final vc project

8/6/2019 Final VC Project

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Chapter - 1

INTRODUCTION TO THE

PROJECT


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1.1 RESEARCH OBJECTIVES:

1. To understand the concept of venture capital

2. To understand venture capital investment process in India

3. To study the evolution and need of Venture Capital Industry in India

4. To understand the legal framework formulated by SEBI to encourage VentureCapital activity in Indian economy

5. To find out opportunities & threats those hinder and encourage Venture CapitalIndustry in India

1.2 Limitations of the project:

A study of this type cannot be without limitations. It has been observed that venturecapital is very sensitive about their performance as well as about their investment. Thisattitude has been a major hurdle in data collection. However, venture capitalfunds/companies that are members of Indian Venture Capital association are included instudy. Financial analysis has been restricted by and large to members of IVCA.

1.3 Research & Design Instruments:

In India neither the venture capital theory has been developed nor are there manycomprehensive books on this project. Even the number of research papers available islimited . The research design used is descriptive in nature. (The attempt has been made tocollect maximum facts & figures available on the availability of venture capital in India,nature of assistance granted, future projected demand for this financing, analysis ofproblem faced by entrepreneurs in getting venture capital, analysis of venture capitalist,and social and environmental impact on the existing framework.)The research is based on secondary data collected from published material. The data wasalso collected from the publications and press releases of venture capital associations inIndia.

Scanning the business papers filled the gap in information. The Economic Times,Financial Express and Business Standards were scanned for any article of news itemrelated to venture capital. Sufficient amount of data about the venture capital has beenderived from these reports.


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1.4 Scope:

The scope of the research includes all type of Venture capital firms whether set up ascompany or a trust fund. Venture Capital companies & funds irrespective of the fact that

they are registered with SEBI of India or not the part of this study. Angel investors havebeen kept out of the study as it was not feasible to collect authenticated information aboutthem.


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Chapter 2

CONCEPTUAL FRAMEWORK


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2.1 Concept of Venture Capital

Venture Capital plays an important role in financing small scale enterprise and hightechnology and risky ventures. The Venture Capital activity is quite advanced in

developed countries. It has also taken root in a number of developing countries. VentureCapital has potential to become an important source of financing small scale enterprises.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 isattended the risk or danger of loss. Capital means recourses to start an enterprise. Toconnote the risk and adventure of such a fund, the generic name Venture Capital wascoined.

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 qualifiedentrepreneurs with inadequate funds. The conventional financiers, unlike Venturecapitals, mainly finance proven technologies and established markets. However, hightechnology need not be pre-requisite for venture capital.

Venture Capital has also been described as unsecured risk financing. The relatively highrisk of venture capital is compensated by the possibility of high returns usually throughsubstantial capital gains in the medium term. Venture capital in broader sense is notsolely an injection of funds into a new firm, it is also an input of skills needed to set upthe firm, design its marketing strategy, organize and manage it. Thus it is a long termassociation with successive stages of companys development under highly risk

investment conditions, with distinctive type of financing appropriate to each stage ofdevelopment. Investors join the entrepreneurs as co-partners and support the project withfinance and business skills to exploit the market opportunities.

Venture capital is not a passive finance. It may be at any stage of business/productioncycle, that is, start up, expansion or to improve a product or process, which are associatedwith both risk and reward. The Venture capital makes higher capital gains throughappreciation in the value of such investments when the new technology succeeds. Thusthe primary return sought by the investor is essentially capital gain rather than steadyinterest income or dividend yield.

The most flexible definition of Venture capital is-

The support by investors of entrepreneurial talent with finance and business skills toexploit market opportunities and thus obtain capital gains.

Venture capital commonly describes not only the provision of start up finance or seedcorn capital but also development capital for later stages of business. A long termcommitment of funds is involved in the form of equity investments, with the aim of


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eventual capital gains rather than income and active involvement in the management ofcustomers business.

2.2 Features of Venture Capital:

Venture capital combines the qualities of a banker, stock market investor andentrepreneur in one.

The main features of venture capital can be summarized as follows:

i. High Degrees of Risk: Venture capital represents financial investment in a highlyrisky project with the objective of earning a high rate of return. Venturecapital assumes 4 types of risk:

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.

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

ii. Equity Participation: Venture capital financing is, invariably, an actual orpotential equity participation wherein the objective of venture capitalist is tomake capital gain by selling the shares once the firm becomes profitable.

iii. Long Term Investment: Venture capital financing is a long term investment. Itgenerally takes a long period to en-cash the investment in securities made bythe venture capitalists.

iv. Participation in Management: In addition to providing capital, venture capitalfunds take an active interest in the management of the assisted firms. Thus,the approach of venture capital firms is different from that of a traditionallender or banker. It is also different from that of a ordinary stock marketinvestor who merely trades in the shares of a company without participating intheir management. It has been rightly said, venture capital combines the

qualities of banker, stock market investor and entrepreneur in one.

v. Achieve Social Objectives: It is different from the development capital provided by several central and state level government bodies in that the profitobjective is the motive behind the financing. But venture capital projectsgenerate employment, and balanced regional growth indirectly due to settingup of successful new business.


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vi. Investment is liquid: A venture capital is not subject to repayment on demand aswith an overdraft or following a loan repayment schedule. The investment isrealized only when the company is sold or achieves a stock market listing. It islost when the company goes into liquidation.

2.3 Difference between Venture Capital & Other Funds:

2.3.1. Venture Capital VS Development Funds:

Venture Capital differs from Development Funds as latter means putting up of industrieswithout much consideration of use of new technology or new entrepreneurial venture buthaving a focus on undeveloped areas (locations). In majority of cases it is in the form ofloan capital and proportion of equity is very thin. Development finance is securityoriented and liquidity prone. The criteria for investment are proven track record ofcompany and its promoters, and sufficient cash generation to provide for returns

(principal & interest). The development bank safeguards its interest through collateral.

They have no say in working of the enterprise except safeguarding their interest byhaving a nominee director. They do not play any active role in the enterprise exceptensuring flow of information and proper management information system, regular boardmeetings, adherence to statutory requirements for effective management control where asVenture capitalist remain interested if the overall management of the project o account ofhigh risk involved I the project till its completion, entering into production and makingavailable proper exit route for liquidation of the investment. As against this fixed payments in the form of installment of principal and interest are to be made todevelopment banks.

2.3.2 Venture Capital Vs Seed Capital & Risk capital

It is difficult to make a distinction between venture capital and seed capital and Riskcapital as the latter two forms part of broader meaning of venture capital. Difference between them arises on account of application of funds and terms and conditionsapplicable. The seed capital and risk funds in India are being provided basically toarrange promoters contribution to the project. The objective is to provide finance andencourage professionals to become promoters of industrial projects. The seed capital isprovided to conventional project on the consideration of low risk and security and use

conventional techniques for appraisal. Unlike Venture Capital, Seed capital providersneither provide any value addition nor participation in the management of the project.Unlike Venture capital Seed capital provider is satisfied with low risk-normal returns andlacks any flexibility in its approach.

Risk capital is also provided to established companies for adapting new technologies.Herein the approach is not business oriented but developmental. As a result on the onehand the success rates of units assisted by Seed Capital\Risk


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Finance has been lower than those provided with venture capital. On the other hand thereturn to the seed\risk capital financier has been very low as compare to venturecapitalist.

Seed capital scheme Venture capital scheme

Basis Income or aid Commercial viability

Beneficiaries Very small entrepreneurs Medium or largeentrepreneurs are also

covered

Size of assistance Upto 15 Lacs (Max) Upto 40% of promotersequity

Appraisal process Normal Skilled & Specialized

Estimates returns 20% 30% plus

Flexibility Nil Highly FlexibleValue addition NIL Multiple ways

Exit options Sell back to promoters Several, including publicoffer

Funding sources Owners fund Outsider contributionallowed

Syndication Not done Possible

Tax concession Nil Exempted

Success rate Not good Very satisfactory

Difference between Seed Capital Scheme and Venture Capital Scheme

2.3.3 Venture Capital Vs Bought out deals

The important difference between Venture Capital and Bought out deals is that boughtout deals are not based on high risk-high reward principle. Further unlike VentureCapital, they do not provide equity finance at different stages of the enterprise, Howeverboth have common exception of capital gains yet their objectives and intents are totallydifferent.

2.4 The Venture Capital Spectrum:

The growth of an enterprise follows a life cycle. The requirement of funds vary with thelife stages of the enterprise. Even before a business plan is prepared the entrepreneurinvests his time and resource in surveying the market, finding and understanding thetarget customers and their needs. At the seed stage, the entrepreneur continue to fund theventure with his own funds. At this stage, the funds are needed to solicit the consultantsservice in formulation of business plan, meeting potential customers and technology


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partners. Next the fund would be required for the development of the product\process,hiring key people and building up the management team. This is followed by funds forassembling the manufacturing and marketing facilities in that order. Finally the funds areneeded to expand the business for more profits. Venture Capitalist cater to the need of theentrepreneurs at the different stages of their enterprise. Depending upon the stage they

finance, venture capitalist are called angel investors, venture capitalist or private equitysupplier/investor.

Venture capital was started as early stage financing of relatively small but growingcompanies. However various reasons forced venture capitalist to be more and moreinvolved in expansion financing to support the development of existing portfoliocompanies. With increasing demand of capital for newer business, Venture capitalistbegan to operate across a broader spectrum of investment interest. This diversity ofopportunities enabled Venture capitalists to balance their activities in term of timeinvolvement, risk acceptance and reward potential, while providing on going assistanceto developing business.

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

1. Early Stage Finance

Seed capital

Start up capital

Early\First stage capital

Later\Third Stage Capital

2. Later Stage Finance

Expansion\Development stage capital

Replacement finance

Management Buyouts and Buy ins

Turnarounds

Mezzanine\Bridge Finance

Not all business firms pass all of these stages in a sequential manner. For instance seedcapital is not required by service based ventures. It implies largely to manufacturing orresearch based activities. Similarly second round finance does not always follow earlystage finance. If the business grows successfully, it is likely to develop sufficient cash tofund its own growth, so does not require venture capital for growth.


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

Financing stage Period (fundslocked in years) Risk perception Activity to befinanced

Early stage financeseed

7 10 Extreme For supporting aconcept or idea orR&D for product

development

Start up 5 9 Very high Initializingoperations ordevelopingprototypes

First stage 3 - 7 High Start commercial

production andmarketing

Second stage 3 5 Sufficiently high Expand market andgrowing capital

need

Later stage 1 3 Medium Market expansion,acquisition &

productdevelopment forprofit making

company

Buy out-in 1- 3 Medium Acquisitionfinancing

Turnaround 3 5 Medium to high Turning around asick company

Mezzanine 1 3 Low Facilitating publicissue

Venture capital financing stages

2.4.1 Seed Capital

It is an idea or concept as opposed to a business. European Venture capital associationdefines seed capital as The financing of the initial product development or capitalprovided to an entrepreneur to prove the feasibility of a project and to qualify for start upcapital.


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

Absence of ready product market

Absence of complete management team

Product/ process still in R & D stage

Initial period / licensing stage of technology transfer

Broadly speaking seed capital investment may take 7 to 10 years to achieve realization. Itis the earliest and therefore riskiest stage of Venture capital investment. The newtechnology 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 financialsupport for their adaptation, commencement and eventual success.

However, while the earliest stage of financing is fraught with risk, it also provides greaterpotential for realizing significant gains in long term. Typically seed enterprises lack asset base or track record to obtain finance from conventional sources and are largelydependent upon entrepreneurs personal resources. Seed capital is provided after beingsatisfied that the entrepreneur has used up his own resources and carried out his idea to astage of acceptance and has initiated research. The asset underlying the seed capital isoften technology or an idea as opposed to human assets (a good management team) sooften sought by venture capitalists.

Volume of Investment Activity

It has been observed that Venture capitalist seldom make seed capital investment andthese are relatively small by comparison to other forms of venture finance. The absenceof interest in providing a significant amount of seed capital can be attributed to thefollowing 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 onthe performance of all but the smallest venture capitalists portfolio. Larger venturecapitalists avoid seed capital investments. This is because the small investments are seento be cost inefficient in terms of time required to analyze, structure and manage them.

b) The time horizon to realization for most seed capital investments is typically 7-10years 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 isextended. These types of obsolescence are particularly likely to occur with hightechnology investments particularly in the fields related to Information Technology.


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2.4.2 Start up Capital

It is stage 2 in the venture capital cycle and is distinguishable from seed capitalinvestments. An entrepreneur often needs finance when the business is just starting. Thestart 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 fullyinvestigated 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, initialmarketing and establishment of product facility.

The characteristics of start-up capital are:-

i. Establishment of company or business: The company is either beingorganized or is established recently. New business activity could be based onexperts, experience or a spin-off from R & D.

ii. Establishment of most but not all the members of the team: The skills andfitness to the job and situation of the entrepreneurs team is an importantfactor for start up finance.

iii. Development of business plan or idea: The business plan should be fullydeveloped yet the acceptability of the product by the market is uncertain. Thecompany has not yet started trading.

In the start up preposition venture capitalists investment criteria shifts from idea topeople involved in the venture and the market opportunity. Before committing any

finance at this stage, Venture capitalist however, assesses the managerial ability and thecapacity of the entrepreneur, besides the skills, suitability and competence of themanagerial team are also evaluated. If required they supply managerial skills andsupervision for implementation. The time horizon for start up capital will be typically 6or 8 years. Failure rate for start up is 2 out of 3. Start up needs funds by way of both firstround investment and subsequent follow-up investments. The risk tends t be lowerrelative to seed capital situation. The risk is controlled by initially investing a smalleramount of capital in start-ups. The decision on additional financing is based upon thesuccessful performance of the company. However, the term to realization of a start upinvestment remains longer than the term of finance normally provided by the majority offinancial institutions. Longer time scale for using exit route demands continued watch on

start up projects.

Volume of Investment Activity

Despite potential for spectacular returns most venture firms avoid investing in start-ups.One reason for the paucity of start up financing may be high discount rate that venturecapitalist applies to venture proposals at this level of risk and maturity. They often prefer


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to spread their risk by sharing the financing. Thus syndicates of investors oftenparticipate in start up finance.

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-riskingand acquisition costs.

At this stage the company passed into early success stage of its life cycle. A provenmanagement team is put into this stage, a product is established and an identifiablemarket 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 requirefurther funds to initiate commercial manufacturing and sales but may not be generatingprofits.

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 withtechnical and specialist background and with little experience in the managementof 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 stagefinance is the earliest in which two of the fundamentals of business are in place i.e. fullyassembled management team and a marketable product. A company needs this round offinance 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 thusprompting venture capitalist that, have financed the start up stage to provide furtherfinancing. The management risk is shifted from factors internal to the firm (lack ofmanagement, lack of product etc.) to factors external to the firm (competitive pressures,in sufficient will of financial institutions to provide adequate capital, risk of productobsolescence etc.)


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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 obtainand so Venture capital particularly equity investment without associated debt burden iskey 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 alarger competition.

b) There is a risk of product obsolescence. This is more so when the firm is involved inhigh-tech business like computer, information technology etc.

2.4.4 Second Stage Finance

It is the capital provided for marketing and meeting the growing working capital needs ofan enterprise that has commenced the production but does not have positive cash flowssufficient to take care of its growing needs. Second stage finance, the second trench ofEarly State Finance is also referred to as follow on finance and can be defined as theprovision of capital to the firm which has previously been in receipt of external capitalbut whose financial needs have subsequently exploded. This may be second or even thirdinjection of capital.

The characteristics of a second stage finance are:

A developed product on the market

A full management team in place Sales revenue being generated from one or more products

There are losses in the firm or at best there may be a break even but the surplusgenerated is insufficient to meet the firms needs.

Second round financing typically comes in after start up and early stage funding and sohave shorter time to maturity, generally ranging from 3 to 7 years. This stage of financinghas both positive and negative reasons.

Negative reasons include:I. Cost overruns in market development.

II. Failure of new product to live up to sales forecast.III. Need to re-position products through a new marketing campaign.IV. Need to re-define the product in the market place once the product deficiency

is revealed.

Positive reasons include:I. Sales appear to be exceeding forecasts and the enterprise needs to acquire assets

to gear up for production volumes greater than forecasts.


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II. High growth enterprises expand faster than their working capital permit, thusneeding additional finance. Aim is to provide working capital for initial expansionof an enterprise to meet needs of increasing stocks and receivables.

It is additional injection of funds and is an acceptable part of venture capital. Often

provision for such additional finance can be included in the original financing package asan option, subject to certain management performance targets.

2.4.5 Later Stage Finance:

It is called third stage capital is provided to an enterprise that has established commercialproduction and basic marketing set-up, typically for market expansion, acquisition,product development etc. It is provided for market expansion of the enterprise. Theenterprises eligible for this round of finance have following characteristics:

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

Funds are utilized for further plant expansion, marketing, working capital ordevelopment of improved products. Third stage financing is a mix of equity with debt orsubordinate debt. As it is half way between equity and debt in US it is calledmezzanine finance. It is also called last round of finance in run up to the trade sale orpublic 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 financialcontrol. The time horizon for realization is shorter, ranging from 3 to 5 years. This helpsthe venture capitalists to balance their own portfolio of investment as it provides arunning yield to venture capitalists. Further the loan component in third stage financeprovides tax advantage and superior return to the investors.

There are four sub divisions of later stage finance.

Expansion / Development Finance

Replacement Finance

Buyout Financing Turnaround Finance

Expansion / Development Finance:

An enterprise established in a given market increases its profits exponentially byachieving the economies of scale. This expansion can be achieved either through an


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organic growth, that is by expanding production capacity and setting up properdistribution system or by way of acquisitions. Anyhow, expansion needs finance andventure 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 andmanaging a larger business.

Realization horizon for expansion / development investment is one to three years. It isfavored 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 byenterprise with established business that has already achieved break even and has startedmaking profits.

Replacement Finance:

It means substituting one shareholder for another, rather than raising new capital resultingin the change of ownership pattern. Venture capitalist purchase shares from theentrepreneurs and their associates enabling them to reduce their shareholding in unlistedcompanies. They also buy ordinary shares from non-promoters and convert them topreference shares with fixed dividend coupon. Later, on sale of the company or its listingon stock exchange, these are re-converted to ordinary shares. Thus Venture capitalistmakes 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 fundsprovided to the current operating management to acquire or purchase a significant shareholding in the business they manage are called management buyout.

Management Buy-in refers to the funds provided to enable a manager or a group ofmanagers from outside the company to buy into it.

It is the most popular form of venture capital amongst later stage financing. It is less riskyas venture capitalist in invests in solid, ongoing and more mature business. The funds areprovided for acquiring and revitalizing an existing product line or division of a majorbusiness. MBO (Management buyout) has low risk as enterprise to be bought haveexisted for some time besides having positive cash flow to provide regular returns to theventure capitalist, who structure their investment by judicious combination of debt andequity. 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 :


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It is rare form later stage finance which most of the venture capitalist avoid because ofhigher degree of risk. When an established enterprise becomes sick, it needs finance aswell 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; itscash 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 normallyhave high debt burden but lack competent staff at various levels. Such enterprises arecompelled 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 andanticipated 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 lastround 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. Bridgefinance often has a realization period of 6 months to one year and hence the risk involvedis low. The bridge finance is paid back from the proceeds of the public issue.

2.5 What does a Venture Capitalist look in a Venture Capital?

Venture Capitalists are high risk investors and, in accepting these risks, they desire ahigher risks, they desire a higher return on their investment. The Venture Capitalistmanages the risk-return ratio by only investing in businesses that fit their investment

criteria and after having completed extensive due diligence.

Venture capitalists have differing operating approaches. These differences may relate tothe location of the business, the size of the investment, the stage of the company, industryspecialization, structure to the investment and involvement of the venture capitalists inthe companys activities. The entrepreneur should not be discouraged if one venturecapitalist does not wish to proceed with an investment in the company. The rejection maynot be a reflection of the quality of the business, but rather a matter of the business notfitting with the venture capitalists particular investment criteria.

Venture capital is not suitable for all businesses, as a venture capitalist typically seeks:

Superior businesses: Venture capitalists look for companies with superior products orservices targeted at fast-growing or untapped markets with a defensible strategic position.Alternatively, for leveraged management buyouts, they are seeking companies with highborrowing capacity, stability of earnings and an ability to generate surplus cash to quicklyrepay debt.


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Quality and depth of management: Venture capitalists must be confident that the firmhas the quality and depth in the management team to achieve its aspirations. Venturecapitalists seldom seek managerial control; rather, they want to add value to theinvestment where they have particular skills including fundraising, mergers andacquisitions, international marketing and networks.

Corporate governance and structure: In many ways the introduction of a venturecapitalist is preparatory to a public listing. The venture capitalist will want to ensure thatthe investee company has the willingness to adopt modern corporate governancestandards, such as non-executive directors, including a representative of the venturecapitalist. Venture capitalists are put off by complex corporate structures without a clearownership and where personal and business assets are merged.

Appropriate investment structure: As well as the requirement of being an attractivebusiness opportunity, the venture capitalist will also be seeking to structure a satisfactorydeal to produce the anticipated financial returns to investors.

Exit plan: Lastly, venture capitalists look for clear exit routes for their investments suchas public listing or a third-party acquisition of the investee company.

2.6 The Venture Capital Process

The venture capital investment activity is a sequential process involving five steps:

1. Deal Origination

2. Screening

3. Evaluation or due diligence4. Deal structuring

5. Post-investment activities and exit


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The Venture Capital Investment Process

The Venture Capital Investment Process

1. Deal origination: A continuous flow of deals is essential for the venture capital

business. Deals may originate in various ways. Referral system is an important source of

deals. Deals may be referred to the VCs through their parent organizations, trade partners,

industry associations, friends etc. The venture capital industry in India has become quite

proactive in its approach to generating the deal flow by encouraging individuals to come

up with their business plans. Consultancy firms like Mckinsey and Arthur Anderson havecome up with business plan competitions on an all India basis through the popular press

as well as direct interaction with premier educational and research institutions to source

new and innovative ideas. The short listed plans are provided with necessary expertise

through people who have experience in the industry.

2. Screening: VCFs carry out initial screening of all projects on the basis of some broad

criteria. For example the screening process may limit projects to areas in which the


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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.

3. Evaluation or due diligence: Once a proposal has passed through initial screening, it

is subjected to a detailed evaluation or due diligence process. Most ventures are new andthe entrepreneurs may lack operating experience. Hence a sophisticated, formal

evaluation is neither possible nor desirable. The VCs thus rely on a subjective but

comprehensive, evaluation. VCFs evaluate the quality of the entrepreneur before

appraising the characteristics of the product, market or technology. Most venture

capitalists ask for abusiness plan to make an assessment of the possible risk and expected

return on the venture.

According to a study conducted by Professor IM Pandey of Indian Institute of

Management, Ahmedabad a venture capital fund places most importance on the

following eleven parameters in the same order of importance while evaluating a venture

for possible funding: Integrity, urge to grow, long-term vision, commercial orientation,critical competence vis--vis venture, ability to evaluate and react to risk, well-thought

out strategy to remain ahead of competition, high market growth rate, expected return

over 25% p.a. in five years, managerial skills, marketing skills.

Investment Valuation The investment valuation process is aimed at ascertaining an

acceptable price for the deal. The valuation process goes through the following steps:

Projections on future revenue and profitability

Expected market capitalization

Deciding on the ownership stake based on the return expected on the proposedinvestment

The pricing thus calculated is rationalized after taking in to consideration various

economic scenarios, demand and supply of capital, founder's/management team's track

record, innovation/ unique selling propositions (USPs), the product/service size of the

potential market, etc

4. Deal Structuring: Once the venture has been evaluated as viable, the venture capitalist

and the investment company negotiate the terms of the deal, i.e. the amount, form and

price of the investment. This process is termed as deal structuring. The agreement also

includes the protective covenants and earn-out arrangements. Covenants include theventure capitalists right to control the investee company and to change its management if

needed, buy back arrangements, acquisition, making initial public offerings (IPOs) etc,

Earn-out arrangements specify the entrepreneur's equity share and the objectives to be

achieved.
https://www.key.com/pdf/strategynotebook.pdfhttps://www.key.com/pdf/strategynotebook.pdf


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Venture capitalists generally negotiate deals to ensure protection of their interests. They

would like a deal to provide for:

A return commensurate with the risk

Influence over the firm through board membership

Minimizing taxes

Assuring investment liquidity

The right to replace management in case of consistent poor managerial

performance.

The investee companies would like the deal to be structured in such a way that their

interests are protected. They would like to earn reasonable return, minimize taxes, have

enough liquidity to operate their business and remain in commanding position of their

business.

There are a number of common concerns shared by both the venture capitalists and theinvestee companies. They should be flexible, and have a structure, which protects their

mutual interests and provides enough incentives to both to cooperate with each other.

The instruments to be used in structuring deals are many and varied. The objective in

selecting the instrument would be to maximize (or optimize) venture capital's

returns/protection and yet satisfy the entrepreneur's requirements. The different

instruments through which a Venture Capitalist could invest a company include: Equity

shares, preference shares, loans, warrants and options.

5. Post-investment Activities and Exit: Once the deal has been structured and

agreement finalized, the venture capitalist generally assumes the role of a partner andcollaborator. He also gets involved in shaping of the direction of the venture. This may be

done via a formal representation of the board of directors, or informal influence in

improving the quality of marketing, finance and other managerial functions. 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.

Venture capitalists typically aim at making medium-to long-term capital gains. They

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 capitalist can exit in four ways:

Initial Public Offerings (IPOs)

Acquisition by another company

Repurchase of the venture capitalists share by the investee company

Purchase of the Venture Capitalist's share by a third party.


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2.7 Methods of Venture FinancingVenture 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 percent of the total equity capital. Thus, the effective control andmajority ownership of the firm remains with the entrepreneur. They buy shares ofan enterprise with an intention to ultimately sell them off to make capital gains.

ConditionalLoan: It is repayable in the form of a royalty after the venture isable to generate sales. No interest is paid on such loans. In India, VCFs chargeroyalty ranging between 2 to 15 percent; actual rate depends on other factors ofthe venture such as gestation period, cost-flow patterns, riskiness and other factorsof the enterprise.

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

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

OtherFinancingMethods: A few venture capitalists, particularly in the privatesector, have started introducing innovative financial securities. The participatingdebentures is an example of innovative venture financial. Such security carries inthree phases:

In the start-up phase, before the venture attains operations to a minimum level, no interestis charged. After this, a low rate of interest is charged up to a particular level ofoperation. Once the venture starts operating on full commercial basis, a high rate of

interest is required to be paid. A variation could be in terms of paying a certain share ofthe post-tax profits instead of royalty.

VCFs in India provide venture finance through partially of fully convertible debenturesand cumulative convertible preference shares (CPP). CPP could be particularly attractivein the Indian context since CPP shareholders do not have the right to receive dividendconsecutively for two years

In the developed countries like USA and the UK, the venture capital firms areaccustomed to using a wide range of financial instruments. They include:

1. Deferred Shares: where ordinary share rights are deferred for a certain numberof years

2. Convertible Loan Stock: which is unsecured long term loan convertible intoordinary shares and subordinated to all creditors

3. Special Ordinary Shares: with voting rights but without a commitment towardsdividend.

4. Preferred Ordinary Shares: With voting rights and a modest fixed dividendright and a right to share in profits.


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2.8 Disinvestment Mechanism:

The true objective of a true venture capitalist is to sell of his investment at substantial

capital gains. But most venture funds in India aim to operate on commercial lines along

with satisfying their developmental objectives. A venture capitalist is generally not in a

position to realize his investment before five to seven years.

The disinvestment options generally available to venture capitalist are:

1. Promoters Buyback:

The most important disinvestments route in India is the promoters buyback. This route is

suited to Indian condition because it keeps the ownership and control of the promoter

intact. The obvious limitation, however, is that in the 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 position to buy them back.

In India, promoters are invariably given the option to buyback the 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 promoters to buyback the shares of the assisted firm within an agreed

period at a predetermined price. If the promoter fails to buyback the shares within the

stipulated time, Canfina-VCF would have the discretion to divest them in any manner it

deemed appropriate. SBI capital market ensures through examining the personal assets of

the promoters and their associates, which buyback, would be a feasible option.

2. Initial Public Offerings (IPOs):

The benefits of the 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. The option has certain

limitations in Indian context. The promotion of the public issue would be difficult and

expensive since the first generation entrepreneurs are not known in the capital market.

Further, difficulties will be caused if the entrepreneurs business is perceived to be an

unattractive investment proposition by investors. Also the emphasis of the Indian

investors on the short term profits and dividends may tend to make the market price

unattractive. Yet another difficulty in India until recently was the Controller of Capital

Issues (CCI) guidelines for determining the premium on shares took into account thebook 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


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costs because of the inefficiency of the secondary market in a country like India. Also,

this option has become far less feasible for small ventures on account of the higher listing

requirement of the stock exchanges. In February 1989, the Government of India raised

the minimum capital for listing on the stock exchanges from Rs 10 million to Rs 30

million and the minimum public offer from Rs 6 million to Rs 18 million.

3. 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 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 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 enterprises.

The other disinvestments mechanisms such as the management buyouts or sale to otherventure funds are not considered to be appropriate by VCFs in India.


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2.9 The Players

The players:

There are following group of players:

Angels and angel clubs

Venture Capital funds

Small

Medium

Large

Corporate Venture Funds

Financial service venture groups


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Angels and angel clubs:

Angels are wealthy individuals who invest directly into companies. They can form angelclubs to coordinate and bundle their activities. Besides the money, angels often providetheir 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 theirearly stages. Examples for angel clubs are Media Club, Dinner Club, Angel's Forum

Small and Upstart Venture Capital Funds :

These are smaller Venture Capital Companies that mostly provide seed and start-upcapital. The so called "Boutique firms" are often specialised in certain industries ormarket segments. Their capitalisation is about USD 20 to USD 50 million (is this dealssize or total money under management or money under management per fund?).Examples are:

Artemis Comaford Abbell Venture Fund

Acacia Venture Partners

Medium Venture Funds :

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

Large Venture Funds:As the medium funds, large funds operate in all business sectors and provide all types ofcapital for companies after seed stage. They often operate internationally and financedeals up to USD 500 mio. Examples are:

AIG American International Group

Cap Vest Man

3i

Corporate Venture Funds :

These Venture Capital funds are set up and owned by technology companies. Their aim isto widen the parent company's technology base in an win-win-situation for both, theinvestor and the investee. In general, corporate funds invest in growing or maturingcompanies, often when the investee wishes to make additional investments in technologyor product development. The average deals size is between USD 2 million and USD 5million. Examples are:

Oracle


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Adobe

Dell

Kyocera

As an example, Adobe systems launched a $40m venture fund in 1994 to invest in

companies strategic to its core business, such as Cascade Systems Inc and LantanaResearch Corporation- has been successfully boosting demand for its core products, sothat Adobe recently launched a second $40m fund.

Financial funds:

A solution for financial funds could be a shift to a higher security 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 and expectations in the economy. As

long as the sownturn continues without any sign of recovery customers might prefer less

risky alternatives.


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CHAPTER 3

VENTURE CAPITALIN INDIA


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3.1 Evolution of VC Industry in India

The major analysis on risk capital on India was reported in 1983. It indicated that newcompanies often confront serious barriers to entry into capital markets for raising equityfinance which undermines their future prospects of expansion & diversification. It alsoindicated that on the whole there is the need to revive the equity cult among the massesby ensuring competitive return on equity investment. This brought out the institutionalinadequacies with respect to evolution of the Venture Capital.

In India, Industrial Finance Corporation of India (IFCI) initiated the idea of VC when itestablished the Risk Capital Foundation in 1975 to provide seed capital to small and riskyprojects. However the concept of VC financing got statutory recognition for the first timein the Fiscal Budget for the year 1986 87.

The Venture Capital companies operating at present can be divided into 4 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 VC fund in 1987 as per the long term fiscal policy of government ofIndia, with an initial capital of 10 crores which raised by imposing a cess of 5% on allpayment made for the import of Technology know-how projects requiring funds from Rs5 Lacs to Rs 2.5 Crores were considered for financing. Promoters contribution rangedfrom this fund was available at a concessional interest rate of 9% (during gestationperiod) which could be increased at later stages.

The ICICI provides the required impetus to VC activities in India, 1986, it startedproviding VC finance on 1998 it promoted, along with the Unit Trust of India (UTI)Technology Development & Information Company of India (TDICI) as the first VCcompany registered under companies act, 1956. The TDICI may provide financial

assistance to Venture Capital undertakings which are set up by technocrat entrepreneursor technology information & 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 & Technology FinanceCompany (RCTC) as a subsidiary company of IFCI. The RCTC provides assistance inthe form of conventional loans, interest free conditional loans on profit and risk sharingbasis or equity participation in extends financial support to high technology projects for


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technological up-gradation. The RCTC has been renamed as IFCI Venture Capital FundsLtd (IVCF).

Promoted by State Level Financial Institutions

In India, the State Level Financial Institutions in some states such as Madhya Pradesh,Gujarat, Uttar Pradesh etc have done an excellent job and have provided VC to a smallscale enterprises. Several successful entrepreneurs have been the beneficiaries of theliberal funding environment. In 1990, the Gujarat Industrial Investment Corporation,promoted the Gujarat Venture Financial Ltd (GVFL) along with other promoters such asIDBI, the World Bank etc. The GVFL provides assistance to businesses in the form ofequity , conditional loans or income notes for technological development and productinnovation. It also provides financial assistance to entrepreneurs.

The Government of Andhra Pradesh has also promoted the Andhra Pradesh Industrial

Development Corporation (APIDC) Venture Capital Ltd to provide VC financing inAndhra Pradesh.

Promoted by Commercial Banks

Canbank Venture Capital Fund, State bank Venture Capital Fund and Grindlays BankVenture Capital Funds have been set up by respective commercial banks to undertake VCactivities.

The State bank Venture Capital Fund provides financial assistance for bought-out deal aswell as new companies in the form of equity which it disinvests after the

commercialization of the project.

Canbank Venture Capital Fund provides financial assistance for proven but yet to becommercially exploited technologies. It provides assistance both in the form of equityand conditional loans.

Private Venture Capitalists

Several private sector Venture Capital Funds have been established in India such as the20th Centure Venture Capital Company, Indus venture Capital Fund, InfrastructureLeasing and Financial services Ltd.

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

Mastek, one of the oldest software house in India

Ruskan Software, Pune based software consultancy

SQL Star, Hyderabad based training and software development consultancy

Satyam Infoway, the first private ISP in India

Hinditron, makers of embedded software

Selectia, provider of interactive software selectior


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Yantra, ITLinfosys US subsidiary, solution for supply chain management

Rediff on the net, Indian website featuring electronic shopping, news, chat etc.

3.2 Industry Life Cycle:

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

The growth of VC in India has four separate phases:

3.2.1 Phase I - Formation of TDICI in the 80s and regional funds as GVFL & APIDC inthe early 90s.

The first origins of modern venture capital in India can be traced to the setting up of aTechnology Development Fund in the year 1987-88, through the levy of access on all

technology import payments. Technology Development Fund was started to providefinancial support to innovative and high risk technological programs through theIndustrial 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 1980swere marked by an increasing disillusionment with the trajectory of the economic systemand a belief that liberalization was needed. The liberalization process started in 1985 in alimited way. The concept of venture capital received official recognition in 1988 with theannouncement of the venture capital guidelines.

During 1988 to 1992 about 9 venture capital institutions came up in India. Though theventure capital funds should operate as open entities, Government of India controlledthem rigidly. One of the major forces that induced Government of India to start venturefunding was the World Bank. The initial funding has been provided by World Bank. Themost important feature of the 1988 rules was that venture capital funds received thebenefit of a relatively low capital gains tax rate which was lower than the corporate 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 somesignificant 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 theproject.

Between 1988 and 1994 about 11 VC funds became operational either throughreorganizing the businesses or through new entities.


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All these followed the Government of India guidelines for venture capital activities andhave primarily supported technology oriented innovative businesses started by firstgeneration entrepreneurs. Most of these were operated more like a financing operation.The main feature of this phase was that the concept got accepted. VCs becameoperational 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 fundswithout collateral. The first stage of the venture capital industry in India was plagued byin experienced management, mandates to invest in certain states and sectors and generalregulatory problems. Many public issues by small and medium companies have shownthat the Indian investor is becoming increasingly wary of investing in the projects of newand unknown promoters.

The liberation of the economy and toning up of the capital market changed the economiclandscape. The decisions relating to issue of stocks and shares was handled by an officenamely: Controller of Capital Issues (CCI). According to 1988 VC guideline, anyorganization requiring to start venture funds have to forward an application to CCI.

Subsequent to the liberalization of the economy in 1991, the office of CCI was abolishedin May 1992 and the powers were vested in Securities and Exchange Board of India. TheSecurities 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 in1996, through a government notification. The power to control venture funds has beengiven to SEBI only in 1995 and the notification came out in 1996. Till this time, venturefunds were dominated by Indian firms. The new regulations became the harbinger of thesecond phase of the VC growth.

3.2.2Phase II - Entry of Foreign Venture Capital funds (VCF) between 1995 -1999

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

3.2.3 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 thosein India) also declined substantially. Consequently, during 2001-2003, the VCs startedinvesting less money and in more mature companies in an effort to minimize the risks.This decline broadly continued until 2003.


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3.2.4 Phase IV 2004 onwards - Global VCs firms actively investing in India

Since 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 growingat 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.

3.3 Growth of venture capital in India:

The venture capital is growing 43% CAGR. However, in spite of the venture capitalscenario improving, several specific VC funds are setting up shop in India, with the year2006 having been a landmark year for VC funding in India. The total deal value in 2007is 14234 USD Million. The No. of deals are increasing year by year. The no. of deals in2006 only 56 and now in 2007 it touch the 387 deals. The introduction stage of venturecapital 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 are 146. The reason is good position of capital market.But in 2008 no. of venture capital firms increase by only 14. the reason is crash down ofcapital market by 51% from January to November 2008. The No. of venture capital fundsare increasing year by year.

2000 2001 2002 2003 2004 2005 2006 2007 2008

841 77 78 81 86 89 105 146 160

www.nasscom.org, strategic review 2008 published by (National Association of Softwareand Service Companies)

Venture capital growth and industrial clustering have a strong positive correlation.Foreign direct investment, starting of R&D centers, availability of venture capital andgrowth of entrepreneurial firms are getting concentrated into five clusters. The cost ofmonitoring and the cost of skill acquisition are lower in clusters, especially forinnovation. Entry costs are also lower in clusters. Creating entrepreneurship andstimulating innovation in clusters have to become a major concern of public policymakers. This is essential because only when the cultural context is conducive for riskmanagement 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 economicliberalization.

The venture capital firm invest their money in most developing sectors like health care,IT-ITES, telecom, Bio-technology, Media& Entertainment, shipping & logistics etc.


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Venture capital is nascent stage in India. Now due to growth of this sector, the venturecapital industry is also grow. The top most player in the industries are ICICI venturecapital fund, Avishhkar venture capital fund, IL&FS venture capital fund, Canbank.

3.4 Venture Capital investment Q3, 2008:

Venture Capital firms invested $274 million over 49 deals in India during the threemonths ending September 2008. The VC investment activity during the period wassignificantly higher compared to the same quarter last year (which had witnessed 36investments worth $252 million) as well as the immediate previous quarter ($165 millioninvested across 28 deals).

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

3.4.1 Top Investments :

The largest investment reported during Q3 2008 was the $18 million raised by onlinetutoring services provider TutorVista from existing investors Sequoia Capital India andLightSpeed Ventures.

Company Sector Amount(US$ M)

Investors

Tutor Vista Online servicing(Remote Tutoring)

18.0 Sequoia CapitalIndia,

Lightspeed VenturesConnectiva Systems CommunicationsTech

(Revenue Assurance

17.0 IFC, NEA-IUV,SAP

Ventures, Others

Seventymm Online Services(Video Rental)

12.0 NEA-IUV, ePlanetVentures, Matrix

PartnersIndia,DFJ

Equitas MicroFinance

Microfinance 12.0 Bellwether, Others

HaloSource Water Purifiers 11.5 Origo Sino-India,Unilever

Tech Ventures

Top venture capital investments


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3.4.2 Investments by Industry:

Information Technology and IT-Enabled Services (IT & ITES) industry retained itsstatus as the favorite among VC investors during Q3 08.

Industry VolumeQ3 08

No of DealsYTD

ValueQ3 08

US$ MYTD

IT & ITES 25 58 147 361

BFSI 5 8 34 54

Engineering &Construction

3 4 23 33

Healthcare &Life Sciences

6 12 4 52

Education 2 3 17 23

Other Services 1 6 15 29

Manufacturing 2 2 13 13

Media 2 5 11 19Energy 2 6 6 48

Travel &Transport

1 2 4 14

Retail - 1 - 10

Telecom - 1 - 5

Venture capital investment by industry

Led by the $12 million investment by Bellwether and others into Chennai-basedmicrofinance firm Equitas, BFSI emerged as the second largest (in value terms) for VCinvestments during the period. Other microfinance firms that attracted investments duringQ3 08 included Kolkata-based Arohan Financial Services (which raised funding fromLok Capital and others) and Guwahati-based Asomi Finance (IFC and AavishkaarGoodwell).

3.4.3 Investment By Stage:

About 67% of VC investments during Q3 08 were in the early stage segment.

Stage of CompanyDevelopment VolumeQ3 08 YTD ValueQ3 08 YTD

Early 33 67 172 339

Growth 16 41 102 322

Investment by Stage


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3.5 Need for growth of venture capital in India

In India, a revolution is ushering in a new economy, wherein entrepreneurs mind set istaking a shift from risk averse business to investment in new ideas which involve highrisk. The conventional industrial finance in India is not of much help to these newemerging enterprises. Therefore there is a need of financing mechanism that will fit withthe requirement of entrepreneurs and thus it needs venture capital industry to grow inIndia.

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

Innovation : needs risk capital in a largely regulated, conservative, legacyfinancial 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 officeservices, catering, transportation

3.6 Regulatory and legal framework

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

a. Whose shares are not listed on a recognized stock exchange in Indiab. Which is engaged in business including providing services, production or manufactureof articles or things, or does not include such activities or sectors which are specified inthe negative list by the Board with the approval of the Central Government bynotification in the Official Gazette in this behalf? The negative list includes real estate,non-banking financial services, gold financing, activities not permitted under theIndustrial Policy of the Government of India.


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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 thefund before the fund can start activities shall be at least Rs. 5 crores.

Investment Criteria: The earlier investment criteria has been substituted by a newinvestment criteria which has the following requirements :

Disclosure of investment strategy;

maximum investment in single venture capital undertaking not to exceed 25% ofthe 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:

a) Subscription to initial public offer of a venture capital undertaking whose sharesare 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 venturecapital 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 investmentwithin 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 processof fund raising, the requirement of filing the Placement memorandum with SEBI isdispensed with and instead the fund will be required to submit a copy of PlacementMemorandum/ copy of contribution agreement entered with the investors along with thedetails of the fund raised for information to SEBI. Further, the contents of the PlacementMemorandum are strengthened to provide adequate disclosure and information toinvestors. 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 toparticipate in the IPO through book building route as Qualified Institutional Buyersubject to compliance with the SEBI (Venture Capital Fund) Regulations.


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Relaxation in Takeover Code: The acquisition of shares by the company or any of thepromoters from the Venture Capital Fund under the terms of agreement shall be treatedon the same footing as that of acquisition of shares by promoters/companies from thestate level financial institutions and shall be exempt from making an open offer to othershareholders.

Investments by Mutual Funds in Venture Capital Funds: In order to increase theresources for domestic venture capital funds, mutual funds are permitted to invest upto5% of its corpus in the case of open ended schemes and upto 10% of its corpus in thecase of close ended schemes. Apart from raising the resources for Venture Capital Fundsthis would provide an opportunity to small investors to participate in Venture Capitalactivities through mutual funds.

Government of India Guidelines: The Government of India (MOF) Guidelines forOverseas Venture Capital Investment in India dated September 20, 1995 will be repealedby the MOF on notification of SEBI Venture Capital Fund Regulations.

The following will be the salient features of SEBI (Foreign Venture Capital

Investors) Regulations, 2000 :

Definition of Foreign Venture Capital Investor : Any entity incorporated andestablished outside India and proposes to make investment in Venture Capital Fund orVenture Capital Undertaking and registered with SEBI.

Eligibility Criteria : Entity incorporated and established outside India in the form ofinvestment company, trust, partnership, pension fund, mutual fund, university fund,endowment fund, asset management company, investment manager, investmentmanagement company or other investment vehicle incorporated outside India would beeligible for seeking registration from SEBI. SEBI for the purpose of registration shallconsider whether the applicant is regulated by an appropriate foreign regulatoryauthority; or is an income tax payer; or submits a certificate from its banker of its or itspromoters track record where the applicant is neither a regulated entity nor an incometax 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 inone 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:

a. Subscription to initial public offer of a venture capital undertaking whose sharesare proposed to be listed subject to lock-in period of one year;


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b. Debt or debt instrument of a venture capital undertaking in which the venturecapital fund has already made an investment by way of equity.

Hassle Free Entry and Exit: The Foreign Venture Capital Investors proposing to makeventure 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 underAnnexure III of Statement of Industrial Policy without any approval from FIPB. Further,SEBI registered FVCIs shall be granted a general permission from the exchange controlangle for inflow and outflow of funds and no prior approval of RBI would be required for pricing, however, there would be ex-post reporting requirement for the amounttransacted.

Trading in unlisted equity : The Board also approved the proposal to permit OTCEI todevelop a trading window for unlisted securities where Qualified Institutional Buyers(QIB) would be permitted to participate.

Over the last few years Indian venture capital has evolved its own set of procedures andpractices. The foremost of these practices is the manner in which Indian venture firmschoose their investments. Like their counterparts in US and Europe venture capitalistshere look for investments with a characteristic of high risk and high return. The choice ofinvestment is the function of the venture capitalists policy with regards to the preferredindustries and the stage of the investee company, yet the exact choice of investment varyfrom one venture capital fund to another.

3.7 Key considerations

For investor/venture capitalist Ideal entrepreneur

A venture capital (VC) who is financing the firm would as the first necessity assess andgauge the promoters. Because in the case of start-up where the product or the technologyis yet to be tested, the only thing they can trust and their investment on the people behindit. While investing in a company what a VC is essentially looking for is a partnership andtherefore the first decision making criterion is the character and personality of thepromoters. However from a venture capitalists perspective, the ideal entrepreneur,

Is qualified in a hot area of interest

Delivers sales or technical advances such as FDA approval with reasonable

probability Tells a compelling story and is presentable to outside investors,

Recognizes the need for speed to an Initial Public Offering (IPO) for liquidity,

Has a good reputation and can provide references that show competences andskill,

Understand the need for a team with a variety of skill and therefore sees whyequity has to be allocated to other people

Works diligently toward a goal but maintains flexibility


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Get along with the investor group

Understands the cost of capital and typical deal structures and is not offended bythem

Is sought after by many VCs

Has a realistic expectation about process and outcome.

Besides the ideal entrepreneur, the investor tries to ensure the following for himself.

Reasonable reward given in the level of risk.

Sufficient influence on the management of the company through boardrepresentation.

Minimization of taxes.

Ease in achieving future liquidity on the investment.

Flexibility of structure that will allow room to enable additional investment later,incentives for future management and retention of stocks if management leaves

Balance-sheet attractiveness to suppliers and debt financier

Retention of key employees through adequate equity participation

3.8 Venture financing practices and procedures:

Factors Influencing Venture Capitalists Choice of Investment

The venture capitalists usually take into account the following factors while deciding onthe investment.

1. Track record of the promoters and the management team is the single most importantfactor. It is often said that three most important considerations in selecting the venturecapital investment are Management, Management and Management. Venturecapitalists look for a track record in terms of the successes of the promoters in theirprevious vocations, whatever these might have been. They put their bets on successfulpeople and avoid those who have tasted failures earlier.

A venture capital fund manager does not take more than ten minutes to decide if themanagement quality is not okay. The two key points a venture capital manager sees areweather the entrepreneur has a vision and whether the management team is cohesive.

Here he looks for various questions like:

How do entrepreneurs work together?

How compatible is the venture capital fund with the team?

How complete is the management expertise in the area of business? This means,do the team have members with expertise in various aspects of business.

How is the chemistry between various members of the team?


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They also check on the softer issues like temperament of team members, past record andoverall management competence.

2. The nature of the business and the promoters experience in the proposed or relatedbusiness is an important consideration. Venture capitalists are the firm believer of the

Corridor Principal1 that states that the probability of the ventures success is high whenthe business falls in the corridor of the entrepreneurs previous vocation or education.

3. The business should meet the investment objectives of the venture capitalist in terms ofrisk profile, the return and the time horizon of the fund. In case of closed ended funds, ifthe venture capital has earned a substantial return in the first round of investments, it ismore open to investments with comparatively higher risk. In the initial investment roundsof a fund the venture capitalist is normally willing to take a longer term exposure ascompared the later rounds when the fund is nearing maturity. In the later rounds theventure capitalist goes in for balancing investments.

4. The funds normally invest in select industries where they have the knowledge andexpertise. This helps then in providing value added services to the investee companies.

5. Project cost, scheme for financing and financial projections over next few years,including details of underlying assumptions are closely studied, The resultant Internalrate of return (IRR) must meet the minimum fixed by the venture capitalist as the hurdlerate. The IRR is adjusted for any protection, the venture might be enjoying in the form ofsubsidy or any other concession from any government or statutory body. This is to ensurethe inherent earning potential of the investment in spite of policy changes by thegovernment.

6. Marketing strategy, including target market, market survey, marketing effort, marketsize and growth potential also effect the decision.

7. Technology and technology collaboration if any are looked at carefully.

8. Miscellaneous factors looked at include raw material availability, pollution clearances,government policy, rules and regulations controlling the industry, location, water andelectricity needs etc..

Most of the venture capital firms do not want an introduction from any one. A businessproposal that is well prepared is the best introduction that one can haye. Most venturecapital firms are interested in good investments and not in social contacts andintroductions.

A detailed and well-organized business plan is the only way to gain a venture capitalistattention and obtain funding. VCs do not invest in a two page summery. The summary isneeded as a start but not as a substitute for a sound plan. A well prepared business planserves two functions. Firstly it informs the venture capitalists about the entrepreneurs


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ideas, secondly it shows that the entrepreneur has seriously thought about the intendedbusiness, knows the industry and has thought through all the potential problems.

The summary should contain the name, address and telephone number of the contactpersons in a conspicuous location. Briefly the type of business or nature of industry

should be discussed. This should be followed by a thumb nail sketch of the companys upto date history. The experience of the entrepreneurs and the top management personalshould be mentioned. A short description of product or service is required. The amount offunds and the form in which required should also be given. Summary of five yearsfinancial projections and five years history of existing group companies should beappended. Besides the exit plan should also be mentioned.

The detailed proposal must cover the following issues:

I. Business and its Future1. Nature of Business

2. Business History3. Future Projections4. Uniqueness5. Target Customers6. Competition7. Production Process8. Market9. Labor and Employees10. Suppliers11. Sub-contractors12. Plant and Equipment

13. Property and Facilities14. Patents and Trademark15. Research & Development16. Litigations17. Government Regulations18. Conflict of Interest19. Orders outstanding20. Insurance21. Taxes22. Corporate Structure

II. Management1. Directors and Officers2. Key Employees3. Remunerations4. Conflict of Interest5. Principal Share Holders6. Consultants, Lawyers Accountants, & Bankers


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III. Financing1. Proposed Financing2. Collaterals3. Condition of Financing4. Proposed Reporting and MIS

5. Investor Involvement6. Capital Structure7. Guarantees8. Use of Proceeds9. Fees Paid

IV. Risk Factors1. Limited Operating History2. Limited Resources3. Limited Management Experience4. Market Uncertainties

5. Production Uncertainties6. Liquidation7. Dependence on Key Management Personal8. What Could Go Wrong?

V. Analysis of Operations and Projections

1. Financial Projections2. Ratio Analysis3. Contingent Liability

VI. Product Literature, Procedure and Articles

Venture capital firms in India usually have either a fixed format or guidelines on how topresent a proposal and the information they are looking for.

IDBI has prescribed a preliminary application format, to include, brief details ofperformance of industrial concerns if existing, nature and advantages of the proposedprocess / product, development content in the process, proposal for scheme includingnature of up-scaling and appropriate cost of ventu

final vc project

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