPO Turnaround

point technology

Angle Small Medium

Venture Corporate venture
Fund investors funds

Big Venture Funds + Financial Funds

Players in Venture Capital Industry

There are following group of players:

39
  Angels and angel clubs

 Venture capital funds

o Small

o Medium

o Large

 Corporate Venture funds

 Financial service venture groups

 Angels and angel clubs

Angels are wealthy individuals who invest directly into companies. They can form angel
clubs to coordinate and bundle their activities. Beside the money, angels often provide their
personal knowledge, experience and contacts to support their investees. With average deals
sizes from USD100, 000 to USD 500,000 they finance companies in their early stages.
Examples for angel clubs are –Media Club, Dinner Club, and Angel’s forum

 Small and Upstart Capital Funds

These are smaller Venture Capital Companies that mostly provide seed and startup capital.
The so called “Boutique firms” are often specialized in certain industries or market segments.
Their capitalization is about USD 20 to USD 50 million (is this deals size or total money
under management or money under management per fund?). As for small and medium
Venture capital funds strong competition will clear the market place. There will be mergers
and acquisitions leading to a concentration of capital. Funds specialized in different business
areas will form strategic partnerships. Only the more successful funds will be able to attract
new money. Examples are:

o Artemis Comaford

o Abbell Venture Fund

o Acacia Venture Partners

 Medium Venture Funds

40
The medium venture funds finance all stages after seed and operate in all business segments.
They provide money for deals up to USD 250 million. Single funds have up to USD 5 billion
under management. An example is Accel Partners

 Large Venture Funds

As the medium funds, large funds operate in all business sectors and provide all types of
capital for companies after seed stage. They often operate internationally and finance deals up
to USD 500 million the large funds will try to improve their position by mergers and
acquisitions with other funds to improve size, reputation and their financial muscle. In
addition they will to diversify. Possible areas to enter are other financial services by means of
M&As with financial services corporations and the consulting business. For the latter one the
funds have a rich resource of expertise and contacts in house. In a declining market for their
core activity and with lots of tumbling companies out there is no reason why Venture Capital
funds should offer advice and consulting only to their investees.

Examples are:

o AIG American International Group

o Cap Vest man

o 3i

 Corporate Venture Funds

These Venture Capital funds are set up and owned by technology companies. Their aim is to
widen the parent company’s technology base in an win-win-situation for both, the investor
and the investee. In general, corporate funds invest in growing or maturing companies, often
when the investee wishes to make additional investments in technology or product
development. The average deals size is between USD 2 million and USD 5 million. The large
funds will try to improve their position by mergers and acquisitions with other funds to
improve size, reputation and their financial muscle. In addition they will to diversify. Possible
areas to enter are other financial services by means of M&As with financial services
corporations and the consulting business. For the latter one the funds have a rich resource of
expertise and contents in house. In a declining market for their core activity and with lots of

41
tumbling companies out there is no reason why Venture Capital funds should offer advice and
consulting only to their investees. Examples are:

o Oracle

o Adobe

o Dell

o Kyocera

As an example, Adobe systems launched a $40m venture fund in 1994 to invest in companies
strategic to its core business, such as Cascade Systems Inc and lantana research Corporation-
has been successfully boosting demand for its core products, so that Adobe recently launched
a second $40m fund.

 Financial Funds:

A solution for financial funds could be a shift to a higher securisation of Venture Capital
activities. That means that the parent companies shift the risk to their customers by creating
new products such as stakes in a Venture Capital fund. However, the success of such products
will depend on the overall climate and expectations in the economy. As long as the sown turn
continues without any sign of recovery customers might prefer less risky alternatives.

GLOBAL SCENARIO OF VENTURE CAPITAL INDUSTRY

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 OVERVIEW

The global economic downturn has many venture capitalists altering strategies, including
reducing investment levels in the short term, according to the 2009 Global Venture Capital
Survey by Deloitte Touche Tohmatsu and the National Venture Capital Association. Fifty-one
percent of the survey respondents are decreasing the number of companies in which they plan
to invest and just 13 percent are increasing this activity.

The 2009 Global Venture Capital survey, which measured the opinions of more than 750
venture capitalists worldwide, also shines headlights into the post-recession landscape. The
cleantech sector is poised to become the leading investment category and the globalization of
the venture capital industry will intensify the latter posing significant competitive questions
for the United States and opportunities for emerging markets such as China.

“While the recession has slowed the pace of venture investing in the short term, it may very
well have expedited the global evolution of the industry in the long run,” said Mark Jensen,
national managing partner of Deloitte LLP’s Venture Capital Services. “In recent years, many
entrepreneurs who have been educated in the United States have returned home to start
companies in their home countries. The playing field continues to level out in terms of new
innovation hot spots, broader access to capital and growing regional ecosystems that foster
risk taking and capital formation.”

 HISTORY & EVOLUTION

Prior to World War Two, the source of capital for entrepreneurs everywhere was either the
government, government-sponsored institutions meant to invest in such ventures, or informal
investors (today, termed “angels’) that usually had some prior relationship to the
entrepreneur. In general, throughout history private banks, quite reasonably, have been
unwilling to lend money to a newly established firm because of the high risk and lack of
collateral. After World War two, in the U.S. a set of intermediaries emerged who specialized
in investing in fledgling firms having the potential for extremely rapid growth.

Form its earliest beginnings on the U.S. East Coast, venture capital gradually expanded and
became an increasingly professionalized institution. During this period, the locus of the
venture capital industry shifted from New York and Boston on the east Coast to Silicon

43
Valley on the west coast. By the mid 1980s, the ideal-typical venture capital firm was based
in Silicon Valley and invested largely in electronics with lesser sums devoted to biomedical
technologies. Until the present, in addition to Silicon Valley, the two other major
concentrations have been Boston and New York City.

In both Europe and Asia, there are significant concentrations of venture capital in London,
Israel, Hong Kong, Taiwan, and Tokyo. In the U.S., the government has played a role in the
development of venture capital, though, for the most part, it was indirect. The indirect role,
i.e., the general policies that also benefited the development of the venture capital industry,
was probably the most significant. Some of the most important of these were;

 The U.S. government generally practiced sound monetary and fiscal policies
ensuring relatively low inflation with a stable financial environment and currency.

 U.S. tax policy, though it evolved, has been favorable to capital gains, and a
number of decreases in capital gains taxes may have had some positive effect on
the availability of venture capital.

 With the exception of a short period in the 1970s, U.S. pension funds have been
allowed to invest prudent amounts in venture capital funds.

 The NASDAQ stock market, which has been the exit strategy of choice for
venture capitalists, was strictly regulated and characterized by increasing
openness thus limiting investor’s fears of fraud and deception.

This created a general macroeconomic environment of transparency and predictability,

reducing risk for investors. Put differently, environmental risks stemming from government
action were minimized- a shop contrast to most developing nations.

Another important policy has been a willingness to invest heavily and continuously in
university research. This investment funded generations of graduate students in the sciences
and engineering. From this research has come trained personal and innovations; U.S.
universities particularly, MIT, Stanford, and UC Berkeley played a particular salient role.

The most important direct U.S. government involvement in encouraging the growth of
venture capital was the passage of the small Business Investment Act of 1958 authorizing the

44
formation of Small Business Investment Corporations (SBICs). This legislation created a
vehicle for funding small firms of all types. The legislation was complicated, but for the
development of venture capital the following features were most significant:

 It permitted individuals to from SBICs with private funds as paid-in capital and then
they could borrow money on a 2:1 ratio initially up to $300,000, i.e., they could use
up to $300,000 of SBA-guaranteed money for their investment of $150,000 in
private capital.

 There were also tax and other benefits, such as income and a capital gains pass
through and the allowance of a carried interest as compensation.

The SBIC program becomes one that many other nations either learned from or emulated.
The SBIC program also provided a vehicle for banks to circumvent the Depression-era laws
prohibiting commercial allowed them to acquire equity in small firms. This made even more
capital available to fledgling firms, and was a significant source of capital in the 1960s and
1970s. The final investment format permitted SBICs to raise money in the public market. For
the most part, these public SBICs failed and/or were liquidate by the mid 1970s. After the
mid 1970s, with the exception of the bank SBICs, the SBIC program was no longer
significant for the venture capital industry.

The SBIC program experienced serious problems from its inception. One problem was that as
a government agency it was very bureaucratic having many rules and regulations that were
constantly changing. Despite the corruption, something valuable also occurred. Namely, and
especially, in Silicon Valley, a number of individuals used their SBICs to leverage their
personal capital, and some were so successful that were able to reimburse the program and
raise institutional money to become formal venture capitalists. The SBIC program accelerated
their capital accumulation, and as important, government regulations made these new venture
capitalists professionalize their investment activity, which had been informal prior to entering
the program. Now-illustrious firms such as Sutter hill ventures, Institutional Venture Partners,
Bank of America Ventures, and Menlo Ventures began as SBICs.

The historical record also indicates that government action can harm venture capital. The
most salient example came in 1973 when the U.S. Congress, in response to widespread
corruption in pension funds, changed Federal pension fund regulations. In their haste to

45
prohibit pension fund abuses, Congress passed the employment Retirement Income Security
Act (ERISA) making pension fund managers criminally liable for losses incurred in High-risk
investments. This was interpreted to include venture capital funds; as a result pension
managers shunned venture capital nearly destroying the entire industry.

This was only reversed after active lobbying by newly created National Venture Capital
Association (NVCA). In 1977, it succeeded in starting a gradual loosening process that was
completed in 1982. The new interpretation of these pension fund guidelines contributed to
first a trickle then a flood of new money into venture capital funds. The most successful case
of the export of Silicon Valley- style venture capital practice is Israel where the government
played an impotent role in encouraging the growth of venture capital.

The government has a relatively good economic record; there is a minimum of corruption,
massive investment in military, particularly electronics research and the excellent higher
educational system. The importance of the relationships between Israelis and Jewish
individuals in U.S. high-technology industry and the creation of the Israeli venture capital
system should not be underestimated.

For example, the well-known U.S. venture capitalist, Fred Adler, began investing in Israeli
startups in the early 1970s, was involved in forming the first Israeli venture capital fund. Still
the creation of Israeli venture capital industry would wait until the 1990s, when the
government funded an organization Yozma, to encourage venture capital in Israel.

Yozma received $100 million from the Israeli government. I invested $8 million in ten funds
that were required to raise another $12 million each from “a significant foreign partner”,
presumably an overseas venture capital firm. Yozma also retained $20 million to invest itself.
These “sibling” funds were the backbone of a now vibrant community that invests in excess
of $1 billion in Israel in 1999 (Pricewaterhouse 2000). In the U.S., venture capital emerged
through an organic trial-and-error process, and the role of the government was limited and
contradictory. In Israel the government played a vital role in a supportive environment in
which private-sector venture capital had already emerged.

The role of government differs. In the U.S. the most important role of the government in was
indirect, in Israel it was largely positive in assisting the growth of venture capital, in India the

46
role of the government has had to be proactive in removing barriers (Dossani and Kenney
2001).

In every nation, the state has played some role in the development of venture capital. Venture
capital is a very sensitive institutional from due to the high-risk nature of its investments, so
the state must be careful to ensure its policies do not adversely affect its venture capitalists.
Put differently, capricious governmental action injects extra risk into the investment equation.
However, judicious, well planned government policies to create incentives for private sector
involvement have in the appropriate lead to the establishment of what becomes an
independent self-sustaining venture capital industry.

 CURRENT INDUSTRY TRENDS

 Round Class Distribution

The distribution of financing rounds by round class in mature markets is typically 30-40% in
the early stage rounds, 20-25% in second round, and 35-40% in later rounds. In emerging
market like China, the round distribution is very different as 68% in early stage and 25% in
second round. In mature countries, the investments are made at early start up or product
development phase.

 Industry Shifts

It is perhaps no surprise that contraction is mostly concentrated in information technology

and the business, consumer and retail industries, give the huge number of companies financed
in the technology and Internet boom of 1999-2000, and the subsequent down turn. The
healthcare pool, driven by investment in biopharmaceuticals and medical devices, has
actually grown to some degree in the different geographies. In United States, the healthcare
pool has grown consistently over the last several years, both in terms of number of companies
and cumulative dollars invested.

Key observations on the pool of private companies by industry:-

47
 o The information and technology pool has declined by just 6% since 2002;
particularly due to increasing Interest in WEB 2.0 innovations.

o Since 2003, the cumulative investment has declined in similar amounts.

o The business, consumer and retail category has faced the steepest declines across the
board. In US the number had fallen 54% since 2002 and 54% in Europe since 2003.
In Israel; it dropped 67% since 2004.

o The number of healthcare companies has grown in U.S. since 2002 by 27% and the
capital risen 30% in last five years. Capital investment to the pool of healthcare of
companies dropped by 95 in Europe since 2003 and 9% in Israel since 2004.

o Clean technology is a small but increasing element of the pool. There were 262 clean
technology companies with a cumulative invested venture capital of U.S. $38 billion
in 2007.

 Mega Trends

Several global mega trends will likely have an impact on venture capital in the next decade:-

o Beyond the BRICs: - A new wave of fast growing economies is joining the global
growth leaders like Brazil, China, India And Russia. The beginning of venture
capital activity has been seen in others countries such as Indonesia, Korea, Turkey
and Vietnam.

o The new multinationals: - A new breed of global company is emerging from

developing countries and redefining industries through low-cost advantage,
modern infrastructure, and vast customer databases in their home countries. These
companies are potential acquirers of developed market companies at all stages of
growth.

o Globalization of capital: - Changes in economic and financial landscape are

creating significant regional shifts in IPO activity. These changes have also
sparked global consolidation alliances among stock exchanges.

48
 o Transformation of the CFO’s role and function: - With the globalization and
increasingly complex regulatory environment, CFOs have a wider range of
responsibilities and finance function has been transformed to face broader
mandates.

o Clean Technology: - Clean technology is poised to become the first break through
sector of 21st century. Encompassing energy, air and water treatment, industrial
efficiency improvements, new material and waste management etc. are playing
very vital role globally because of which VC investors are enjoying rewards.

 GROWTH OF VENTURE CAPITAL IN GLOBAL

Source: Venture pulse Q2’17 Global Analysis of venture funding KPMG Enterprise.

 Growth of venture capital in global

49
Clean technology venture investments in North America, Europe, China and India totaled
US$5.6 billion in 557 deals. However, as these figures are preliminary, the firms expect the
final figures could be up by as much as 10%.

"Utilities continue to bring their capital and access to credit to the cleantech sector and are
playing a key role in getting more projects off the ground. In 2009 we saw a surge in utility
Power Purchase Agreement (PPA) announcements with Solar Thermal and Solar PV
accounting for 80% of the total PPAs, while Wind saw increased capacity announcements in
the second half of the year aided by the extension of the production tax credit," said Scott
Smith, U.S. Clean Tech leader for Deloitte. "Additional project financing came from large
corporations whose direct investments in cleantech increased by 14% in the second half of
2009 compared to the same period in 2008. Leading global utilities and non-utilities are
likely to continue to see cleantech projects as an attractive investment from an economical
and regulatory perspective."

Venture investment was down 33% in 2009, compared to US$8.5 billion in 2008, yet
investment in cleantech declined less than other sectors, despite the economic recession.

After 2011 there are spikes everyyear deals closed till 2015. Since 2015there is a downfall
trend.

The amount invested during 2015-16 was the most after 2010. After a relative platue for three
quarters VC invested resurged in the second quarter of 2017 even as the volume of financing
declined.

The largest deal in all sectors was Solyndra’s US$198 million to expand its CIGS thin film
production. The company has since filed for an IPO.

Venture capital that investors like Marc Andreessen or Peter Thiel put into high-potential
start-ups such as Twitter, Facebook or Alibaba is on the rise – and, like the sun, it’s rising in
the east.

The United States, most particularly the Bay Area, continues to be the largest recipient of
investments, according to a study by Ernst & Young. But China and India, the largest

50
emerging markets for venture capital, are closing in, doubling their share of the global market
in just a few years. Taken together, China and India now account for a quarter of the venture-
capital market. In Europe, Germany has for the first time surpassed the United
Kingdom, signalling a growing start-up scene in cities such as Berlin.

Overall, 2014 was the best year for the sector since 2001, with almost $87 billion worth of
investments globally, according to the study, a rise of some 60% compared with 2013, when
venture capitalists invested some $54 billion. But due to the rise of the East, the US, Europe,
Canada and Israel each saw their share in the total decline. They now make up about 75% of
the market, whereas in the previous period they totaled almost nine out of every 10 dollars
invested in venture capital.

Here is what the venture capital market looked like from 2006 to 2013:

In that period, a total of about $373 billion was invested in venture capital worldwide, a
number equivalent to Thailand’s GDP. The country in which most venture capital was
invested in that time was the US, with about $255 billion (or almost 70% of the total). The
European countries came in second, with some $55 billion invested (or just over a fifth of the

51
amount invested in the US). Of the emerging economies, China and India made a mark, with
$33 and $10 billion invested respectively (or about 9% and 3% of the total).

But these numbers have changed dramatically in the last year for which data is available —
2014:

The same countries and regions dominated the venture-capital market last year, but the
proportions have changed. The US still came in first, with about $52 billion. But its
proportion of the total fell to just over 60%, compared with 70% in the eight years previously.
Europe went through a similar evolution: its global proportion fell from 15% to 12%, though
its ratio versus the US of about one to five remained intact.

The countries that made a big jump were the large emerging economies – China and India. In
a single year, the proportion of Chinese venture capital in the global total doubled, from an
average of 9% from 2006 to 2013, to 18% in 2014. In one year, Chinese venture capitalists
invested half of the amount they had invested in the previous eight years combined. As a
consequence, China surpassed Europe as the world’s second-largest market for venture
capital.

52
A similar jump happened in India, which saw its proportion of the global market for venture
capital double to 6% in 2014. Doing so, it surpassed Israel as the fourth-largest market for
venture capital.

Going one step deeper, to the country or regional level, the Ernst & Young numbers show that
Silicon Valley (or the Bay Area) is still the largest region for venture capital, with almost $25
billion invested. But three other US regions also make the top five: New York ($5.3 billion),
New England (including Boston, $4.8 billion) and southern California ($4 billion).

In Europe, Germany and its hotspot Berlin surpassed the UK and London for the first time in
over five years, coming in at $2.8 billion versus the UK’s $2.7 billion. In the emerging
markets, Beijing is the largest recipient, with $7.7 billion of venture capital investments,
ahead of Bangalore ($2.2 billion) and Shanghai ($2.1 billion).

 PRIMARY REASONS FOR VENTURE CAPITAL INVESTORS EXPANDING

GLOBALLY

Among the primary reasons VCs around the world are interested in investing globally is to
take advantage of higher quality deal flow- particularly in the United States, China, parts of
Europe, and Israel. This is especially true for non- U.S. firms. A second reason is the
emergence of an entrepreneurial environment, again and notably in China, but also India.
Among U.S. firms, this latter rationale is the most significant motivation for investing
globally. Other motivators include access to quality entrepreneurs, diversification of industry
and geographic risk and access to foreign markets.

53
 40

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Primary reasons why investors expanding globally venture

Above chart reveals that 19% U.S. respondents are expand globally for generating high
quality deal flow. And 31% believe that expand globally for getting benefit of emergence of
entrepreneurial environment. Whit 17% respondents of non U.S are expanding globally for
diversification of industry and geographic risk. All respondents are least concerned about low
cost of locations.

 INVESTING GLOBALLY BY INVESTING LOCALLY

One way to build a comfort zone for global investing and to take advantage of opportunities abroad
is to invest locally in companies with operations outside their home country, as opposed to investing
directly in foreign countries. This year, there was a significant increase in the number of respondents
who indicated that a sizeable number of their portfolio companies have a considerable amount of
operations outside the country in which they are headquartered.

54
A significant number, 88 percent of U.S. respondents and 82 percent of non-U.S. respondents,
indicated that at least some portion of their portfolio has significant operations outside of the country
of headquarters. Again, moderation is evident as more than half of those indicated that less than 25
percent of their portfolio had significant foreign operations. Nonetheless, these numbers have
increased significantly from prior years and reflect an increased trend in this method of investment.

35
32 32 32
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25
25
21
20 18 18
17
15 15
15
12 12

10 9

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5 3
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0 Global U.S. Non- U.S.

0% 1-10% 11-25% 26-50% 51-75% 76-100%
Percentage of venture capital firms portfolio companies that give significant operation
outside the country

Globally and among U.S. respondents, China has become the primary choice for relocating
manufacturing operations, while India is the primary choice For R&D operations. Engineering
operations tend to land in India as well, but China is also a popular location. For back office
activities, again the choice is India. However, for non-U.S. respondents, the United States is the
primary choice for R&D and engineering while European respondents preferred Central and Eastern
Europe for manufacturing R&D and Engineering.

One reason why this approach is taking off is that investors are concerned about intellectual property
and liquidity events and in general they feel a need to be closer to top management. This also reflects
a new reality from day one companies that reflect a larger global entrepreneurial sector. This strategy
allows the portfolio companies (and investors) to take advantage of cost saving and access o talent in
foreign markets while protecting intellectual property. There are however concerns that such a trend
could result in the U.S. losing its R&D edge.

55
 IMPEDIMENTS TO GLOBAL INVESTING

For all the benefits of overseas investing, VC firms encounter a variety of risks and challenges
abroad. Both U.S. firms and non-U.S. firms perceive the U.S as the country where the cost of
complying with regulation is too high. In fact, the percentage of non-U.S. respondents who indicated
this as a concern leaped from 28% last year to 41% this year. Globally, 4% more, 44% saw this issue
as a concern. 46% of U.S. respondents believe the cost of complying with corporate governance is
too high.

50
46
45 44
41
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Top markets where the cost of complying with corporate governance regulation too high

From the above chart we can see that most of the respondents believe that U.S. has high cost of
complying with Corporate Governance regulation and China, India, Israel and Canada cost of
complying with corporate governance regulation too high.

56
 VENTURE CAPITAL IN INDIA

 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

57
made for the import of technology know-how projects requiring funds from Rs.5 Lacks to
Rs.2.5Cr. Were considered for financing. Promoter’s 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.

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

58
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 20 th
Centure Venture Capital Company, Indus venture capital Funds, Infrastructure Leasing and
financial Services Ltd.

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

o Mastek, one of the oldest software house in India

o Ruskan software, Pune based software consultancy

o SQL Star, Hyderabad based training and software development consultancy

o Satyam Infoway, the first private ISP in India

o Hinditrom, makers of embedded software

o Selectia, provider of interaction software selectior

o Yantra, ITL Infosy’s US subsidiary, solution for supply chain management

o Rediff on the Net, India website featuring electronic shopping, news, chat etc.

 OBJECTIVE AND VISION FOR VENTURE CAPITAL IN INDIA

59
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
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

60
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.

 VENTURE CAPITAL INDUSTRY LIFE CYCLE IN INDIA

From the industry life cycle we can know in which stage venture capital are standing. On the
basis of this management can make future strategies of their business.

Industry Life Cycle

Introduction Growth

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

The growth of venture capital in India has four separate phases:

 Phase I- formation of TDICI in 80’s and regional funds as GVFL & APIDC in early
90s.

The first origin of modern venture capital in India can be traced to the setting up of a
technology Development Funds in the year 1987-88, though the levy of access on all
technology import payment. Technology development fund was stated to provide financial
support to innovative and high risk technological programmers through the Industrial
development bank of India.

The first phase was the initial phase in which the concept of venture capital got wider
acceptance. The first period did not really experience any substantial growth of venture
capitals. The 1980’s were marked by an increasing disillusionment with the trajectory of the
economic system and a belief that liberalization was needed. The liberalization process

61
started in 1985 in a limited way. The concept of venture capital received official recognition
in 1988 with the announcement of the venture capital guidelines.

During 1988 to 1992 about 9 venture capital institutions came up in India. Though the
venture capital funds should operate as open entities, Government of India controlled them
rigidly. One of the major forces that induced Government of India to start venture funding
was the World Bank. The initial funding has been provided by World Bank. The most
important feature of the 1988 rules was that venture capital funds received the benefit of a
relatively low capital gains tax rate which was lower than the corporate rate. The 1988
guidelines stipulated venture capital funding firms should meet the following criteria:

o Technology involved should be new, relatively untried, very closely held, in the
process of being taken from pilot to commercial stage or incorporate some
significant improvement over the existing ones in India.

o Promoters/entrepreneurs using the technology should be relatively new,

professionally or technically qualified, with inadequate resources to finance the
project.

Between 1988 and 1994 about 11venture capital funds became operational either through
reorganizing the business or through new entities.

All these followed the Government of India guidelines for venture capital activities and have
primarily supported technology oriented innovative business started by first generation
entrepreneurs. Most of these were operated more like a financing operation. The main feature
of this phase was that the concept got accepted. Venture capitals become operational in India
before the liberalization process started. The context was not fully ripe for growth of venture
capitals. Till 1995 the venture capital operated like any bank but provided funds without
collateral. The first stage of the venture capital industry in India was plagued by in
experienced management, mandates to invest in certain states and sectors and general
regulatory problems. Many public issue by small and medium companies have shown that the
Indian investor is becoming increasingly wary of investing in the projects of new and
unknown promoters.

62
The liberation of the economy and toning up of the capital market changed the economic
landscape. The decisions relating to issue of stocks and shares was handled by an office
namely: Controller of capital issues (CCI). According to 1988 venture capital guideline, any
organization requiring starting venture funds have to forward an application to CCI.
Subsequent to the liberalization of the economy in 1991, the office of CCI was abolished in
May 1992 and the powers were vested in Securities and Exchange Board of India (SEBI).
The Securities and Exchange Board of India Act, 1992 empower SEBI under section 11(2)
thereof to register and regulate the working of venture capital funds. This was done in 1996,
through a government notification. The power to control venture funds has been given to
SEBI only in 1995 and the notification came out in 1996. Till this time venture funds were
dominated by Indian firms. The new regulations became the harbinger of the second phase of
the venture capital growth.

 Phase II- Entry of Foreign Venture Capital Funds (VCF) between 1995-1999

The second phase of venture capital growth attracted many foreign institutional investors.
During this period overseas and private domestic venture capitalists began investing in VCF.
The new regulations in 1996 helped in this. Though the changes proposed in 1996 had a
salutary effect, the development of venture capital continued to be inhibited because of the
regulatory regime and restricted the FDI environment. To facilitate the growth of venture
funds, SEBI appointed a committee to recommend the changes needed in the venture capital
funding context. This coincided with the IT boom as well as the success of Silicon Valley
startups. In other words, venture capital growth and IT growth co-evolved in India.

 Phase III-(2000 onwards)- Venture capital becomes risk averse and activity declines:

Not surprisingly, the investing in India came “crashing down” when NASDAQ lost 60% of
its value during the second quarter of 2000 and public markets (including those in India) also
declined substantially. Consequently, during 2001-2003, the venture capitals started investing
less money and in money and in more mature companies in an effort to minimize the risks.
This decline broadly continued until 2003.

 Phase IV- (2004 onward)- Global venture capitals firms actively investing in India

Since India’s economy has been growing at 7%-8% a year, and since some sectors, including
the services sector and the high end manufacturing sector, have been growing at 12%-14% a

63
year investors renewed their interest and started investing again in 2004 the number of deals
and the total dollars invested in India has been increasing substantially

 NEED FOR GROWTH OF VENTURE CAPITAL IN INDIA

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

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 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.

 REGULATORY AND LEGAL FRAMEWORK

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

 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.

65
 MAJOR REGULATORY FRAMEWORKS FOR VENTURE CAPITAL
INDUSTRY

VC & FVCI

SEBI RBI FIPB TAX

 SEBI (VCF) Reg. 1996  FEMA,  FDI  IT Act, 1961

 SEBI(FVCI) Reg.2000 1999 policy  DTAA
 SCR Act.1956  Transfer or issue  Investmen  Singapore
 SEBI(SAST) Reg.1997 of security by a t approvals  Mauritius
 SEBI(DIP)Guidelines,2000 person resident  Press  Others
 SEBI Act,1992 outside India Notes
regulation 2000

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:

 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.

66
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;

o 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;

o Debt or debt instrument of a venture capital undertaking in which the venture

capital funds has already made an investment by way of equity.

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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.

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:

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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
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:

o Subscription to initial offer of a venture capital undertaking whose shares

are proposed to be listed subject to lock in period of one year;

o 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

69
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:-

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.-

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(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
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

71
 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.

 KEY SUCCESS FACTOR FOR VENTURE CAPITAL INDUSTRY IN INDIA

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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
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 :

73
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.

 Balance between three factors

Venture Capital backed companies can provide high returns. However, despite of success
stories like Apple, FedEx of Microsoft, a lot of these deals fail. It is said that only one out of
ten companies succeed. That's why every deal has an element of potential profit and an
element of risk, depending on the deals size. To be successful, a Venture Capital Company
must manage the balance between these three factors.

Financial markets and the

industries to invest in

Knowledge

Risk management skills Possible investees and

and contacts to investors external expertise

Frame work for key success factor

74
Knowledge is key, to get the balance in this "Magic Triangle". With knowledge we mean
knowledge about the financial markets and the industries to invest in, risk management skills
and contacts to investors, possible investees and external expertise. High profits, achievable
by larger deals, are not only important for the financial performance of the Venture Capital
Company. As a good track record they are also a vital argument to attract funds which are the
basis for larger deals. However, larger deals imply higher risks of losses. Many Venture
Capital companies try to share and limit their risks. Solutions could be alliances and careful
portfolio management. There are Venture Capital firms that refuse to invest in e-start-up
because they perceive it as too risky to follow today's type.

 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.

 Product innovation:

Venture capital firms are coming with new ideas of investment to attract the buyers to their
firms. For this purpose they are introducing new types of funds and schemes.

For example, IFCI Venture Capital Funds Limited (IVCF) has launched three new funds in
emerging sectors of the economy namely:

i) India Automotive Component Manufacturers Private Equity Fund –1-Domestic (IACM-1-

D) with a target corpus of Euro 60 million equivalent to Rs.396 crores. This Fund will be

75
dedicated for investment mainly in Indian Automotive Component companies and in other
related/ emerging sectors.

ii) India Enterprise Development Fund (IEDF), a Venture Capital fund set up with target
corpus of Rs.250 crores to invest in knowledge based projects in key sectors of Indian
economy with outstanding growth prospects.

iii) Green India Venture Fund (GIVF), a Venture Capital fund setup with a target corpus of
Euro 50 million (approx. Rs.330 crores) with the objective to invest in commercially viable
Clean Development Mechanism (CDM), energy efficient and other commercially viable
projects with an aim to reduce negative ecological impact, efficient usage of resources such
as energy, power etc and other related sectors/projects. The summary of the Funds:

Launching of new funds by IFCI

Funds IACM –1 GIVF IEDF

Objective To invest in Indian The objective of GIVF To invest in knowledge
companies engaged in, would be to invest in based projects with
amongst others, the companies setting up relatively high entry
automotive parts and Clean Development barriers, critical
components Mechanism (CDM) applications, prospects
manufacturing sector in projects and other for high growth and
order to generate high commercially viable global scalability in
returns for its investors. projects/ business. diversified and/ or
emerging sectors.
Size Euro 60 million (INR 396 Euro 50 million (INR INR 250 Cr
Cr) 330 Cr) with green shoe
option
Nature of Fund PE Fund VC Fund VC Fund
Tenure 8 yrs. With two 10 years with two 10 years with two
prolongation option of 1 prolongation options of prolongation options of
year each 1 year each 1 year each.
Expected returns 20% p.a. 20% p.a. 20% p.a.
Size of investment Rs. 6 to 40 Cr Rs. 2 to 25 Cr
Rs. 2 to 30 Cr

Management fee 2% of the total 2% of the total 2% of the total

subscription amount subscription amount subscription amount

76
 Launching of new funds by IFCI

The SICOM venture capital firm introduce SME opportunity fund for small scale industries.

 GUIDELINES FOR OVERSEAS VENTURE CAPITAL INVESTMENT IN INDIA

In recognition of growing importance of Venture Capital as one of the sources of finance for
Indian industry, particularly for the smaller unlisted companies, the Government has
announced a policy governing the establishment of domestic Venture Capital
Funds/Companies. An amendment has also been carried out in the SEBI Act empowering the
Securities and Exchange Board of India (SEBI) to register and regulate Venture Capital
Funds (VCFs) and Venture Capital Companies (VCCs) through specific regulations.

With a view to augment the availability of Venture Capital, the Government has decided to
allow overseas venture capital investments in India subject to suitable guidelines as outlined
below:

 Offshore investment may invest in approved domestic Venture Capital Funds/Companies

set up under the new policy after obtaining FIPB approval for the investment. There is no
limit to the extent of foreign contribution to a domestic venture capital company/ fund.
An offshore venture capital company may contribute 100% of the capital of domestic
venture capital fund, and may also set up a domestic asset management company to
manage the Fund.

 Establishment of an asset management company with foreign investment to manage such

funds would require FIPB approval and would be subject to the existing norms for foreign
investment in non-bank financial services companies.

 Once the initial FIPB approval has been obtained, the subsequent investment b y the
domestic venture capital company/fund in Indian companies will not require FIPB
approval. Such investments will be limited only by the general restriction applicable to
venture capital companies viz.-

o A minimum lock-in period of three years will apply to all such investments.

77
 o VCFs and VCCs shall invest only in unlisted companies and their investment shall
be limited to 40% of the paid up capital of the company. The ceiling will be
subject to relevant equity investment limits that may be in force from time to time
in relation to areas reserved for the Small Scale Sector.

o Investment in any single company by a VCF/VCC shall not exceed 20% of the
paid-up corpus of the domestic VCF/VCC.

 The tax exemption available to domestic VCFs and VCCs under Section 10(23F) of the
Income Tax Act, 1961, will also be extended to domestic VCFs and VCCs which attract
overseas venture capital investments provided these VCFs/VCCs conform to the
guidelines applicable for domestic VCFs/VCCs. However, if the VCF/VCC is willing to
forego the tax exemptions available under Section 10(23F) of the Income Tax Act, it
would be within its rights to invest in any sector.

 Income paid to offshore investors from Indian VCFs/VCCs will be subject to tax as per
the normal rates applicable to foreign investors.

 Offshore investors may also invest directly in the equity of unlisted Indian companies
without going through the route of a domestic VCF/VCC. However, in such cases each
investment will be treated as a separate act of foreign investment and will require separate
approval as required under the general policy for foreign investment proposals.

 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.

78
Thus, the investment made by Venture Capitalists generally involves –

o Financing new and rapidly growing companies.

o Purchasing equity securities.

o Taking higher risk in expectation of higher rewards.

o Having a long frame of time period, generally of more than 5 - 6 years.

o Actively working with the company's management to devise strategies pertaining to

the overall functioning of the project.

o 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

79
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:

o Requirement of an experienced management team.

o Requirement of an above average rate of return on investment.

o Longer payback period.

o Uncertainty regarding the success of the product in the market.

o Questions regarding the infrastructure details of production like plant location,

accessibility, relationship with the suppliers and creditors, transportation facilities,
labor availability etc.

o The category of potential customers and hence the packaging and pricing details of
the product.

o The size of the market.

o Major competitors and their market share.

o Skills and Training required and the cost of training.

o 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.

 OPPORTUNITIES AND THREATS

 OPPORTUNITIES:

Initiatives taken by the Government in formulating policies to encourage investors and

entrepreneurs

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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. Government of India understands this.

Also, The Government of India in an attempt to bring the nation at par and above the
developed nations has been promoting venture capital financing to new, innovative concepts
& ideas, liberalizing taxation norms providing tax incentives to venture firms, giving an
opportunity for the creation of local pools of capital and holding training sessions for the
emerging VC investors.

In the year 2000, the finance ministry announced the liberalization of tax treatment for
venture capital funds to promote them & to increase job creation. This is expected to give a
strong boost to the non resident Indians located in the Silicon Valley and elsewhere to invest
some of their capital, knowledge and enterprise in these ventures.

 SME Growth

VC, to be able to contribute to developing entrepreneurship in India, needs to concentrate its

investment in small and medium enterprises. A “Package for Promotion of Micro and
Small Enterprises” was announced in February 2007. This includes measures addressing
concerns of credit, fiscal support, cluster-based development, infrastructure, technology, and
marketing. Capacity building of MSME Associations and support to women entrepreneurs are
the other important features of this package. SMEs have been allowed to manage their
direct/indirect exposure to foreign exchange risk by booking/canceling/rollover of forward
contracts without prior permission of RBI.

To boost the micro and small enterprise sector, the bank has decided to refinance an amount
of 7000 crore to the Small Industries Development Bank of India, which will be available up
to March 31, 2010. The Central Bank said that it is also working on a similar refinance
facility for the National Housing Bank (NHB) of an amount of Rs 4, 000 crore.

81
The Indian economy is growing at 8-9% so the there is a development of all sector like
manufacturing, services sector. So there is a great opportunities for Venture Capital firms.
Because mostly invest their money in this sectors.

India amongst leading entrepreneurial Hotbeds globally

City competencies emerging

o Bangalore

 All IP-led companies; IT and IT-enabled services

o Delhi (NCR)

 Software services, IT enabled services, Telecom

o Mumbai

 Software services, IT enabled services, Media, Computer Graphics, Animation,

Banking

o Other emerging Centers

 Chennai, Hyderabad, and Pune

Emerging sectors for investments

As the venture industry continues to accelerate, a number of trends that cross geographies can
be seen. The industry is becoming even more globalized .As a result, innovation in clean tech,
IT, and healthcare, pharmaceutical are having a global impact. This changing landscape is
driving new approaches in how large corporations are interacting with the venture
community.

Clean technology

Global climate changes, high oil prices, accelerated growth in emerging markets, energy
security concerns and the finite nature of resources are some of the key drivers of the growing
global demand for clean technologies in energy and water. In addition ,the increased

82
willingness of consumers and governments to pay for and use green technologies ,combined
with the positive exit environment of the last years ,has provided venture capitalists with the
confidence to invest in emerging companies around the globe.

According to the research from Dow Jones Venture One and Ernst &Young .US $1.28 billion
was invested in 140financing rounds in 2006 in China , Europe Israel and United States that
compares to US $ 664.1 million invested in 103 financing rounds in 2005,showing the capital
investment in the field has nearly doubled over the past year. It is expected that investment in
clean technologies will continue to increase not only in developed markets but also in the
developing markets, mainly in India and China.

Biotechnology

Over last few years ,the story of the US biotech industry has been one of the remarkable
success .There are signs that this success story is now repeated in other parts of world ,with
maturing pipelines, record breaking financing totals, strong deal activity and impressive
financial results. Industry is grew 31% for second year in raw in 2007.

Pharmaceutical

The industry's growth rate is likely to touch 19 per cent from the current 13 per cent,
according to a projection released by the Confederation of Indian Industries (CII), on
September 1, 2008.

According to a McKinsey study, the Indian pharmaceutical industry is projected to grow to

US$ 25 billion by 2010 whereas the domestic market is likely to more than triple to US$ 20
billion by 2015 from the current US$ 6 billion to become one of the leading pharmaceutical
markets in the next decade.

The Indian pharmaceutical industry has shown robust growth in terms of infrastructure
development, technology base creation and a wide range of products with a determination to
flourish in the rapidly changing environment, thereby establishing its global presence. The
Indian pharmaceutical industry has increased its competitive intensity owing to pricing
pressures and striving consistently to innovate. ICICI Venture-controlled Ranbaxy Fine
Chemicals (RFCL) has acquired the US-based specialty chemicals major Mallinckrodt Baker
in a deal estimated at US$ 340 million.

83
So there is great opportunity for venture capital industry to invest their money in this sector.
Nowadays, India will become a global pharmacy hub exporting by exporting domestically
produced generic products.

IT/IT-ES Industry

The Department of Information Technology is setting up Nano Electronic Centers at the

Indian Institute of Technology, Mumbai and the Indian Institute of Science, Bangalore. With
an outlay of about Rs. 100 crore to carry out R&D activities in nano-electronics devices and
materials.

In 2006-07, the performance of the Information Technology Enabled Services–Business

Process Outsourcing (ITES-BPO) industry was marked by double-digit revenue growth,
steady expansion into newer service lines and increased geographic penetration and an
unprecedented rise in investments by multinational corporations (MNCs).

The Special Incentive Package Scheme (SIPS) to encourage investments for setting up
semiconductor fabrication and other micro- and nano-technology manufacturing industries
was announced in March2007. The incentives admissible would be 20 per cent of the capital
expenditure during the first 10 years for units located in Special Economic Zones (SEZs) and
25 per cent for units located outside SEZs.

Electronic Industry

There is a high growth of software and solutions related to the consumer Internet, software as
a service (SAAS), open source, software-cum-services and telecommunications (both
wireless and wire-line) products and related services. There is a great opportunity for venture
capital industry to invest in this electronic production industry.

 Threats:

Venture Capital Market in India Getting Overheated

The Venture Capital market in India seems to be getting as hot as the country’s famous
summers. However, this potential over-exuberance may lead to some stormy days ahead,

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based on sobering research compiled by global research and analytics services firm,
Evalueserve. Evalueserve research shows an interesting phenomenon is beginning to emerge:

Over 44 US-based Venture capital firms are now seeking to invest heavily in start-ups and
early-stage companies in India. These firms have raised, or are in the process of raising, an
average of US $100 million each. Indeed, if these 40-plus firms are successful in raising
money, they would garner approximately $4.4 billion to be invested during the next 4 to 5
years. Taking Indian Purchasing Power Parity (PPP) into consideration, this would be
equivalent to $22 billion worth of investment in the US. Since about $1.75 billion (or
approximately 40% of $4.4 billion) has been already raised, even if only $2.2 billion is raised
by December 2006, Evalueserve cautions that there will be a glut of Venture Capital money
for early stage investments in India. This will be especially true if the VCs continue to invest
only in currently favorite sectors such as IT, BPO, software and hardware products, telecom,
and consumer Internet. Given that a typical start-up in India would require $9 million during
the first three years (i.e., $3 million per year) and even assuming that the start-up survives for
three years, investing $2.2 billion during 2007-2010 would imply investing in 150 to 180
start-ups every year during this period, which simply does not seem practical if the VCs
continue to focus only on their current favorite sectors.

Unproductive workforce:

A global survey by McKinsey & Company revealed that Indian business leaders are much
more optimistic about the future than their international peers. So Indian employees are tardy
in their job so it will effect reversely on the economic condition of the country. Because they
are unproductive to the economy of the country.

Exit route barriers:

Due to crash down of market by 51% from January to November 2008. It creates a problem
for venture capital firms. Because nobody is trying to come up with IPO and IPO is the exits
route door Venture Capital.

Taxes on emerging sector:

As per Union Budget 2007 and its broad guidelines, Government proposed to limit pass-
through status to venture capital funds (VCFs) making investment in nine areas. These nine

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areas are biotechnology, information technology, nanotechnology, seed research and
development, R&D for pharmacy sectors, dairy industry, poultry industry and production of
bio-fuels. Pass-through status means that the incomes earned by funds are taxable now.

RECOMMENDATIONS

 Multiplicity of regulations – need for harmonization and nodal Regulator:

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.

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 Mobilization of Global and Domestic resources:

 Foreign Venture Capital Investors (FVCIs):

Presently, FIIs registered with SEBI can freely invest and disinvest without taking FIPB/RBI
approvals. This has brought positive investments of more than US $10 billion. At present,
foreign venture capital investors can make direct investment in venture capital undertakings
or through a domestic venture capital fund by taking FIPB / RBI approvals. This investment
being long term and in the nature of risk finance for start-up enterprises, needs to be
encouraged. Therefore, at least on par with FIIs, FVCIs should be registered with SEBI and
having once registered, they should have the same facility of hassle free investments and
disinvestments without any requirement for approval from FIPB / RBI. This is in line with
the present policy of automatic approvals followed by the Government. Further, generally
foreign investors invest through the Mauritius-route and do not pay tax in India under a tax
treaty. FVCIs therefore should be provided tax exemption. This provision will put all FVCIs,
whether investing through the Mauritius route or not, on the same footing. This will help the
development of a vibrant India-based venture capital industry with the advantage of best
international practices, thus enabling a jump-starting of the process of innovation. The hassle
free entry of such FVCIs on the pattern of FIIs is even more necessary because of the
following factors:

o Venture capital is a high risk area. In out of 10 projects, 8 either fail or yield
negligible returns. It is therefore in the interest of the country that FVCIs bear such a
risk.

o For venture capital activity, high capitalization of venture capital companies is

essential to withstand the losses in 80% of the projects. In India, we do not have such
strong companies.

o The FVCIs are also more experienced in providing the needed managerial expertise
and other supports.

 Augmenting the Domestic Pool of Resources:

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The present pool of funds available for venture capital is very limited and is predominantly
contributed by foreign funds to the extent of 80 percent. The pool of domestic venture capital
needs to be augmented by increasing the list of sophisticated institutional investors permitted
to invest in venture capital funds. This should include banks, mutual funds and insurance
companies’ up to prudential limits. Later, as expertise grows and the venture capital industry
matures, other institutional investors, such as pension funds, should also be permitted. The
venture capital funding is high-risk investment and should be restricted to sophisticated
investors. However, investing in venture capital funds can be a valuable return-enhancing
tool for such investors while the increase in risk at the portfolio level would be minimal.
Internationally, over 50% of venture capital comes from pension funds, banks, mutual funds,
insurance funds and charitable institutions.

 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
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 fund’s investible funds must be invested in unlisted equity or equity-
linked instruments, while the rest may be invested in other instruments. Though sectoral

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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 fund’s 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 venture-
financed 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.

 Global integration and opportunities:

 Incentives for Employees:

The limits for overseas investment by Indian Resident Employees under the Employee Stock
Option Scheme in a foreign company should be raised from present ceilings of US$10,000
over 5 years, and US$50,000 over 5 years for employees of software companies in their
ADRs/GDRs, to a common ceiling of US$100,000 over 5 years. Foreign employees of an
Indian company may invest in the Indian company to a ceiling of US$100,000 over 5 years.

 Incentives for Shareholders:

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 The shareholders of an Indian company that has venture capital funding and is desirous of
swapping its shares with that of a foreign company should be permitted to do so. Similarly,
if an Indian company having venture funding and is desirous of issuing an ADR/GDR,
venture capital shareholders (holding saleable stock) of the domestic company and desirous
of disinvesting their shares through the ADR/GDR should be permitted to do so.
Internationally, 70% of successful startups are acquired through a stock-swap transaction
rather than being purchased for cash or going public through an IPO. Such flexibility
should be available for Indian startups as well. Similarly, shareholders can take advantage of
the higher valuations in overseas markets while divesting their holdings.

 Global investment opportunity for Domestic Venture Capital Funds (DVCF):

DVCFs should be permitted to invest higher of 25% of the fund’s corpus or US $10 million
or to the extent of foreign contribution in the fund’s corpus in unlisted equity or equity-linked
investments of a foreign company. Such investments will fall within the overall ceiling of
70% of the fund’s corpus. This will allow DVCFs to invest in synergistic startups offshore
and also provide them with global management exposure.

 Infrastructure and R&D :

Infrastructure development needs to be prioritized using government support and private

management of capital through programmers similar to the Small Business Investment
Companies in the United States, promoting incubators and increasing university and research
laboratory linkages with venture-financed startup firms. This would spur technological
innovation and faster conversion of research into commercial products.

 Self Regulatory Organization (SRO):

A strong SRO should be encouraged for evolution of standard practices, code of conduct,
creating awareness by dissemination of information about the industry. Implementation of
these recommendations would lead to creation of an enabling regulatory and institutional
environment to facilitate faster growth of venture capital industry in the country. Apart from
increasing the domestic pool of venture capital, around US$ 10 billion are expected to be
brought in by offshore investors over 3/5 years on conservative estimates. This would in turn
lead to increase in the value of products and services adding up to US$100 billion to GDP by

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2005. Venture supported enterprises would convert into quality IPOs providing over all
benefit and protection to the investors. Additionally, judging from the global experience, this
will result into substantial and sustainable employment generation of around 3 million jobs in
skilled sector alone over next five years. Spin off effect of such activity would create other
support services and further employment. This can put India on a path of rapid economic
growth and a position of strength in global economy.

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.

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.

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 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

 www.nvca.org

 www.economictimes.indiatimes.com

 www.100ventures.com

 www.google.com

 www.deloitte.com

 www.weform.org

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