Chapter 1 “introduction to Project”

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CHAPTER 1

INTRODUCTIONTO

PROJECT

1.1 Research objective:To understand concept of Venture Capital.To understand Venture Capital industry in global scenario.To study the evolution and need of Venture Capital Industry in India.

To understand the legal framework formulated by SEBI to encourage Ventu

re capital activity in Indian Economy.To find out opportunity and threats those hinder and encourage Venture Capital Industry in India.

To know the impact of political and economical factors on Venture Capital investment. 1.2 Limitation of project Limitations:A study of this type cannot be without limitations. It has been observed that venture capitals are very secretive about their performance as well as about their

investments. This attitude has been a major hurdle in data collection. Howeverventure capital funds/companies that are members of Indian venture capital association are included in the study. Financial analysis has been restricted by andlarge to members of IVCA.1.3 Research Design & InstrumentsIn 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 attempthas 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 these reportsScope:The scope of the research includes all type of venture capital firms whether setup as a company or a trust fund. Venture capital companies and funds irrespective of the fact that they are registered with SEBI of India or not are part of this study. Angel investors have been kept out of the study as it was not feasibleto collect authenticated information about them.


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CHAPTER 2CONCEPTUAL

FRAMEWORK

2.1 Concept of Venture Capital

The term venture capital comprises of two words that is, Venture and Capital. Venture is a course of processing, the outcome of which is uncertain but to which is attended the risk or danger of loss. Capital means recourses to start

an enterprise. To connote the risk and adventure of such a fund, the generic name Venture Capital was coined. Venture capital is considered as financing of high and new technology based enterprises. It is said that Venture capital involves investment in new or relatively untried technology, initiated by relatively new and professionally or technically qualified entrepreneurs with inadequate funds. The conventional financiers, unlike Venture capitals, mainly finance proven technologies and established markets. However, high technology need not be pre-requisite for venture capital. Venture capital has also been described as unsecured risk financing. The relatively high risk of venture capital is compensatedby the possibility of high returns usually through substantial capital gains inthe medium term. Venture capital in broader sense is not solely an injection offunds into a new firm, it is also an input of skills needed to set up the firm,design its marketing strategy, organize and manage it. Thus it is a long term association with successive stages of companys development under highly risk investment conditions, with distinctive type of financing appropriate to each stageof development. Investors join the entrepreneurs as co-partners and support theproject with finance and business skills to exploit the market opportunities. Venture capital is not a passive finance. It may be at any stage of business/production cycle, that is, starting up, expansion or to improve a product or process, which are associated with both risk and reward. The Venture capital makes higher capital gains through appreciation in the value of such investments when thenew 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-To support by investors of entrepreneurial talent with finance and business skills to exploit market opportunities and thus obtain capital gains.Venture capital commonly describes not only the provision of start up finance or

seed corn capital but also development capital for later stages of business.A long term commitment of funds is involved in the form of equity investments, with the aim of eventual capital gains rather than income and active involvement


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in the management of customers business.

2.2 Features of Venture Capital2.2.1 High RiskBy 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. Venture capital assumes four types of risks, these are:

Management risk - Inability of management teams to work together.

Market risk - Product may fail in the market.

Product risk - Product may not be commercially viable.

Operation risk - Operations may not be cost effective resulting in increased cost decreased gross margins.

2.2.2 High TechAs 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

areas, 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.2.2.3 Equity Participation & Capital GainsInvestments are generally in equity and quasi equity participation through direct purchase of shares, options, convertible debentures where the debt holder hasthe option to convert the loan instruments into stock of the borrower or a debtwith 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.2.2.4 Participation in ManagementVenture capital provides value addition by managerial support, monitoring and follow up assistance. It monitors physical and financial progress as well as market development initiative. It helps by identifying key resource person. They want

one seat on the companys board of directors and involvement, for better or worse, in the major decision affecting the direction of company. This is a unique philosophy of hands on management where Venture capitalist acts as complementary to the entrepreneurs. Based upon the experience other companies, a venture capitalist advise the promoters on project planning, monitoring, financial management, including working capital and public issue. Venture capital investor cannotinterfere in day today management of the enterprise but keeps a close contact with the promoters or entrepreneurs to protect his investment.2.2.5 Length of InvestmentVenture 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. 2.2.6 Illiquid InvestmentVenture 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 gains when the investment is sold at market place. The investmentis 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 th


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is illiquidity and factors this in his investment decisions.

2.3 Difference between Venture Capital & Other Funds

2.3.1 Venture Capital Vs Development FundsVenture capital differs from Development funds as latter means putting up of industries without much consideration of use of new technology or new entrepreneurial venture but having a focus on underdeveloped areas (locations). In majority of cases it is in the form of loan capital and proportion of equity is very thin.

Development finance is security oriented and liquidity prone. The criteria forinvestment are proven track record of company and its promoters, and sufficientcash generation to provide for returns (principal and interest). The development

bank safeguards its interest through collateral. They have no say in working of the enterprise except safeguarding their interest by having a nominee director. They do not play any active role in the enterprise except ensuring flow of information and proper management information system, regular board meetings, adherence to statutory requirements for effective management control where as Venture

capitalist remain interested if the overall management of the project o account

of high risk involved I the project till its completion, entering into production and making available proper exit route for liquidation of the investment. Asagainst this fixed payments in the form of instalment of principal and interestare to be made to development banks.2.3.2 Venture Capital Vs Seed Capital & Risk CapitalIt is difficult to make a distinction between venture capital, seed capital, and

risk capital as the latter two form part of broader meaning of Venture capital.Difference between them arises on account of application of funds and terms andconditions applicable. The seed capital and risk funds in India are being provi

ded basically to arrange promoters contribution to the project. The objective is to provide finance and encourage professionals to become promoters of industrial projects. The seed capital is provided to conventional projects on the consideration of low risk and security and use conventional techniques for appraisal.Seed capital is normally in the form of low interest deferred loan as against equity investment by Venture capital. Unlike Venture capital, Seed capital providers neither provide any value addition nor participate in the management of the project. Unlike Venture capital Seed capital provider is satisfied with low risk-normal returns and lacks any flexibility in its approach. Risk capital is alsoprovided to established companies for adapting new technologies. Herein the approach is not business oriented but developmental. As a result on one hand the success rate of units assisted by Seed capital/Risk Finance has been lower than those provided with venture capital. On the other hand the return to the seed/riskcapital financier had been very low as compared to venture capitalist.

Seed Capital Scheme Venture capital Scheme

Basis Income or aid Commercial viabilityBeneficiaries Very small entrepreneurs Medium and large entrepreneurs are also covered

Size of assistance Rs. 15 Lac (Max) Up to 40 percent of promoters equityAppraisal process Normal Skilled and specializedEstimates returns 20 percent 30 percent plus

Flexibility Nil Highly flexible

Value addition Nil Multiple ways

Exit option Sell back to promoters Several ,including Public offer

Funding sources Owner funds Outside contribution allowed


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Syndication Not done Possible

Tax concession Nil ExemptedSuccess rate Not good Very satisfactory

Table 2.1: Difference between Seed Capital Scheme and Venture capital Scheme

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

2.4 The Venture Capital SpectrumThe growth of an enterprise follows a life cycle as shown in the diagram below.The requirements of funds vary with the life cycle stage of the enterprise. Even

before a business plan is prepared the entrepreneur invests his time and resources in surveying the market, finding and understanding the target customers andtheir needs. At the seed stage the entrepreneur continue to fund the venture with own his or family funds. At this stage the funds are needed to solicit the consultants services in formulation of business plans, meeting potential customers

and technology partners. Next the funds would be required for development of the product/process and producing prototypes, hiring key people and building up the managerial team. This is followed by funds for assembling the manufacturing and marketing facilities in that order. Finally the funds are needed to expand the

business and attaint the critical mass for profit generation. Venture capitalists cater to the needs of the entrepreneurs at different stages of their enterprises. Depending upon the stage they finance, venture capitalists are called angel

investors, venture capitalist or private equity supplier/investor.

Figure 2.1: Venture Capital Spectrum

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 balancetheir activities in term of time involvement, risk acceptance and reward potential, while providing ongoing assistance to developing business. Different venture capital firms have different attributes and aptitudes for different types of Venture capital investments. Hence there are different stages of entry for different Venture capitalists and they can identify and differentiate between types of

Venture capital investments, each appropriate for the given stage of the investee company, These are:-1. Early Stage Finance

Seed CapitalStart up CapitalEarly/First Stage CapitalLater/Third Stage Capital

2. Later Stage FinanceExpansion/Development Stage CapitalReplacement FinanceManagement Buy Out and Buy insTurnaroundsMezzanine/Bridge Finance


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

Financing StagePeriod (funds locked in years) Risk perception Activity to be financed

Early stage finance seed 7-10 Extreme For supporting a concept or ideaor R & D for product development

Start up 5-9 Very high Initializing operations or developing prototypesFirst stage 3-7 High Start Commercial production and marketingSecond stage 3-5 Sufficiently

high Expand market & growing working capital needLater stage finance 1-3 Medium Market expansion, acquisition & productdevelopment for profit making company

Buy-out in 1-3 Medium Acquisition financingTurn around 3-5 Medium to high Turning around a sick companymezzanine 1-3 Low Facilitating public issue

Table 2.2 Venture Capital Financing stage2.4.1 Seed CapitalIt is an idea or concept as opposed to a business. European Venture capital association defines seed capital as The financing of the initial product development or capital provided to an entrepreneur to prove the feasibility of a project and to qualify for start up capital.The characteristics of the seed capital may be enumerated as follows:

Absence of ready product marketAbsence of complete management teamProduct/ process still in R & D stageInitial period / licensing stage of technology transfer

Broadly speaking seed capital investment may take 7 to 10 years 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 ofsuccess and failure. Such projects, particularly hi-tech, projects sink a lot of

cash and need a strong financial support for their adaptation, commencement andeventual success. However, while the earliest stage of financing is fraught wit

h risk, it also provides greater potential for realizing significant gains in long term.2.4.2 Start up CapitalIt is stage 2 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:-


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I. 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.ii. Establishment of most but not all the members of the team. The skills and fitness to the job and situation of the entrepreneurs team is an important factor

for start up finance.iii. 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.2.4.3 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 ma

y not be generating profits.. A company needs this round of finance because of any of the following reasons:-

Project overruns on product development.Initial loss after start up phase.

The firm needs additional equity funds, which are not available from other sources thus prompting venture capitalist that, have financed the start up stage to provide further financing. The management risk is shifted from factors internal to the firm (lack of management, lack of product etc.) to factors external to the

firm (competitive pressures, in sufficient will of financial institutions to provide adequate capital, risk of product obsolescence etc.)2.4.4 Second Stage FinanceIt 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 State Finance is also referredto 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 financialneeds have subsequently exploded. This may be second or even third injection ofcapital.The characteristics of a second stage finance are:

A developed product on the marketA full management team in placeSales revenue being generated from one or more productsThere are losses in the firm or at best there may be a breakeven but the

surplus generated is insufficient to meet the firms needs.Second round financing typically comes in after start up and early stage funding

and so have shorter time to maturity, generally ranging from 3 to 7 years.2.4.5 Later Stage FinanceIt is called third stage capital is provided to an enterprise that has established commercial production and basic marketing set-up, typically for market expansion, acquisition, product development etc. It is provided for market expansion of the enterprise.The enterprises eligible for this round of finance have following characteristics.

Established business, having already passed the risky early stage.Expanding high yield, capital growth and good profitability.Reputed market position and an established formal organization structure

.


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Funds are utilized for further plant expansion, marketing, working capital or development of improved products. Third stage financing is a mix of equity withdebt or subordinate debt. As it is half way between equity and debt in US it iscalled mezzanine finance. It is also called last round of finance in run up to

the trade sale or public offer. Venture capitalist s prefer later stage investment vis a vis early stage investments, as the rate of failure in later stage financing is low. It is because firms at this stage have a past performance data,track record of management, established procedures of financial control.The time horizon for realization is shorter, ranging from 3 to 5 years. This helps the venture capitalists to balance their own portfolio of investment as it provides a running yield to venture capitalists.Further the loan component in third stage finance provides tax advantage and superior return to the investors. There are four sub divisions of later stage finance.

Expansion / Development FinanceReplacement FinanceBuyout FinancingTurnaround Finance

Expansion / Development FinanceAn enterprise established in a given market increases its profits exponentiallyby achieving the economies of scale. This expansion can be achieved either thro

ugh 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.

Replacement FinanceIt means substituting one shareholder for another, rather than raising new capi

tal resulting in the change of ownership pattern. Venture capitalist purchase shares from the entrepreneurs and their associates enabling them to reduce their shareholding in unlisted companies. They also buy ordinary shares from non-promoters and convert them to preference shares with fixed dividend coupon. Later, onsale of the company or its listing on stock exchange, these are re-converted toordinary shares. Thus Venture capitalist makes a capital gain in a period of 1 to 5 years.Buy - out / Buy - in Financing

It is a recent development and a new form of investment by venture capitalist.The funds provided to the current operating management to acquire or purchase asignificant 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 later 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 FinanceIt 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 foe a major restructuring to revitalize growth of profits. Unquoted company at an early stage of development often has higher debt than equity; its cash flows are slowing down due to lack of managerial skill and inability to exploit the market potential.The sick companies at the later stages of development do not normally have high


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debt burden but lack competent staff at various levels. Such enterprises are compelled to relinquish control to new management.The venture capitalist has to carryout 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 FinanceIt 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 helpin building a stable and experienced management team that will help the companyin 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 thepublic issue.2.5 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 a model of venture capital investment activity which with some variations is common

ly used presently.As per this model this activity is a five step process as follows:1. Deal Organization2. Screening3. Evaluation or due Diligence4. Deal Structuring5. Post Investment Activity and Exit

Figure 2.2 Venture Capital investment process

Deal organization: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 organisations, 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 allprojects on the basis 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 associatedwith evaluating an investment proposal. The venture capitalists evaluate the quality of entrepreneur before appraising the characteristics of the product, market or technology. Most venture capitalists ask for a business plan to make an assessment of the possible risk and return on the venture. Business plan contains detailed information about the proposed venture. The evaluation of ventures by VCFs in India 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


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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 t

erms of the deals, that is, 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 arrangements, acquisition, making initial public offerings (IPOs), etc. Earned out arrangements specify the entrepreneur

s equity share and the objectives to be achieved.Post Investment Activities:

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

venture capitalist to get involved in the day-to-day operation of the venture.If a financial or managerial crisis occurs, the venture capitalist may intervene

, and even install a new management team.Exit:Venture capitalists generally want to cash-out their gains in five to ten yearsafter 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 companyRe-purchase of venture capitalists share by the investee companyPurchase of venture capitalists share by a third party

Promoters Buy-backThe most popular disinvestments 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 not be in a financial position tobuy them back. In India, the promoters are invariably given the first option t

o buy back equity of their enterprises.For example, RCTC participates in the assisted firms equity with suitable agreement for the promoter to repurchase it. Similarly, Canfina-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, Canfina-VCF would have the discretion to divest them in any manner it deemed appropriate.SBI capital Markets ensures through examining the personal assets of the promoters and their associates, which buy back, would be a feasible option. GVFL wouldmake disinvestments, in consultation with the promoter, usually after the project has settled down, to a profitable level and the entrepreneur is in a positionto 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 b


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y the Indian investors on short-term profits and dividends may tend to make themarket 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 tillthe date of the new issue. This formula failed to give due weight age to the expected stream of earning of the venture firm. Thus, the formula would underestimate the premium.The Government has now abolished the Capital Issues Control Act, 1947 and consequently, the office of the controller of Capital Issues. The existing companies are now free to fix the premium on their shares. The initial public issue for disinvestments of VCFs holding can involve high transaction costs because of the inefficiency of the secondary market in a country like India. Also, this option has become far less feasible for small ventures on account of the higher listingrequirement 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 succes

s 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 shares 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 ofSecurities Dealers Automated Quotation System (NASDAQ) in the USA daily quotes over 8000 stock prices of companies backed by venture capital. The OTC Exchangein India was established in June 1992. The Government of India had approved thecreation 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 enterprises.The other disinvestments mechanisms such as the management buyouts or sale to other venture funds are not considered to be appropriate by VCFs in India. The growth of an enterprise follows a life cycle as shown in the diagram below. The requirements of funds vary with the life cycle stage of the enterprise.Even before a business plan is prepared the entrepreneur invests his time and resources in surveying the market, finding and understanding the target customersand their needs. At the seed stage the entrepreneur continue to fund the venture

with own his or family funds.At this stage the funds are needed to solicit the consultants services in formulation of business plans, meeting potential customers and technology partners. Next the funds would be required for development of the product/process and producing prototypes, hiring key people and building up the managerial team.This is followed by funds for assembling the manufacturing and marketing facilities in that order. Finally the funds are needed to expand the business and attaint the critical mass for profit generation.Venture capitalists cater to the needs of the entrepreneurs at different stagesof their enterprises.Depending upon the stage they finance, venture capitalists are called angel investors, venture capitalist or private equity supplier/investor

.Figure: 2.3 players in venture capital ind

ustry


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2.6 The playersThere are following groups of players:

Angels and angel clubsVenture Capital funds

Small Medium Large

Corporate venture fundsFinancial service venture groups

Angels and angel clubsAngels are wealthy individuals who invest directly into companies. They can form

angel clubs to coordinate and bundle their activities. Besides the money, angels often provide their personal knowledge, experience and contacts to support their investees. With average deals sizes from USD 100,000 to USD 500,000 they finance companies in their early stages. Examples for angel clubs are Media Club,Dinner Club, Angels Forum

Small and Upstart Venture Capital FundsThese are smaller Venture Capital Companies that mostly provide seed and start-up capital. The so called "Boutique firms" are often specialised in certain industries or market segments. Their capitalization is about USD 20 to USD 50 million

(is this deals size or total money under management or money under management per fund?).As Venture Capital funds strong competition will clear the market place for thesmall and medium. There will be mergers and acquisitions leading to a concentration of capital. Funds specialised in different business areas will form strategic partnerships. Only the more successful funds will be able to attract new money.Examples are:1. Artemis Coma ford2. Abbell Venture Fund3. Acacia Venture Partners

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

Large Venture FundsAs the medium funds, large funds operate in all business sectors and provide all

types of capital for companies after seed stage. They often operate internationally and finance deals up to USD 500 millionThe large funds will try to improve their position by mergers and acquisitions with other funds to improve size, reputation and their financial muscle. In addition they will to diversify. Possible areas to enter are other financial services

by means of M&As with financial services corporations and the consulting business.

For the latter one the funds have a rich resource of expertise and contacts inhouse. In a declining market for their core activity and with lots of tumbling companies out there is no reason why Venture Capital funds should offer advice and consulting only to their investees.Examples are:1. AIG American International Group2. Cap Vest Man3. 3i

Corporate Venture Funds


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These Venture Capital funds are set up and owned by technology companies. Theiraim is to widen the parent company

s technology base in a win-win-situation forboth, the investor and the investee.In general, corporate funds invest in growing or maturing companies, often whenthe investee wishes to make additional investments in technology or product development. The average deals size is between USD 2 million and USD 5 million.The large funds will try to improve their position by mergers and acquisitions with other funds to improve size, reputation and their financial muscle. In addition they will to diversify. Possible areas to enter are other financial services

by means of M&As with financial services corporations and the consulting business.For the latter one the funds have a rich resource of expertise and contacts in house. In a declining market for their core activity and with lots of tumbling companies out there is no reason why Venture Capital funds should offer advice and

consulting only to their investees.Examples are:1. Oracle2. Adobe3. Dell

4. KyoceraAs an example, Adobe systems launched a $40m venture fund in 1994 to invest in companies strategic to its core business, such as Cascade Systems Inc and Lantana

Research Corporation.- has been successfully boosting demand for its core products, so that Adobe recently launched a second $40m fund.

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

of recovery customers might prefer less risky alternatives.

CHAPTER 3GLOBAL SCENARIO OFVENTURE CAPITALINDUSTRY

3.1 Overview Over the last 18 months, the venture capital industry around the globe has experienced a welcome acceleration in the mature investment hotbeds United States,Europe and Israel and in the emerging venture capital hotbeds China and India.

Global venture capital investment last year reached US $ 35.2 billion, the high


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est level since 2001, and is maintaining a robust pace in year 2007. The acceleration has been bolstered by the increasing globalization of both venture capital

funds and venture backed companies and a substantial investor focus on emergingsectors. As the dotcom market of the late 1990 has gathered the momentum, ven

ture capital stood at the nexus of hype and hope. In 2000 , they poured nearly$95 billion into mostly young , untested companies , some no more than ideas, expecting to reap rich rewards by later selling of these outfits to public .But the bubble burst the market for the new stock issues tanked --- and by 2003 , venture capital funding had dwindled to $19 billion. The VC showed the signs of stabilizing as the industry were bolstered by the 2005s strong 4thquarter, the financing exceeded the $ 21.5 billion invested in venture-backed companies in 2004, reaching $22.1billion .While that was far below 2000s peak, it represents amore sustainable pace of funding for both entrepreneurs and investors. In another sign of the industry firming, pension funds, foundations, and other investorsare again getting interested to invest their money in venture funds, which provided seed money for young companies to grow on.

3.2 History & EvolutionPrior to World War Two, the source of capital for entrepreneurs everywhere was e

ither the government, government-sponsored institutions meant to invest in suchventures, or informal investors (today, termed "angels") that usually had some prior relationship to the entrepreneur. In general, throughout history private banks, quite reasonably, have been unwilling to lend money to a newly establishedfirm, because of the high risk and lack of collateral. After World War Two, in the U.S. a set of intermediaries emerged who specialized in investing in fledgling firms having the potential for extremely rapid growth. From its earliest beginnings on the U.S. East Coast, venture capital gradually expanded and became an

increasingly professionalized institution. During this period, the locus of theventure capital industry shifted from New York and Boston on the East Coast to

Silicon Valley on the West Coast. By the mid 1980s, the ideal-typical venture capital firm was based in Silicon Valley and invested largely in electronics withlesser sums devoted to biomedical technologies. Until the present, in addition to Silicon Valley, the two other major concentrations have been Boston and New York City. In both Europe and Asia, there are significant concentrations of venture capital in London, Israel, Hong Kong, Taiwan, and Tokyo. In the U.S., the government has played a role in the development of venture capital, though, for themost part, it was indirect. The indirect role, i.e., the general policies that also benefited the development of the venture capital industry, was probably themost significant. Some of the most important of these were:

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

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

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

The NASDAQ stock market, which has been the exit strategy of choice forventure capitalists, was strictly regulated and characterized by increasing openness thus limiting investor

s fears of fraud and deception.

This created a general macroeconomic environment of transparency and predictability, reducing risks for investors. Put differently, environmental risks stemming

from government action were minimized -- a sharp contrast to most developing nations. Another important policy has been a willingness to invest heavily and continuously in university research. This investment funded generations of graduate students in the sciences and engineering. From this research has come trainedpersonnel and innovations; some of who formed firms that have been funded by venture capitalists. U.S. universities particularly, MIT, Stanford, and UC Berkeley

played a particularly salient role. The most important direct U.S. government


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involvement in encouraging the growth of venture capital was the passage of theSmall Business Investment Act of 1958 authorizing the formation of small business investment corporations (SBICs). This legislation created a vehicle for funding small firms of all types. The legislation was complicated, but for the development of venture capital the following features were most significant:

It permitted individuals to form SBICs with private funds as paid-in capital and then they could borrow money on a two to one ratio initially up to$300,000, i.e., they could use up to $300,000 of SBA-guaranteed money for theirinvestment of $150,000 in private capital.

There were also tax and other benefits, such as income and a capital gains pass-through and the allowance of a carried interest as compensation.The SBIC program became one that many other nations either learned from or emulated. The SBIC program also provided a vehicle for banks to circumvent the Depression-Era laws prohibiting commercial banks from owning more than 5 percent of industrial firms. The banks

SBIC subsidiaries allowed them to acquire equity in small firms. This made even more capital available to fledgling firms, and was asignificant source of capital in the 1960s and 1970s. The final investment format permitted SBICs to raise money in the public market. For the most part, these

public SBICs failed and/or were liquidated by the mid 1970s. After the mid 1970s, with the exception of the bank SBICs, the SBIC program was no longer significant for the venture capital industry The SBIC program experienced serious problems from its inception. One problem was that as a government agency it was very bureaucratic having many rules and regulations that were constantly changing. Despite the corruption, something valuable also occurred. Namely, and especially, in

Silicon Valley, a number of individuals used their SBICs to leverage their personal capital, and some were so successful that they were able to reimburse the program and raise institutional money to become formal venture capitalists. The SBIC program accelerated their capital accumulation, and as important, government

regulations made these new venture capitalists professionalize their investmentactivity, which had been informal prior to entering the program. Now-illustriou

s firms such as Sutter Hill Ventures, Institutional Venture Partners, Bank of America Ventures, and Menlo Ventures began as SBICs The historical record also indicates that government action can harm venture capital. The most salient example

came in 1973 when the U.S. Congress, in response to widespread corruption in pension funds, changed Federal pension fund regulations. In their haste to prohibit pension fund abuses, Congress passed the Employment Retirement Income Security

Act (ERISA) making pension fund managers criminally liable for losses incurredin high-risk investments. This was interpreted to include venture capital funds;

as a result pension managers shunned venture capital nearly destroying the entire industry. This was only reversed after active lobbying by the newly created

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

The government has a relatively good economic record; there is a minimum of corruption, massive investment in military and, particularly, electronics research,and the excellent higher educational system. The importance of the relationships

between Israelis and Jewish individuals in U.S. high-technology industry and the creation of the Israeli venture capital system should not be underestimated.For example, the well-known U.S. venture capitalist, Fred Adler, began investing

in Israeli start-ups in the early 1970s, and in 1985 was involved in forming the first Israeli venture capital fund. Still, the creation of an Israeli venturecapital industry would wait until the 1990s, when the government funded an organization, Yozma, to encourage venture capital in Israel. Yozma received $100 million from the Israeli government. It invested $8 million in ten funds that were required to raise another $12 million each from "a significant foreign partner,"


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presumably an overseas venture capital firm. Yozma also retained $20 million toinvest itself. These sibling funds were the backbone of a now vibrant community that invested in excess of $1 billion in Israel in 1999 (Pricewaterhouse 2000). In the U.S., venture capital emerged through an organic trial-and-error process, and the role of the government was limited and contradictory. In Israel the government played a vital role in a supportive environment in which private-sector venture capital had already emerged. The role of government differs. In the U.S. the most important role of the government was indirect, in Israel it was largely positive in assisting the growth of venture capital, in India the role of the government has had to be proactive in removing barriers (Dossani and Kenney 2001). In every nation, the state has played some role in the development of venture capital. Venture capital is a very sensitive institutional form due to thehigh-risk nature of its investments, so the state must be careful to ensure itspolicies do not adversely affect its venture capitalists. Put differently, capricious governmental action injects extra risk into the investment equation. However, judicious, well-planned government policies to create incentives for private

sector involvement have in the appropriate lead to the establishment of what became an independent self-sustaining venture capital industry.3.3 Current Industry Trends

Round Class DistributionThe distribution of financing rounds by round class in mature markets is typically 30-40% in the early stage rounds, 20-25% in second round, and 35-40% in later

rounds. In emerging market like China, the round distribution is very differentas 68% in early stage round and 25% in second round. In mature countries, the i

nvestments are made at early start up or product development phase.Industry shiftsIt is perhaps no surprise that the contraction is mostly concentrated in information technology and the business, consumer and retail industries, give the hugenumber of companies financed in the technology and Internet boom of 1999-2000, and the subsequent downturn. The healthcare pool, driven by investment in biopharmaceuticals and medical devices, has actually grown to some degree in the different geographies .In United States, the healthcare pool has grown consistently over the last several years, both in terms of number of companies and cumulative dollars invested.Key observations on the pool of private companies by industry:-

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

Since 2003, the IT pool has decreased by 27% in Europe and since 2004 17% in Israel. Cumulative investment has declined in similar amounts.

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

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

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

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

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

The new multinationals: - A new breed of global company is emerging fromdeveloping countries and redefining industries through low-cost advantage, mode

rn infrastructure, and vast customer databases in their home countries. These co


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mpanies are potential acquirers of developed market companies at all stages of growth.

Globalization of capital: - Changes in economic and financial landscapeare creating a significant regional shift in IPO activity. These changes have also sparked global consolidation alliances among stock exchanges.

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

Clean Technology: - Clean technology is poised to become the first breakthrough sector of 21stcentury. Encompassing energy, air and water treatment, in

dustrial efficiency improvements, new material and waste management etc are playing very vital role globally because of which VC investors are enjoying rewards.

1.2 GLOBAL TREND IN VENTURE CAPITAL INDUSTRY

The 2007 Global Venture Capital Survey was sponsored by Deloitte & Touche LLP in conjunction with the National Venture Capital Association and other venture capital associations* throughout the world.It was administered in April and May 2007 to venture capitalists (VCs) in the Americas, Asia Pacific, Europe, the Middle East, and Africa.There were 528 responses from general partners, with 45 percent of respondents from the United States and 31 percent from Europe. A complete geographic breakdown of respondents is as follows:

Figure: 3.1 Primary focused location for investment (APAC) respondents

The breadth of assets under management by these respondents was varied. The highest number of respondents42 percenthad managed assets totaling less than $100million; 35 percent managed assets between $100 million and $499 million; 12 percent managed assets between $500 million to $1 billion; and 11 percent more than

$1 billion in assets under management There are 13 % respondents from APAC in which China, India, Japan, South Korea, other Asia. 45% respondents from Middle East include Israel and other area of Middle East.Global VC investment increasing, but growth is slow and cautious.We may live in a global economy, but the venture capital community is not broadly embracing global investment. Rather, roughly half of the venture community has

made a commitment to a global investment strategy and those firms are implementing that strategy slowly and cautiously. The intentions for growth of foreign investment, as demonstrated by this years survey data, are modest at best.

Figure: 3.2 Percentage of venture capitalist currently investing outside homecountry (U.S respondent)

Figure: 3.3 Percentage of venture capitalist currently investing outside home country (Non U.S. respondents)

Among U.S. investors, 54 percent indicated that they would be expanding their investment focus outside of their home country or region in the next five years. Adequate deal flow in their home country was the reason indicated most for not wanting to expand globally.

Some venture investors are certainly taking advantage of opportunities outside


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their home countries, actual growth in terms of percentage of venture investorsinvesting globally is occurring much more slowly than is commonly believed. And,

for a lot of firms, theyre not diving deep into investing in other countries,but dipping a toe in with one or two deals.This cautious approach allows the venture firms to further assess the investment

environment, evaluate how their strategy may need to be adjusted and how critical challenges, such as tax and intellectual property issues impact overall performance.

3.5 Current strategiesAmong those VCs who are currently investing abroad, 48 percent of them have dev

eloped strategic alliances with a foreign-based firm and 51 percent invest onlywith other investors who have a local presence.This underscores the need in venture capital to be physically close to the portfolio companies in order to work with management. Firms also indicated that to succeed, they need to understand local culture, and to do so they must have a local presence in their target countries to take advantage of in-country expertise.To this end, they also are hiring investment staff with expertise in target coun

tries (41 percent) and requiring their partners to travel more (58 percent).Figure: 3.4 Current business practices used by venture capitalist to manage foreign investment Focus

3.6 China, India, Israel and Canada are primary target countries for U.S. venture capitalistsThere continues to be a consensus among U.S. venture capitalists regarding where

the most opportunities exists globally. Most of the U.S. firms who have invested globally are making investments in China, India, Israel, and Canada. However,even in these countries, the majority of U.S. respondents are essentially dabbling, making only one to two investments thus far.

Figure: 3.5 foreign investments currently held byfirmsAllocations by U.S. and non-U.S. firms alike for the most part represent less than 5 percent of capital invested overseas in fewer than three to five deals. Survey results indicate that there will not be significant change during the next five years.

RESPONSE FROM U.S. RESPONDENTS

Figure: 3.6 Primary focused location for investment (U.S) respondentsHere from the above chart we can see that the highest percent of respondents are

interested in China for setting up their businesses. India is the second choicefor the global investors

RESPONSE FROM (APAC) RESPONDENTS

Figure: 3.7 Primary focused location for investment (APAC)respondents

While China, India, Israel, and Canada are by far the most seductive target markets for investment by U.S. firms, venture capitalists in non-US countries have a

different focus. By far the greatest contrast is among European respondents, who indicated a strong preference for investing in other parts of Europe (67 percent) and the United States (17 percent), with the remainder focused on Asia. Asian respondents had a similar level of interest in the United States (18 percent),


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but looked primarily inward to other Asian countries (78 percent), with the remainder focused on the Middle East. This data shows that while non-U.S. investors

are interested in making deals outside of their home countries, theres still adesire to remain somewhat close to home and do business with cultures close to

theirs. Most of APAC respondents like to investment china and other Asia. Thereis 3% ready to invest in South Korea, Japan and South KoreaResources are critical for international investingThe survey findings indicate that global investing will broaden among U.S. VC firms at a slow pace for the foreseeable future. Of those VCs who indicated they currently have capital deployed abroad, more than half of U.S. respondents (54 percent) expect to expand their global investment focus over the next five years,and 61 percent of non-U.S. firms also see a future in investing outside of their

home country. Not surprising, larger VC firms are most likely to be investing outside the United States and plan to increase their overseas investment. In fact, 85 percent of U.S. firms and 92 percent of non-U.S. firms with capital management over $1 billion indicated plans to increase their foreign investments. Interestingly, among mid-size firms, 47 percent of the VCs with $100 to$499 million capital under management are investing outside the U.S. This underscores that global investing requires additional resources and a sophisticated infrastructure i

n order to manage a global investment strategy. That said, the study also showsthat a significant percentage of mid-size firms recognize that opportunities exist outside their home country and are building their franchise in a way that will enable them to take advantage of those opportunities.

Figure: 3.8 Percentage of venture capitalist expecting to expand investment focus Outside home country

3.7 Primary reasons why investors expanding globally ventureAmong the primary reasons VCs around the world are interested in investing globally is to take advantage of higher quality deal flowparticularly in the UnitedStates, China, parts of Europe, and Israel. This is especially true for non-U.S.

firms. A second reason is the emergence of an entrepreneurial environment, again and notably in China, but also India. Among U.S. firms, this latter rationaleis the most significant motivation for investing globally. Other motivators include access to quality entrepreneurs, diversification of industry and geographicrisk and access to foreign markets.

Figure: 3.9 primary reasons why venture investors expanding globally

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

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

operations outside the country in which theyre headquartered. A significant n


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umber, 88 percent of U.S. respondents and 82 percent of non-U.S. respondents, indicated that at least some portion of their portfolio has significant operations

outside of the country of headquarters. Again, moderation is evident as more than half of those indicated that less than 25 percent of their portfolio had significant foreign operations. Nonetheless, these numbers have increased significantly from prior years and reflect an increased trend in this method of investment

Figure: 3.10 Percentage of venture capital firms portfolio companies that givesignificant operation outside the country

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

off is that investors are concerned about intellectual property and liquidity eventsand, in general, they feel a need to be closer to top management. This also reflects a new realitythat VCs are now investing in companies that operate globally from day one companies that reflects a larger global entrepreneurial sector. This strategy allows the portfolio companies (and investors) to take advantage of cost savings and access to talent in foreign markets while protecting intellectual property. There are, however, concerns that such a trend could resultin the U.S. losing its R&D edge.

3.9 Impediments to global investing

For all the benefits of overseas investing, VC firms encounter a variety of risks and challenges abroad. Both U.S. and non-U.S. firms perceive the U.S. as the country where the cost of complying with regulation is too high. In fact, the percentage of non-U.S. respondents who indicated this as a concern leaped from 28 percent last year to 41 percent this year. Globally, 4 percent more, 44 percent saw this issue as a concern. Forty-six percent of U.S. respondents believe the cost of complying with corporate governance is too high. Figure: 3.11 Top markets where the cost of complying with corporate governance

regulation too high

From the above chart we can see that most of the respondents believe that U.S. has high cost of complying with Corporate Governance regulation and china, India,

Israel and Canada cost of complying with corporate governance regulation too high.


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CHAPTER 4VENTURE CAPITALIN INDIA

4.1 Evolution of VC Industry in India

The first major analysis on risk capital for India was reported in 1983. It indicated that new companies often confront serious barriers to entry into capital market for raising equity finance which undermines their future prospects of expansion and diversification. It also indicated that on the whole there is a need to revive 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 Corporationof India (IFCI) initiated the idea of VC when it established the Risk Capital Foundation in 1975 to provide seed capital to small and risky projects. However the concept of VC 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 institutionsThe IDBI started a VC fund in 19876 as per the long term fiscal policy of gover

nment of India, with an initial capital of Rs. 10 cr which raised by imposing acess of 5% on all payments made for the import of technology know- how projectsrequiring funds from rs.5 lacs to Rs 2.5 cr were considered for financing. Promoters contribution ranged from this fund was available at a concessional interest rate of 9% (during gestation period) which could be increased at later stages.

The ICICI provided the required impetus to VC activities in India, 1986, it started providing VC finance in 1998 it promoted, along with the Unit Trust of India (UTI) Technology Development and Information Company of India (TDICI) as thefirst VC company registered under the companies act, 1956. The TDICI may provide

financial assistance to venture capital undertakings 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 Financecompany (RCTC) as a subsidiary company of the ifci the rctc provides assistancein the form of conventional loans, interest free conditional loans on profit and risk sharing basis or equity participation in extends financial support to hig


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h technology projects for technological up gradations. The RCTC has been renamedas IFCI Venture Capital Funds Ltd.(IVCF)

Promoted by State Level Financial InstitutionsIn 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 VC to a small scale enterprises. 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 businesses in the form of equity, conditional loans or income notes for technologies development and innovative products. It also provides finance assistance to entrepreneurs. The government of Andhra Pradesh has

also promoted the Andhra Pradesh Industrial Development Corporation (APIDC) toprovide VC financing in Andhra Pradesh.

Promoted by commercial banksCanbank Venture Capital Fund, State Bank Venture Capital Fund and Grindlays bank

Venture Capital Fund have been set up by the respective commercial banks to undertake Vc activities.The State Bank Venture Capital Funds provides financial assistance for bought o

ut deal as well as new companies in the form of equity which it disinvests afterthe commercialization of the project.Canbank Venture Capital Fund provides financial assistance for proven but yet to

b commercially exploited technologies. It provides assistance both in the formof equity and conditional loans.

Private Venture Capital FundsSeveral private sector venture capital funds have been established in India suc

h as the 20ThCenture Venture Capital Company, Indus Venture Capital Fund, Infrastructure Leasing and Financial Services Ltd.Some of the companies that have received funding through this route include: Mastek, on of the oldest softwear house in India Ruskan software, Pune based software consultancy SQL Star, Hyderabad-based training and software development consultancy Satyam infoway, the first private ISP in India Hinditron, makers of embedded software Selectia, provider of interactive software selectior Yantra, ITLInfosys US subsidiary, solution for supply chain management Rediff on the Net, Indian website featuring electronic shopping, news,chat etc.

4.2 INDUSTRY LIFE CYCLE:From the industry life cycle we can know in which stage we are standing. On thebasis of this management can make future strategies of their business.

Figure: 4.1 Industry life cycles

The growth of VC in India has four separate phases:

4.2.1 Phase I - Formation of TDICI in the 80s and regional funds as GVFL & APIDC in the early 90s.The first origins of modern venture capital in India can be traced to the setting up of a Technology Development Fund in the year 1987-88, through the levy of access on all technology import payments. Technology Development Fund was started

to provide financial support to innovative and high risk technological programmes through the Industrial Development Bank of India.The first phase was the initial phase in which the concept of VC got wider acceptance. The first period did not really experience any substantial growth of VCs. The 1980s were marked by an increasing disillusionment with the trajectory of


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the economic system and a belief that liberalization was needed.The liberalization process started in 1985 in a limited way. The concept of venture capital received official recognition in 1988 with the announcement of the venture capital guidelines.During 1988 to 1992 about 9 venture capital institutions came up in India. Though the venture capital funds should operate as open entities, Government of India

controlled them rigidly.One of the major forces that induced Government of India to start venture funding was the World Bank. The initial funding has been provided by World Bank. The most important feature of the 1988 rules was that venture capital funds receivedthe benefit of a relatively low capital gains tax rate which was lower than thecorporate rate. The 1988 guidelines stipulated that VC funding firms should meet

the following criteria:Technology involved should be new, relatively untried, very closely held

, in the process of being taken from pilot to commercial stage or incorporate some significant improvement over the existing ones in India

Promoters / entrepreneurs using the technology should be relatively new,professionally or technically qualified, with inadequate resources to finance t

he project.

Between 1988 and 1994 about 11 VC funds became operational either through reorganizing the businesses or through new entities.All these followed the Government of India guidelines for venture capital activities and have primarily supported technology oriented innovative businesses started by first generation entrepreneurs. Most of these were operated more like a financing operation. The main feature of this phase was that the concept got accepted.VCs became operational in India before the liberalization process started. The context was not fully ripe for the growth of VCs. Till 1995; the VCs operated like any bank but provided funds without collateral. The first stage of the venture

capital industry in India was plagued by in experienced management, mandates toinvest in certain states and sectors and general regulatory problems. Many publ

ic issues by small and medium companies have shown that the Indian investor is becoming increasingly wary of investing in the projects of new and unknown promoters.The liberation of the economy and toning up of the capital market changed the economic landscape. The decisions relating to issue of stocks and shares was handled by an office namely: Controller of Capital Issues (CCI). According to 1988 VC

guideline, any organization requiring to start venture funds have to forward anapplication to CCI. Subsequent to the liberalization of the economy in 1991, th

e office of CCI was abolished in May 1992 and the powers were vested in Securities and Exchange Board of India. The Securities and Exchange Board of India Act,1992 empowers SEBI under section 11(2) thereof to register and regulate the working of venture capital funds.This was done in 1996, through a government notification. The power to control venture funds has been given to SEBI only in 1995 and the notification came out in 1996. Till this time, venture funds were dominated by Indian firms. The new regulations became the harbinger of the second phase of the VC growth.4.2.2 Phase II - Entry of Foreign Venture Capital funds (VCF) between 1995 -1999

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

as well as the success of Silicon Valley start-ups. In other words, VC growth and IT growth co-evolved in India


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4.2.3 Phase III - (2000 onwards) - VC becomes risk averse and activity declines: Not surprisingly, the investing in India came crashing down when NASDAQ lost 60% of its value during the second quarter of 2000 and other public markets (including those in India) also declined substantially. Consequently, during 2001-2003, the VCs started investing less money and in more mature companies in an effort to minimize the risks. This decline broadly continued until 2003.4.2.4 Phase IV 2004 onwards - Global VCs firms actively investing in IndiaSince Indias economy has been growing at 7%-8% a year, and since some sectors,including the services sector and the high-end manufacturing sector, have been growing at 12%-14% a year, investors renewed their interest and started investing

again in 2004.The number of deals and the total dollars invested in India has been increasingsubstantially.4.3 Growth of venture capital in India

Figure: 4.2 Growth of Venture capitals in Indi

aThe venture capital is growing 43% CAGR. However, in spite of the venture capital scenario improving, several specific VC funds are setting up shop in India, with the year 2006 having been a landmark year for VC funding in India. The total

deal value in 2007 is 14234 USD Million. The no. of deals are increasing year by year. The no. of deals in 2006 only 56 and now in 2007 it touch the 387 deals. The introduction stage of venture capital industry in India is completed in 2003

after that growing stage of Indian venture capital industry is started. There are 160 venture capital firms/funds in India. In 2006 it is only but in 2007 thenumber of venture capital firms is 146. The reason is good position of capitalmarket. But in 2008 no. of venture capital firms increase by only 14. The reason

is crash down of capital market by 51% from January to November 2008. The No. of venture capital funds are increasing year by year2000 2001 2002 2003 2004 2005 2006 2007 2008841 77 78 81 86 89 105 146 160www.nasscom.org, strategic review 2008 published by (National Association of Software and Service Companies)Venture capital growth and industrial clustering have a strong positive correlation. Foreign direct investment, starting of R&D centres, availability of venture

capital and growth of entrepreneurial firms are getting concentrated into fiveclusters. The cost of monitoring and the cost of skill acquisition are lower inclusters, especially for innovation. Entry costs are also lower in clusters. Creating entrepreneurship and stimulating innovation in clusters have to become a major concern of public policy makers. This is essential because only when the cultural context is conducive for risk management venture capital will take-of. Clusters support innovation and facilitates risk bearing. VCs prefer clusters because the information costs are lower. Policies for promoting dispersion of industries are becoming redundant after the economic liberalization. The venture capital firm invest their money in most developing sectors like health care, IT-ITes,, telecom, Bio-technology, Media& Entretainment, shipping & ligistics etc.

Figure 4.3 Total sector wise venture capital investment-2007

Now venture capital is nascent stage in India. Now due to growth of this sector,the venture capital industry is also grow. The top most player in the industrie

s are ICICI venture capital fund, Avishhkar venture capital fund, IL&FS venturecapital fund, Canbank.

4.4 Venture Capital investment Q3, 2008.


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Venture Capital firms invested $274 million over 49 deals in India during the three months ending September 2008. The VC investment activity during the period was significantly higher compared to the same quarter last year (which had witnessed 36 investments worth $252 million) as well as the immediate previous quarter

($165 million invested across 28 deals).The latest numbers take the total VC investments in the first nine months of 2008 to $661 million (across 108 deals) as against the $648 million (across 97 deals) during the corresponding period in 2007.

4.4.1 Top InvestmentsThe largest investment reported during Q3 2008 was the $18 million raised by online tutoring services provider TutorVista from existing investors Sequoia Capital India and LightSpeed Ventures.

Table: 4.1 Top venture capital investments

4.4.2 Investments by IndustryInformation Technology and IT-Enabled Services (IT & ITES) industry retained its status as the favorite among VC investors during Q3 08.

Table: 4.2 Venture capital investment by industryLed by the $12 million investment by Bellwether and others into Chennai-based microfinance firm Equitas, BFSI emerged as the second largest (in value terms) for

VC investments during the period. Other microfinance firms that attracted investments during Q3 08 included Kolkata-based Arohan Financial Services (which raised funding from Lok Capital and others) and Guwahati-based Asomi Finance (IFC and Aavishkaar Goodwell).

Figure: 4.4 investment by industry Q3,2008

4.4.3 Investment by StageAbout 67% of VC investments during Q3 08 were in the early stage segment.

Table: 4.3 Venture investments by stage

Figure: 4.5 Stage wise investment4.5 Need for growth of venture capital in India

In India, a revolution is ushering in a new economy, wherein entrepreneurs mindset is taking a shift from risk adverse business to investment in new ideas whi

ch 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 needsventure capital industry to grow in India. Few reasons for which active Ventu

re Capital Industry is important for India include:Innovation : needs risk capital in a largely regulated, conservative, le

gacy financial system

Job creation: large pool of skilled graduates in the first and second tier cities

Patient capital: Not flighty, unlike FIIsCreating new industry clusters: Media, Retail, Call Centres and back off

ice processing, trickling down to organized effort of support services like office services, catering, transportation


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4.6 Regulatory and legal framework

Definition of Venture Capital Fund :The Venture Capital Fund is now defined as afund established in the form of a Trust, a company including a body corporate a

nd registered with SEBI which:A. Has a dedicated pool of capital;B. Raised in the manner specified under the regulations; andC. To invest in venture capital undertakings in accordance with the regulations.

Definition of Venture Capital Undertaking: Venture Capital Undertaking means a domestic company:-1. Whose shares are not listed on a recognized stock exchange in India2. Which is engaged in business including providing services, production or

manufacture of articles or things, or does not include such activities or sectors which are specified in the negative list by the Board with the approval of the Central Government by notification in the Official Gazette in this behalf? The

negative list includes real estate, non-banking financial services, gold financ

ing, activities not permitted under the Industrial Policy of the Government of India.Minimum contribution and fund size: the minimum investment in a Venture CapitalFund 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.

Investment Criteria: The earlier investment criteria have 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 2

5% 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 s

hares or equity linked instruments.Not more than 25% of the investible funds may be invested by way of:

a. Subscription to initial public offer of a venture capital undertaking whose shares are proposed to be listed subject to lock-in period of one year;b. Debt or debt instrument of a venture capital undertaking in which the venture capital fund has already made an investment by way of equity.

It has also been provided that Venture Capital Fund seeking to avail benefit under the relevant provisions of the Income Tax Act will be required to divest from the investment within a period of one year from the listing of the Venture Capital Undertaking.Disclosure and Information to Investors:In order to simplify and expedite the process of fund raising, the requirement of filing the Placement memorandum with SEBI is dispensed with and instead the fund will be required to submit a copy of Placement Memorandum/ copy of contribution agreement entered with the investors along with the details of the fund raised for information to SEBI. Further, the contents of the Placement Memorandum are

strengthened to provide adequate disclosure and information to investors. SEBIwill 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 bo

ok building route as Qualified Institutional Buyer subject to compliance with the SEBI (Venture Capital Fund) Regulations.Relaxation in Takeover Code:

The acquisition of shares by the company or any of the promoters from the Venture Capital Fund under the terms of agreement shall be treated on the same footing as that of acquisition of shares

Documents

Chapter 1 “introduction to Project”