“STUDY OF VENTURE CAPITAL IN INDIA”

BACHELOR OF COMMERCE
BANKING & INSURANCE
SEMESTER V

(2010)

SUBMITTED BY:
MIRALI.H.BHUVA
ROLL NO. 05

UNDER THE GUIDANCE OF PROF.DR. SEETHA LEKSHMY

SIES COLLEGE OF COMMERCE AND ECONOMICS,

Plot No. 71/72, Sion Matunga Estate
T.V. Chidambaram Marg,
Sion (East), Mumbai – 400022.
 “STUDY OF VENTURE CAPITAL IN INDIA”

BACHELOR OF COMMERCE
BANKING & INSURANCE
SEMESTER V

(2010)

Submitted

In Partial Fulfillment of the requirements

For the Award of Degree of
Bachelor of Commerce – Banking & Insurance

By
MIRALI.H.BHUVA
ROLL NO. 05

UNDER THE GUIDANCE OF PROF. DR. SEETHA LEKSHMY

2
C E R T I F I C A T E

This is to certify that Shri/Miss of B.Com –

Banking & Insurance – Semester V (2010) has successfully
completed the project on

Under the guidance of

.

Course Coordinator Principal

Project Guide/ Internal Examiner

External Examiner

DATE:

PLACE:

3
DECLARATION

I, the student of B.Com –

Banking & Insurance – Semester V (2010) hereby declare that
I have completed the Project on
.

The information submitted is true & original to the best of my

knowledge.

D ATE: Student’s Signature

PLACE: MIRALI.H.BHUVA
Roll No. 05

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ACKNOWLEDGEMENT

I would sincerely like to give my heartfelt

acknowledgement and thanks to my parents. Any amount of
thanks given to them will never be sufficient.
I would like to thank the University of Mumbai, for
introducing Banking and Insurance course, thereby giving
the student a platform to abreast with changing business
scenario, with the help of theory as a base and practical as
a solution.
I would sincerely like to thank our Principal Meenu
Thomas. I would also like to thank my project guide Prof. DR.
SEETHA LEKSHMY
for her valuable support and guidance whenever needed.
I also feel heartiest sense of obligation my library staff
members & seniors who helped in collection of Data and
materials and also in this processing as well as in drafting
manuscript.
Last, but not the least, I would like to thank my friends &
colleagues for always being there.

5
index
Sr. no. topic Page no.
1 Chapter 1
2 Chapter 2
3 Chapter3
4 Chapter4
5 Chapter5
6 Chapter6
7 Chapter7
8 Chapter8
9 Chapter9
10 Chapter10
11 Chapter11
12 Annexure
13 Bibliography

CHAPTER I

(a) INTRODUCTION:
Venture capital (also known as VC or Venture) is provided as seed funding to
early-stage, high-potential, growth companies and more often after the seed
funding round as growth funding round (also referred as series A round) in the

6
interest of generating a return through an eventual realization event such as an
IPO or trade sale of the company. To put it simply, an investment firm will give
money to a growing company. The growing company will then use this money to
advertise, do research, build infrastructure, develop products etc. The investment
firm is called a venture capital firm, and the money that it gives is called venture
capital. The venture capital firm makes money by owning a stake in the firm it
invests in. The firms that a venture capital firm will invest in usually have a novel
technology or business model. Venture capital investments are generally made in
cash in exchange for shares in the invested company. It is typical for venture
capital investors to identify and back companies in high technology industries,
such as biotechnology and IT (Information Technology).

Venture capital typically comes from institutional investors and high net worth
individuals, and is pooled together by dedicated investment firms.

Venture capital firms typically comprise small teams with technology

backgrounds (scientists, researchers) or those with business training or deep
industry experience.

(b) REVIEW LITERATURE:

A literature review is a body of text that aims to review the critical points of
current knowledge including substantive findings as well as theoretical and
methodological contributions to a particular topic. Literature reviews are
secondary sources, and as such, do not report any new or original experimental
work.

Most often associated with academic-oriented literature, such as theses, a

literature review usually precedes a research proposal and results section. Its
ultimate goal is to bring the reader up to date with current literature on a topic
and forms the basis for another goal, such as future research that may be needed
in the area.

A well-structured literature review is characterized by a logical flow of ideas;

current and relevant references with consistent, appropriate referencing style;
proper use of terminology; and an unbiased and comprehensive view of the
previous research on the topic.

- "Over the past decade, venture capital finance has developed into an
important source of start-up and growth financing. This volume is fascinating
reading and highly informative. Venture Capital in Europe contains thoughtful
and informative essays by several of the leading scholars in the field, and

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provides a comprehensive picture of the structure of venture capital financing, the
valuation of investments, and the exit routes for venture capitalists. I highly
recommend it." Luc Renneboog, Professor of Finance.

- According to Doriot, products or processes which have passed through at

least the early prototype stage and are adequately protected by patents,
copyrights, or trade-secret agreements (the latter rule is often referred to as
investing in situations where the information is "proprietary" (proprietary
information)
- "Despite the overall drop in funding in 2009, VCs placed more bets in the
fourth quarter of 2009 than we've seen all year," said Tracy Lefteroff,
global managing partner of the venture capital practice at
PricewaterhouseCoopers LLP.

(c) 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

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 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.

(d) 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.
(e) 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.

(f) RESEARCH DESIGN AND METHODOLOGY

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In India neither venture capital theory has been developed nor are there many
comprehensive books on the subject. Even the number of research papers
available is very limited. The research design used is descriptive in nature. (The
attempt has been made to collect maximum facts and figures available on the
availability of venture capital in India, nature of assistance granted, future
projected demand for this financing, analysis of the problems faced by the
entrepreneurs in getting venture capital, analysis of the venture capitalists and
social and environmental impact on the existing framework.)

The research is based on secondary data collected from the published material.
The data was also collected from the publications and press releases of venture
capital associations in India.

Scanning the business papers filled the gaps in information. The Economic times,
Financial Express and Business Standards were scanned for any article or news
item related to venture capital. Sufficient amount of data about the venture capital
has been derived from this project.

EXECUTIVE SUMMARY

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Venture capital is a growing business of recent origin in the area of industrial
financing in India. The various financial institution set-ups in India to promote
industries have done commendable work. However, these institutions do not
come up to benefit risky ventures when they are undertaken by new or relatively
unknown entrepreneurs. They contend to give debt finance, mostly in the form of
term loans to the promoters and their functioning has been more akin to that of
commercial banks.

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

11
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.

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

12
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.

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

13
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.

CHAPTER2

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.
o Operation risk -Operation may not be cost effective resulting in
increased cost decreased gross margin.

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  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,

15
a venture capitalist advice the promoters on project planning, monitoring,
financial management, including working capital and public issue. Venture
capital investor cannot interfere in day today management of the enterprise but
keeps a close contact with the promoters or entrepreneurs to protect his
investment.

 Length of Investment

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

 Illiquid Investment

Venture capital investments are illiquid, that is not subject to repayment on

demand or following a repayment schedule. Investors seek return ultimately by
means of capital gain when the investment is sold at market place. The
investment is realized only on enlistment of security or it is lost if enterprise is
liquidated for unsuccessful working. It may take several years before the first
investment starts too locked for seven to ten years. Venture capitalist understands
this illiquidity and factors this in his investment decision.

 THE VENTURE CAPITAL SPECTRUM/STAGES

The growth of an enterprise follows a life cycle as shown in the diagram below.
The requirements of funds vary with the life cycle stage of the enterprise. Even
before a business plan is prepared the entrepreneur invests his time and resources

16
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, venture capitalists are
called angel investors, venture capitalist or private equity supplier/investor.

Venture capital was started as early stage financing of relatively small but rapidly
growing companies. However various reasons forced venture capitalists to be
more and more involved in expansion financing to support the development of
existing portfolio companies. With increasing demand of capital from newer
business, venture capitalists began to operate across a broader spectrum of
investment interest. This diversity of opportunities enabled venture capitalists to
balance their activities in term of time involvement, risk acceptance and reward
potential, while providing ongoing assistance to developing business.

Different Venture capital firms have different attributes and aptitudes for
different types of Venture capital investments. Hence there are different stages of
entry for different venture capitalists and they can identify and differentiate
between types of venture capital investments, each appropriate for the given stage
of the investee company, these are:-

1. Early stage Finance

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  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.

 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:

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 o Absence of ready product market
o Absence of complete management team
o Product/process still in R & D stage
o 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

19
 capital investments. This is because the small investments are seen to be
cost inefficient in terms of time required to analyze structure manage them.
b) The time horizon to realization for most seed capital investment is
typically 7-10 years which is longer than all but most long-term oriented
investors will desire.
c) The risk of product and technology obsolescence increases as the time to
realization I extended. These types of obsolescence are particularly likely
to occur with high technology investments particularly in the fields related
to Information Technology.

 Start Up Capital

It is stage second in the venture capital cycle and is distinguishable from seed
capital investments. An entrepreneur often needs finance when the business is
just starting. The start up stage involves starting a new business. Here in the
entrepreneur has moved closer towards establishment of a going concern. Here in
the business concept has been fully investigated and the business risk now
becomes that of turning the concept into product.

Start up capital is defined as; “Capital needed to finance the product

development, initial marketing and establishment of product facility.”

The characteristics of start-up capital are:-

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

organized or is established recently. New business activity could be based

on experts, experience or a spin-off from R & D.
b) Establishment of most but not all the members of the team: the skills

and fitness to the job and situation of the entrepreneur’s team is an

important factor for start up finance.

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 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 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.

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  Early Stage Finance

It is also called first stage capital is provided to entrepreneur who has a proven
product, to start commercial production and marketing, not covering market
expansion, de-risking and acquisition costs.

At this stage the company passed into early success stage of its life cycle. A
proven management team is put into this stage, a product is established and an
identifiable market is being targeted.

British Venture capital Association has vividly defined early stage finance as:
“Finance provided to companies that have completed the product development
stage and require further funds to initiate commercial manufacturing and sales
but may not be generating profits.”

The characteristics of early stage finance may be:-

 Little or no sales revenue.

 Cash flow and profit still negative.
 A small but enthusiastic management team which consists of people with
technical and specialist background and with little experience in the
management of growing business.
 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.

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The firm needs additional equity funds, which are not available from other
sources thus prompting venture capitalist that, have financed the start up stage to
provide further financing. The management risk is shifted from factors internal to
the firm (lack of management, lack of product etc.) to factor external to the firm
(competitive pressures, in sufficient will of financial institutions to provide
adequate capital, risk of product obsolescence etc.)

At this stage, capital needs, both fixed and working capital needs are greatest.
Further, since firms do not have foundation of a trading record, finance will be
difficult to obtain and so venture capital particularly equity investment without
associated debt burden is key to survival of the business.

The following risks are normally associated to firms at this stage:-

a) The early stage firms may have drawn the attention of and incurred the
challenge of a larger competition.
b) There is a risk of product obsolescence. This is more so when the firm is
involved in high-tech business like computer, information technology etc.

 Second stage Finance

It is the capital provided for marketing and meeting the growing working capital
needs of an enterprise that has commenced the production but does not have
positive cash flows sufficient to take care of its growing needs. Second stage
finance, the second trench of Early Stage Finance is also referred to as follow on
finance and can be defined as the provision of capital to the firm which has
previously been in receipt of external capital but whose financial needs have
subsequently exploded. This may be second or even third injection of capital.

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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.
 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

24
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.

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There are four sub divisions of later stage finance:

 Expansion/Development Finance
 Replacement Finance
 Buyout Financing

 Turnaround Finance

Expansion/ Development finance

An enterprise established in a given market increases its profit exponentially by

achieving the economies of scale. This expansion can be achieved either through
an organic growth, that is by expanding production capacity and setting up proper
distribution system or by way of acquisitions. Anyhow, expansion needs finance
and venture capitalists support both organic growth as well as acquisitions for
expansion.

At this stage the real market feedback is used to analyze competition. It may be
found that the entrepreneur needs to develop his managerial team for handling
growth and managing a larger business.

Realization horizon for expansion/development investment is one to three years.

It is favored by venture capitalist as it offers higher rewards in shorter period with
lower risk. Funds are needed for new or larger factories and warehouses,
production capacities, developing improved or new products, developing new
markets or entering exports by enterprise with established business that has
already achieved break even and has started making profits.

Replacement Finance

It means substituting one shareholder for another, rather than raising new capital
resulting in the change of ownership pattern. Venture capitalist purchase share

26
from the entrepreneurs and their associates enabling them to reduce their
shareholding in unlisted companies. They also buy dividend coupon. Later, on
sale of the company or its listing on stock exchange, these are re-converted to
ordinary shares. Thus Venture capitalist makes a capital gain in a period of 1 to 5
years

Buy-out / Buy-in Financing

It is a resent development and a new form of investment by venture capitalist.

The funds provided to the current operating management to acquire or purchase a
significant share holding in the business they manage are called management
buyout.

Management Buy-in refers to the funds provided to enable a manager or a group

of managers from outside the company to buy into it.

It is the most popular form of venture capital 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

27
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 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.

CHAPTER 3

 VENTURE CAPITAL INVESTMENT PROCESS

Venture capital investment process is different from normal project financing. In

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

1. Deal Organization
2. Screening

28
 3. Evaluation or due Diligence
4. Deal Structuring
5. Post Investment Activity and Exit

 Deal Origination:

In generating a deal flow, the VC investor creates a pipeline of deals or

investment opportunities that he would consider for investing in. deal may
originate in various ways. Referral system, active search system, and
intermediaries. Referral system is an important source of deals. Deals may be
referred to VCFs by their parent organizations, trade partners, industry
associations, friends etc. Another deal flow is active search through networks,
trade fairs, conferences, seminars, foreign visits etc. intermediaries is used by
venture capitalists in developed countries like USA, is certain intermediaries who
match VCFs and the potential entrepreneurs.

 Screening:

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

 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

29
detailed information about the proposed venture. The evaluation of ventures by
VCFs in Indian includes; Preliminary evaluation: the applicant required to
provide a brief profile of the proposed venture to establish prima facie eligibility.

Detailed evaluation: once the preliminary evaluation is over, the proposal is

evaluated in greater detail. VCFs in India expect the entrepreneur to have: -
integrity, long-term vision, urge to grow, managerial skills, commercial
orientation.

VCFs in India also make the risk analysis of the proposed projects which
includes: product risk, market risk, technological risk and entrepreneurial risk.
The final decision is taken in terms of the expected risk-return trade-off as shown
in figure.

 Deal Structuring:

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

 Post Investment Activities:

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

30
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.

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

31
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

32
higher listing requirement of the stock exchanges. In February 1989, the
Government of India raised the minimum capital for listing on the stock
exchanges from Rs 10 million to Rs 30 million and the minimum public offer
from Rs 6 million to Rs 18 million.

Sale on the OTC Market

An active secondary capital market provides the necessary impetus to the success
of the venture capital. VCFs should be able to sell their holdings, and investors
should be able to trade shares conveniently and freely. In the USA, there exist
well-developed OTC markets where dealers trade in share on telephone/terminal
and not on an exchange floor. This mechanism enables new, small companies
which are not otherwise eligible to be listed on the stock exchange, to enlist on
the OTC markets and provides liquidity to investors. The National Association of
Securities dealers Automated Quotation System (NASDAQ) in the USA daily
quotes over 8000 stock prices of companies backed by venture capital.

The OTC Exchange in India was established in June 1992. The Government of
India had approved the creation for the Exchange under the Securities Contracts
(Regulations) Act in 1989. It has been promoted jointly by UTI, ICICI, SBI
Capital Markets, Can Bank Financial Services, GIC, LIC and IDBI. Since this list
of market-makers (who will decide daily prices 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

33
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, venture capitalists are
called angel investors, Venture capitalist or private equity supplier/investor.

CHAPTER4

 METHODS OF VENTURE FINANCING

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

 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.

34
  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.

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.

CHAPTER 5

 EVOLUTION OF VENTURE CAPITAL INDUSTRY

IN INDIA

35
The first major analysis on risk capital for India was reported in 1983. It
indicated that new companies often confront serious barriers to entry into capital
market for raising equity finance which undermines their future prospects of
expansion and diversification. It also indicated that on the whole there is a need
to review the equity cult among the masses by ensuring competitive return on
equity investment. This brought out the institutional inadequacies with respect to
the evolution of venture capital.

In India, the Industrial Finance Corporation of India (IFCO) initiated the idea of
Venture Capital when it established the Risk Capital Foundation in 1975 to
provide seed capital to small and risky projects. However the concept of venture
capital financing got statutory recognition for the first time in the fiscal budget
for the year 1986-87.

The venture Capital companies operating at present can be divided into four
groups:

 Promoted by All-India Development Financial Institutions

 Promoted by State Level Financial Institutions
 Promoted by Commercial Banks
 Private Venture Capitalists.

 Promoted by all India Development Financial Institutions

The IDBI started a Venture Capital in 1976 as per the long term fiscal policy of
government of India, with an initial of Rs. 10 Cr. which raised by imposing a
chess of 5% on all payment made for the import of technology know-how
projects requiring funds from Rs.5 Lacks to Rs.2.5Cr. Were considered for
financing. Promoter’s contribution ranged from this fund was available at a

36
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

37
of equity, conditional loans or income notes for technologies development and
innovative products. It also provides finance assistance to entrepreneurs.

The government of Andhra Pradesh has also promoted the Andhra Pradesh
Industrial Development Corporation (APIDC) venture capital ltd. to provide
venture capital financing in Andhra Pradesh.

 Promoted by Commercial Banks

Canbank Venture Capital Fund, State bank Venture Capital Fund and Grindlays
bank Venture Capital Fund have been set up the respective commercial banks to
undertake venture capital activities.

The State bank Venture Capital funds provides financial assistance for bought out
deal as well as new companies in the form of equity which it disinvests after the
commercialization of the project.

Canbank Venture Capital Funds provides financial assistance for proven but yet
to be commercially exploited technologies. It provides assistance both in the form
of equity and conditional loans.

 Private venture Capital Funds

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

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

38
 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

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

39
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 services and other technology based manufacturing and
product development, venture capital industry can play a catalytic role to put
India on the world map as a success story.

 2009 VENTURE CAPITAL INVESTMENT IN INDIA

Venture Capital firms invested $475 million in 92 deals during 2009, down from
the $836 million invested across 153 deals in the previous year, according to a
study by Venture Intelligence and Global-India Venture Capital Association.

40
Venture capital firms, however, began to increase the pace of their investments in
Indian companies in the October-December quarter, making 42 investments
worth $265 million, compared to 23 investments worth $102 million in the
comparative period a year earlier, the study said.

"The strong recovery in investment activity in the last quarter of 2009, as well the
rising interest among global investors towards emerging markets like India, is
quite encouraging for the growth of the sector," Sudhir Sethi, director of the
Global-India Venture Capital Association, said in a statement.

"During 2010, we expect significant follow-on investments into companies that

raised Series a round (first round) in the past two to three years as well as a rise in
exit activity as the global economic recovery gathers pace," he added.

 NEED FOR GROWTH OF VENTURE CAPITAL IN

INDIA

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

41
spending or through increased consumption spending. In other cases, resources
flow to wealthy individuals who use them to maintain high levels of conspicuous
consumption.

India is still developing country. In India, a revolution is ushering in a new

economy, wherein entrepreneurs mind set is taking a shift from risk adverse
business to investment in new ideas which involve high risk. The conventional
industrial finance in India is not of much help to these new emerging enterprises.
Therefore there is a need of financing mechanism that will fit with the
requirement of entrepreneurs and thus it needs venture capital industry to grow in
India.

Few reasons for which active Venture Capital Industry is important for India
include:

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

financial system
 Job Creation: large pool of skilled graduates in the first and second tier
cities
 Patient capital: Not flighty, unlike FIIs
 Creating new Industry Clusters: Media, Retail, Call Centers and back
office processing, trickling down to organized effort of support services like
Office services, Catering, Transportation.

CHAPTER 6

 REGULATORY AND LEGAL FRAMEWORK

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

42
  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.

 MAJOR REGULATORY FRAMEWORKS FOR

VENTURE CAPITAL INDUSTRY

43
 • SEBI (VCF) Reg. • FEMA, • FDI • IT Act, 1961
1996 1999 policy • DTAA
• SEBI(FVCI) • Transfer or issue • Investme  Singapore
Reg.2000 of security by a nt approvals  Mauritius
• SCR Act.1956 person resident • Press  Others
• SEBI(SAST) outside India Notes
Reg.1997 regulation 2000
• SEBI(DIP)Guidelines
,2000
• SEBI Act,1992

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.

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

44
 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.

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.

45
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.

46
The following will be the salient features of SEBI (foreign Venture Capital
Investors) Regulations, 2000:

Definition of Foreign Venture capital Investor: any entity incorporated and

established outside India and proposes to make investment in Venture Capital
Fund or Venture Capital Undertaking and registered with SEBI.

Eligibility Criteria: entity incorporated and established outside India in the form
of Investment Company, Trust, Partnership, Pension Fund, Mutual Fund,
University Fund, Endowment Fund, Asset Management Company, Investment
Manager, Investment Management Company or other Investment Vehicle
Incorporated outside India would be eligible for seeking registration from SEBI.
SEBI for the purpose of registration shall 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;

47
 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 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;

48
 c) It has a minimum paid-up capital of fifty million rupees raised through
private placement; and
d) For the purpose of managing its entire business, it has entered into a
contract, in writing, with a venture capital company and a copy of which
has been filed with the Commission.

(2) The board of venture capital fund shall not have a director, who is on the
board of any venture project being financed by the fund.

 Condition for grant of license.-

(1) No venture capital fund shall commence business unless a license is granted
under these rules.

(2) For obtaining a license a venture capital fund shall

a. Make an application to the Commission on Form V providing

information as sought in Annex therein, along with all the relevant
documents;
b. Submit a bank draft payable to the Commission evidencing the
payment of non-refundable application processing fee amounting to
fifty thousand rupees; and
c. Submit an undertaking that no change in the memorandum and
articles of association and in the directors shall be made without
prior written authorization of the Commission and that all conditions
for grant of license shall be complied with.

(3) On being satisfied that a venture capital fund is eligible for the grant of a
license and that it would be in the public interest so to do, the Commission may
grant a license in form VI.

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(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 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.

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(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.

CHAPTER 7

 KEY SUCCESS FACTOR FOR VENTURE

CAPITAL INDUSTRY IN INDIA

Knowledge becomes the key factor for a competitive advantage for company.
Venture Capital firms need more expert knowledge in various fields. The various
key success factors for venture capital industry are as follow:

▪ Knowledge about Govt. changing policies:

Investment, management and exit should provide flexibility to suit the business
requirements and should also be driven by global trends. Venture capital

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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 :

Venture capital should become an institutionalized industry financed and

managed by successful entrepreneurs, professional and sophisticated investors.

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

 Regulatory policy

Minimum contribution and fund size: the minimum investment in a Venture

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

CHAPTER 7

 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

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proposes, to make investments in accordance with these regulations. The funds so
collected are available for investment in potentially highly profitable enterprises
at a high risk of loss. A Venture Capitalist is an individual or a company who
provides. Investment Capital, Management Expertise, Networking & marketing
support while funding and running highly innovative & prospective areas of
products as well as services.

Thus, the investment made by Venture Capitalists generally involves –

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:

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

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

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 entrepreneur), borrowed capital, mortgage loans etc. in the capital
employed.

CHAPTER 8

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.

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There is a well established successful precedent in the case of Mutual Funds
which once registered with SEBI are automatically entitled to tax exemption at
pool level. It is an established principle that taxation should be only at one level
and therefore taxation at the level of VCFs as well as investors amount to double
taxation. Since like mutual funds VCF is also a pool of capital of investors, it
needs to be treated as a tax pass through. Once registered with SEBI, it should be
entitled to automatic tax pass through at the pool level while maintaining taxation
at the investor level without any other requirement under Income Tax Act.

 Flexibility in Investment and Exit:

 Allowing multiple flexible structures:

Eligibility for registration as venture capital funds should be neutral to firm

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

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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 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

58
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:

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.

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RBI Pricing Norms:

At present, investment/disinvestment by FVCI is subject to approval of pricing

by RBI which curtails operational flexibility and needs to be dispensed with.

CHAPTER 9:

Findings:

- Is the venture capital concept accepted in India much?

- Indian market is not critically involved into venture capital.

- Are the procedures a hurdle and a cause of failure?

- Yes,certainly.rigid regulations and lengthy procedures are a problem but
at the same time these are required in order to avoid default and loss to
the country’s economy.

- How far the investors invest into new firms via v.c?
- The extent up to which they find it difficult to mange funds from other
resources.

- Has v.c helped the development of Indian technology sector?

- V.c has encouraged brilliant ideas germintated into practical
implementation. Indian technological sector has brilliantly grabbed the
v.c opportunity and approach.

- Does the development of a country depend on v.c? if yes then to

what extent?
- Yes to quite an extent it does since the major input of any business which
is capital is being provided along with other secondary but equally
important inputs.

- Is there currently any development in Indian v.c sector?

- Since 2001 reforms,there has been a great development in v.c specially
with regard to its norms, promotion of the concept and ease in
regulations.

- How far the brand of a bank influences promoters?

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 - The bank’s brand plays a major role since the goodwill helps the
promoter as well as the investor largely to have faith in their merchant
bankers and to have an assurance on the return of their savings.

CHAPTER 10

CONCLUSION

The study provides that the maturity if the still nascent Indian Venture Capital
market is imminent.

Venture Capitalists in Indian have notice of newer avenues and regions to

expand. VCs have moved beyond IT service but are cautious in exploring the
right business model, for finding opportunities that generate better returns for
their investors.

In terms of impediments to expansion, few concerning factors to VCs include;

unfavorable political and regulatory environment compared to other countries,
difficulty in achieving successful exists and administrative delays in
documentation and approval.

In spite of few non attracting factors, Indian opportunities are no doubt promising
which is evident by the large number of new entrants in past years as well in
coming days. Nonetheless the market is challenging for successful investment.

Therefore Venture capitalists responses are upbeat about the attractiveness of the
India as a place to do the business.

ANNEXTURE (QUESTIONNAIRE)

- Is the venture capital concept accepted in India much?

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 - Are the procedures a hurdle and a cause of failure?

- How far the investors invest into new firms via v.c?

- Has v.c helped the development of Indian technology sector?

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

extent?

- Is there currently any development in Indian v.c sector?

- How far the brand of a bank influence promoters?

BIBLIOGRAPHY

 BOOKS:

 Taneja Satish, “Venture Capital in India”.

 Chary T Satyanarayana, “Venture Capital – Concepts & Applications ”

 MAGAZINE:

 Sharma Kapil, an Analysis of Venture Capital Industry in India.

 REPORT:

 Trends of Venture Capital in India, survey Report by Deloitte, 2009.

 Global Trends of Venture Capital, survey report by Deloitte, 2009.
 Economic survey 2008-09,

 WEBSITE:

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 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

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