CHAPTER 1

“INTRODUCTION
TO
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 C
apital Industry in India.
To know the impact of political and economical factors on Venture Capita
l investment.
1.2 Limitation of project Limitations:
A study of this type cannot be without limitations. It has been observed that ve
nture capitals are very secretive about their performance as well as about their
investments. This attitude has been a major hurdle in data collection. However
venture capital funds/companies that are members of Indian venture capital assoc
iation are included in the study. Financial analysis has been restricted by and
large to members of IVCA.
1.3 Research Design & Instruments
In India neither venture capital theory has been developed nor are there many co
mprehensive books on the subject. Even the number of research papers available i
s very limited. The research design used is descriptive in nature. (The attempt
has been made to collect maximum facts and figures available on the availability
of venture capital in India, nature of assistance granted, future projected dem
and for this financing, analysis of the problems faced by the entrepreneurs in g
etting venture capital, analysis of the venture capitalists and social and envir
onmental impact on the existing framework.)
The research is based on secondary data collected from the published material. T
he data was also collected from the publications and press releases of venture c
apital associations in India. Scanning the business papers filled the gaps in
information. The Economic times, Financial Express and Business Standards were s
canned for any article or news item related to venture capital. Sufficient amoun
t of data about the venture capital has been derived from these reports
Scope:
The scope of the research includes all type of venture capital firms whether set
up as a company or a trust fund. Venture capital companies and funds irrespectiv
e of the fact that they are registered with SEBI of India or not are part of thi
s study. Angel investors have been kept out of the study as it was not feasible
to collect authenticated information about them.
CHAPTER 2
CONCEPTUAL
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 wh
ich 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 na
me Venture Capital was coined. Venture capital is considered as financing of hi
gh and new technology based enterprises. It is said that Venture capital involve
s investment in new or relatively untried technology, initiated by relatively ne
w and professionally or technically qualified entrepreneurs with inadequate fund
s. The conventional financiers, unlike Venture capitals, mainly finance proven t
echnologies and established markets. However, high technology need not be pre-re
quisite for venture capital. Venture capital has also been described as ‘unsecu
red risk financing’. The relatively high risk of venture capital is compensated
by the possibility of high returns usually through substantial capital gains in
the medium term. Venture capital in broader sense is not solely an injection of
funds into a new firm, it is also an input of skills needed to set up the firm,
design its marketing strategy, organize and manage it. Thus it is a long term as
sociation with successive stages of company’s development under highly risk inve
stment conditions, with distinctive type of financing appropriate to each stage
of development. Investors join the entrepreneurs as co-partners and support the
project with finance and business skills to exploit the market opportunities. V
enture capital is not a passive finance. It may be at any stage of business/prod
uction 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 high
er capital gains through appreciation in the value of such investments when the
new technology succeeds. Thus the primary return sought by the investor is essen
tially 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 ski
lls 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, w
ith the aim of eventual capital gains rather than income and active involvement
in the management of customer’s business.
2.2 Features of Venture Capital
2.2.1 High Risk
By definition the Venture capital financing is highly risky and chances of failu
re are high as it provides long term start up capital to high risk-high reward v
entures. 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 incre
ased cost decreased gross margins.
2.2.2 High Tech
As opportunities in the low technology area tend to be few of lower order, and h
i-tech projects generally offer higher returns than projects in more traditional
areas, venture capital investments are made in high tech. areas using new techn
ologies or producing innovative goods by using new technology. Not just high tec
hnology, any high risk ventures where the entrepreneur has conviction but little
capital gets venture finance. Venture capital is available for expansion of exi
sting 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 Gains
Investments are generally in equity and quasi equity participation through direc
t purchase of shares, options, convertible debentures where the debt holder has
the option to convert the loan instruments into stock of the borrower or a debt
with warrants to equity investment. The funds in the form of equity help to rais
e term loans that are cheaper source of funds. In the early stage of business, b
ecause dividends can be delayed, equity investment implies that investors bear t
he risk of venture and would earn a return commensurate with success in the form
of capital gains.
2.2.4 Participation in Management
Venture capital provides value addition by managerial support, monitoring and fo
llow up assistance. It monitors physical and financial progress as well as marke
t development initiative. It helps by identifying key resource person. They want
one seat on the company’s board of directors and involvement, for better or wor
se, in the major decision affecting the direction of company. This is a unique p
hilosophy of “hands on management” where Venture capitalist acts as complementar
y to the entrepreneurs. Based upon the experience other companies, a venture cap
italist advise the promoters on project planning, monitoring, financial manageme
nt, including working capital and public issue. Venture capital investor cannot
interfere in day today management of the enterprise but keeps a close contact wi
th the promoters or entrepreneurs to protect his investment.
2.2.5 Length of Investment
Venture capitalist help companies grow, but they eventually seek to exit the inv
estment 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 year
s. The process of having significant returns takes several years and calls on th
e capacity and talent of venture capitalist and entrepreneurs to reach fruition.
2.2.6 Illiquid Investment
Venture capital investments are illiquid, that is, not subject to repayment on d
emand or following a repayment schedule. Investors seek return ultimately by mea
ns of capital gains when the investment is sold at market place. The investment
is realized only on enlistment of security or it is lost if enterprise is liquid
ated for unsuccessful working. It may take several years before the first invest
ment starts too locked for seven to ten years. Venture capitalist understands th
is illiquidity and factors this in his investment decisions.

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 ind
ustries without much consideration of use of new technology or new entrepreneuri
al venture but having a focus on underdeveloped areas (locations). In majority o
f cases it is in the form of loan capital and proportion of equity is very thin.
Development finance is security oriented and liquidity prone. The criteria for
investment are proven track record of company and its promoters, and sufficient
cash generation to provide for returns (principal and interest). The development
bank safeguards its interest through collateral. They have no say in working o
f 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 inf
ormation and proper management information system, regular board meetings, adher
ence 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 producti
on and making available proper exit route for liquidation of the investment. As
against this fixed payments in the form of instalment of principal and interest
are to be made to development banks.
2.3.2 Venture Capital Vs Seed Capital & Risk Capital
It is difficult to make a distinction between venture capital, seed capital, and
risk capital as the latter two form part of broader meaning of Venture capital.
Difference between them arises on account of application of funds and terms and
conditions applicable. The seed capital and risk funds in India are being provi
ded basically to arrange promoter’s contribution to the project. The objective i
s to provide finance and encourage professionals to become promoters of industri
al projects. The seed capital is provided to conventional projects on the consid
eration 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 eq
uity investment by Venture capital. Unlike Venture capital, Seed capital provide
rs neither provide any value addition nor participate in the management of the p
roject. Unlike Venture capital Seed capital provider is satisfied with low risk-
normal returns and lacks any flexibility in its approach. Risk capital is also
provided to established companies for adapting new technologies. Herein the appr
oach is not business oriented but developmental. As a result on one hand the suc
cess rate of units assisted by Seed capital/Risk Finance has been lower than tho
se provided with venture capital. On the other hand the return to the seed/risk
capital financier had been very low as compared to venture capitalist.
Seed Capital Scheme Venture capital Scheme
Basis Income or aid Commercial viability
Beneficiaries Very small entrepreneurs Medium and large entrepreneurs a
re also covered
Size of assistance Rs. 15 Lac (Max) Up to 40 percent of promoters’ e
quity
Appraisal process Normal Skilled and specialized
Estimates 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
Syndication Not done Possible
Tax concession Nil Exempted
Success rate Not good Very satisfactory
Table 2.1: Difference between Seed Capital Scheme and Venture capi
tal Scheme

2.3.3 Venture Capital Vs Bought Out Deals

The important difference between the Venture capital and bought out deals is tha
t bought-outs are not based upon high risk- high reward principal. Further unlik
e Venture capital they do not provide equity finance at different stages of the
enterprise. However both have a common expectation of capital gains yet their ob
jectives and intents are totally
2.4 The Venture Capital Spectrum
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 resour
ces in surveying the market, finding and understanding the target customers and
their needs. At the seed stage the entrepreneur continue to fund the venture wit
h own his or family funds. At this stage the funds are needed to solicit the con
sultant’s services in formulation of business plans, meeting potential customers
and technology partners. Next the funds would be required for development of th
e product/process and producing prototypes, hiring key people and building up th
e managerial team. This is followed by funds for assembling the manufacturing an
d marketing facilities in that order. Finally the funds are needed to expand the
business and attaint the critical mass for profit generation. Venture capitalis
ts cater to the needs of the entrepreneurs at different stages of their enterpri
ses. 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 rap
idly growing companies. However various reasons forced venture capitalists to be
more and more involved in expansion financing to support the development of exi
sting portfolio companies. With increasing demand of capital from newer business
, Venture capitalists began to operate across a broader spectrum of investment i
nterest. This diversity of opportunities enabled Venture capitalists to balance
their activities in term of time involvement, risk acceptance and reward potenti
al, while providing ongoing assistance to developing business. Different ventur
e capital firms have different attributes and aptitudes for different types of V
enture capital investments. Hence there are different stages of entry for differ
ent Venture capitalists and they can identify and differentiate between types of
Venture capital investments, each appropriate for the given stage of the invest
ee 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 Buy Out and Buy ins
Turnarounds
Mezzanine/Bridge Finance
 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 seco
nd round finance does not always follow early stage finance. If the business gro
ws successfully it is likely to develop sufficient cash to fund its own growth,
so does not require venture capital for growth.
The table below shows risk perception and time orientation for different stages
of venture capital financing.
Financing Stage
Period (funds locked in years) Risk perception Activity to be financed
Early stage finance seed 7-10 Extreme For supporting a concept or idea
or R & D for product development
Start up 5-9 Very high Initializing operations or developing pr
ototypes
First stage 3-7 High Start Commercial production and marketing
Second stage 3-5 Sufficiently
high Expand market & growing working capital need
Later stage finance 1-3 Medium Market expansion, acquisition & product
development for profit making company
Buy-out in 1-3 Medium Acquisition financing
Turn around 3-5 Medium to high Turning around a sick company
mezzanine 1-3 Low Facilitating public issue
Table 2.2 Venture Capital Financing stage
2.4.1 Seed Capital
It is an idea or concept as opposed to a business. European Venture capital asso
ciation defines seed capital as “The financing of the initial product developmen
t or capital provided to an entrepreneur to prove the feasibility of a project a
nd to qualify for start up capital”.
The characteristics of the seed capital may be enumerated as follows:
Absence of ready product market
Absence of complete management team
Product/ process still in R & D stage
Initial period / licensing stage of technology transfer
Broadly speaking seed capital investment may take 7 to 10 years to achieve real
ization. It is the earliest and therefore riskiest stage of Venture capital inve
stment. The new technology and innovations being attempted have equal chance of
success and failure. Such projects, particularly hi-tech, projects sink a lot of
cash and need a strong financial support for their adaptation, commencement and
eventual success. However, while the earliest stage of financing is fraught wit
h risk, it also provides greater potential for realizing significant gains in lo
ng term.
2.4.2 Start up Capital
It is stage 2 in the venture capital cycle and is distinguishable from seed capi
tal investments. An entrepreneur often needs finance when the business is just s
tarting. The start up stage involves starting a new business.
Here in the entrepreneur has moved closer towards establishment of a going conce
rn. Here in the business concept has been fully investigated and the business ri
sk now becomes that of turning the concept into product. Start up capital is d
efined as:
“Capital needed to finance the product development, initial marketing and establ
ishment of product facility. “

The characteristics of start-up capital are:-

I. Establishment of company or business. The company is either being organized o
r is established recently. New business activity could be based on experts, expe
rience or a spin-off from R & D.
ii. Establishment of most but not all the members of the team. The skills and fi
tness to the job and situation of the entrepreneur’s team is an important factor
for start up finance.
iii. Development of business plan or idea. The business plan should be fully dev
eloped yet the acceptability of the product by the market is uncertain. The comp
any 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 pro
ven product, to start commercial production and marketing, not covering market e
xpansion, de-risking and acquisition costs. At this stage the company passed in
to early success stage of its life cycle. A proven management team is put into t
his 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 sourc
es thus prompting venture capitalist that, have financed the start up stage to p
rovide further financing. The management risk is shifted from factors internal t
o the firm (lack of management, lack of product etc.) to factors external to the
firm (competitive pressures, in sufficient will of financial institutions to pr
ovide adequate capital, risk of product obsolescence etc.)
2.4.4 Second Stage Finance
It is the capital provided for marketing and meeting the growing working capital
needs of an enterprise that has commenced the production but does not have posi
tive cash flows sufficient to take care of its growing needs.
Second stage finance, the second trench of Early State Finance is also referred
to as follow on finance and can be defined as the provision of capital to the fi
rm which has previously been in receipt of external capital but whose financial
needs have subsequently exploded. This may be second or even third injection of
capital.
The characteristics of a second stage finance are:
A developed product on the market
A full management team in place
Sales revenue being generated from one or more products
There are losses in the firm or at best there may be a breakeven but the
surplus generated is insufficient to meet the firm’s needs.
Second round financing typically comes in after start up and early stage funding
and so have shorter time to maturity, generally ranging from 3 to 7 years.
2.4.5 Later Stage Finance
It is called third stage capital is provided to an enterprise that has establish
ed commercial production and basic marketing set-up, typically for market expans
ion, acquisition, product development etc. It is provided for market expansion o
f the enterprise.
The enterprises eligible for this round of finance have following characteristic
s.
Established business, having already passed the risky early stage.
Expanding high yield, capital growth and good profitability.
Reputed market position and an established formal organization structure
.
“Funds are utilized for further plant expansion, marketing, working capital or d
evelopment of improved products.” Third stage financing is a mix of equity with
debt or subordinate debt. As it is half way between equity and debt in US it is
called “mezzanine” finance. It is also called last round of finance in run up to
the trade sale or public offer. Venture capitalist s prefer later stage invest
ment vis a vis early stage investments, as the rate of failure in later stage fi
nancing 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 hel
ps the venture capitalists to balance their own portfolio of investment as it pr
ovides a running yield to venture capitalists.
Further the loan component in third stage finance provides tax advantage and sup
erior return to the investors. There are four sub divisions of later stage fina
nce.
Expansion / Development Finance
Replacement Finance
Buyout Financing
Turnaround Finance
Expansion / Development Finance
An enterprise established in a given market increases its profits exponentially
by 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 p
roper distribution system or by way of acquisitions. Anyhow, expansion needs fin
ance and venture capitalists support both organic growth as well as acquisitions
for expansion.
Replacement Finance
It means substituting one shareholder for another, rather than raising new capi
tal resulting in the change of ownership pattern. Venture capitalist purchase sh
ares from the entrepreneurs and their associates enabling them to reduce their s
hareholding in unlisted companies. They also buy ordinary shares from non-promot
ers and convert them to preference shares with fixed dividend coupon. Later, on
sale of the company or its listing on stock exchange, these are re-converted to
ordinary shares. Thus Venture capitalist makes a capital gain in a period of 1 t
o 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 a
significant share holding in the business they manage are called management buyo
ut. Management Buy-in refers to the funds provided to enable a manager or a grou
p 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 matur
e business. The funds are provided for acquiring and revitalizing an existing pr
oduct 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 v
enture capitalist, who structure their investment by judicious combination of de
bt and equity. Of late there has been a gradual shift away from start up and ear
ly finance towards MBO opportunities. This shift is because of lower risk than s
tart up investments.
Turnaround Finance
It is rare form later stage finance which most of the venture capitalist avoid b
ecause of higher degree of risk. When an established enterprise becomes sick, it
needs finance as well as management assistance foe a major restructuring to rev
italize growth of profits. Unquoted company at an early stage of development oft
en has higher debt than equity; its cash flows are slowing down due to lack of m
anagerial skill and inability to exploit the market potential.
The sick companies at the later stages of development do not normally have high
debt burden but lack competent staff at various levels. Such enterprises are com
pelled to relinquish control to new management.
The venture capitalist has to carryout the recovery process using hands on manag
ement in 2 to 5 years. The risk profile and anticipated rewards are akin to earl
y stage investment.
Bridge Finance
It is the pre-public offering or pre-merger/acquisition finance to a company. It
is the last round of financing before the planned exit. Venture capitalist help
in building a stable and experienced management team that will help the company
in its initial public offer.
Most of the time bridge finance helps improves the valuation of the company. Bri
dge finance often has a realization period of 6 months to one year and hence the
risk involved is low. The bridge finance is paid back from the proceeds of the
public issue.
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 literatu
re on venture capital finance is carried out. Tyebjee and Bruno in 1984 gave a m
odel 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 Organization
2. Screening
3. Evaluation or due Diligence
4. Deal Structuring
5. 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 invest
ment opportunities that he would consider for investing in. Deal may originate i
n various ways. Referral system, active search system and intermediaries. Referr
al system is an important source of deals. Deals may be referred to VCFs by thei
r parent organisations, trade partners, industry associations, friends etc. Anot
her deal flow is active search through networks, trade fairs, conferences, semin
ars, foreign visits etc. Intermediaries is used by venture capitalists in develo
ped countries like USA, is certain intermediaries who match VCFs and the potenti
al entrepreneurs.
Screening:
VCFs, before going for an in-depth analysis, 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 venture capitalist is familiar in term
s of technology, or product, or market scope. The size of investment, geographic
al location and stage of financing could also be used as the broad screening cri
teria.
Due Diligence:
Due diligence is the industry jargon for all the activities that are associated
with evaluating an investment proposal. The venture capitalists evaluate the qua
lity of entrepreneur before appraising the characteristics of the product, marke
t or technology. Most venture capitalists ask for a business plan to make an ass
essment of the possible risk and return on the venture. Business plan contains d
etailed information about the proposed venture. The evaluation of ventures by VC
Fs in India includes; Preliminary evaluation:
The applicant required to provide a brief profile of the proposed venture to est
ablish prima facie eligibility. Detailed evaluation: Once the preliminary evalu
ation is over, the proposal is evaluated in greater detail. VCFs in India expect
the entrepreneur to have:- Integrity, long-term vision, urge to grow, manageri
al skills, commercial orientation. VCFs in India also make the risk analysis of
the proposed projects which includes: Product risk, Market risk, Technological r
isk and Entrepreneurial risk. The final decision is taken in terms of the expect
ed 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 p
rocess is termed as deal structuring. The agreement also include the venture cap
italists’ right to control the venture company and to change its management if n
eeded, buyback arrangements, acquisition, making initial public offerings (IPOs)
, etc. Earned out arrangements specify the entrepreneur s equity share and the o
bjectives to be achieved.
Post Investment Activities:
Once the deal has been structured and agreement finalised, the venture capitali
st generally assumes the role of a partner and collaborator. He also gets involv
ed in shaping of the direction of the venture. The degree of the venture capital
ists’ involvement depends on his policy. It may not, however, be desirable for a
venture capitalist to get involved in the day-to-day operation of the venture.
If a financial or managerial crisis occurs, the venture capitalist may intervene
, and even install a new management team.
Exit:
Venture capitalists generally want to cash-out their gains in five to ten years
after the initial investment. They play a positive role in directing the company
towards particular exit routes. A venture may exist in one of the following way
s:
There are four ways for a venture capitalist to exit its investment:
Initial Public Offer (IPO)
Acquisition by another company
Re-purchase of venture capitalists’ share by the investee company
Purchase of venture capitalists’ share by a third party
Promoter’s Buy-back
The most popular disinvestments route in India is promoter’s buy-back. This rout
e is suited to Indian conditions because it keeps the ownership and control of t
he promoter intact. The obvious limitation, however, is that in a majority of ca
ses 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 to
buy 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 firm’s equity with suitable agree
ment for the promoter to repurchase it. Similarly, Canfina-VCF offers an opportu
nity to the promoters to buy back the shares of the assisted firm within an agre
ed 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 t
hem in any manner it deemed appropriate.
SBI capital Markets ensures through examining the personal assets of the promote
rs and their associates, which buy back, would be a feasible option. GVFL would
make disinvestments, in consultation with the promoter, usually after the projec
t has settled down, to a profitable level and the entrepreneur is in a position
to avail of finance under conventional schemes of assistance from banks or other
financial institutions.
Initial Public Offers (IPOs)
The benefits of disinvestments via the public issue route are improved marketabi
lity and liquidity, better prospects for capital gains and widely known status o
f the venture as well as market control through public share participation. This
option has certain limitations in the Indian context. The promotion of the publ
ic issue would be difficult and expensive since the first generation entrepreneu
rs are not known in the capital markets.
Further, difficulties will be caused if the entrepreneur’s business is perceived
to be an unattractive investment proposition by investors. Also, the emphasis b
y the Indian investors on short-term profits and dividends may tend to make the
market price unattractive. Yet another difficulty in India until recently was th
at the Controller of Capital Issues (CCI) guidelines for determining the premium
on shares took into account the book value and the cumulative average EPS till
the date of the new issue. This formula failed to give due weight age to the exp
ected stream of earning of the venture firm. Thus, the formula would underestima
te the premium.
The Government has now abolished the Capital Issues Control Act, 1947 and conseq
uently, the office of the controller of Capital Issues. The existing companies a
re now free to fix the premium on their shares. The initial public issue for dis
investments of VCFs’ holding can involve high transaction costs because of the i
nefficiency of the secondary market in a country like India. Also, this option h
as 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 publ
ic 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 invest
ors should be able to trade shares conveniently and freely. In the USA, there ex
ist well-developed OTC markets where dealers trade in shares on telephone/termin
al and not on an exchange floor. This mechanism enables new, small companies whi
ch are not otherwise eligible to be listed on the stock exchange, to enlist on t
he OTC markets and provides liquidity to investors. The National Association of
Securities Dealers Automated Quotation System (NASDAQ) in the USA daily quotes o
ver 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 19
89.
It has been promoted jointly by UTI, ICICI, SBI Capital Markets, Can bank Finan
cial Services, GIC, LIC and IDBI.
Since this list of market-makers (who will decide daily prices and appoint deale
rs 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 securitie
s of new small and medium size enterprises.
The other disinvestments mechanisms such as the management buyouts or sale to ot
her venture funds are not considered to be appropriate by VCFs in India. The gr
owth of an enterprise follows a life cycle as shown in the diagram below. The re
quirements of funds vary with the life cycle stage of the enterprise.
Even before a business plan is prepared the entrepreneur invests his time and re
sources in surveying the market, finding and understanding the target customers
and their needs. At the seed stage the entrepreneur continue to fund the venture
with own his or family funds.
At this stage the funds are needed to solicit the consultant’s services in formu
lation of business plans, meeting potential customers and technology partners. N
ext the funds would be required for development of the product/process and produ
cing prototypes, hiring key people and building up the managerial team.
This is followed by funds for assembling the manufacturing and marketing facilit
ies in that order. Finally the funds are needed to expand the business and attai
nt 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 inve
stors, venture capitalist or private equity supplier/investor
.
Figure: 2.3 players in venture capital ind
ustry
2.6 The players
There are following groups of players: •
Angels and angel clubs
Venture Capital funds
• Small
• Medium
• Large
Corporate venture funds
Financial service venture groups

Angels and angel clubs

Angels are wealthy individuals who invest directly into companies. They can form
angel clubs to coordinate and bundle their activities. Besides the money, angel
s often provide their personal knowledge, experience and contacts to support the
ir investees. With average deals sizes from USD 100,000 to USD 500,000 they fina
nce companies in their early 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-u
p capital. The so called "Boutique firms" are often specialised in certain indus
tries 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 p
er fund?).
As Venture Capital funds strong competition will clear the market place for the
small and medium. There will be mergers and acquisitions leading to a concentrat
ion of capital. Funds specialised in different business areas will form strategi
c partnerships. Only the more successful funds will be able to attract new money
.
Examples are:
1. Artemis Coma ford
2. Abbell Venture Fund
3. Acacia Venture Partners
Medium Venture Funds
The medium venture funds finance all stages after seed stage and operate in all
business segments. They provide money for deals up to USD 250 million. Single fu
nds have up to USD 5 billion under management. An example is Accel Partners

Large Venture Funds

As the medium funds, large funds operate in all business sectors and provide all
types of capital for companies after seed stage. They often operate internation
ally and finance deals up to USD 500 million
The large funds will try to improve their position by mergers and acquisitions w
ith other funds to improve size, reputation and their financial muscle. In addit
ion they will to diversify. Possible areas to enter are other financial services
by means of M&As with financial services corporations and the consulting busine
ss.
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 c
ompanies out there is no reason why Venture Capital funds should offer advice an
d consulting only to their investees.
Examples are:
1. AIG American International Group
2. Cap Vest Man
3. 3i
Corporate Venture Funds
These Venture Capital funds are set up and owned by technology companies. Their
aim is to widen the parent company s technology base in a win-win-situation for
both, the investor and the investee.
In general, corporate funds invest in growing or maturing companies, often when
the investee wishes to make additional investments in technology or product deve
lopment. 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 w
ith other funds to improve size, reputation and their financial muscle. In addit
ion they will to diversify. Possible areas to enter are other financial services
by means of M&As with financial services corporations and the consulting busine
ss.
For the latter one the funds have a rich resource of expertise and contacts in h
ouse. In a declining market for their core activity and with lots of tumbling co
mpanies out there is no reason why Venture Capital funds should offer advice and
consulting only to their investees.
Examples are:
1. Oracle
2. Adobe
3. Dell
4. Kyocera
As an example, Adobe systems launched a $40m venture fund in 1994 to invest in c
ompanies strategic to its core business, such as Cascade Systems Inc and Lantana
Research Corporation.- has been successfully boosting demand for its core produ
cts, 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 Vent
ure Capital activities. That means that the parent companies shift the risk to t
heir customers by creating new products such as stakes in an Venture Capital fun
d. However, the success of such products will depend on the overall climate and
expectations in the economy. As long as the sown turn continues without any sign
of recovery customers might prefer less risky alternatives.

CHAPTER 3
GLOBAL SCENARIO OF
VENTURE CAPITAL
INDUSTRY

3.1 Overview
Over the last 18 months, the venture capital industry around the globe has exper
ienced 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
est level since 2001, and is maintaining a robust pace in year 2007. The acceler
ation has been bolstered by the increasing globalization of both venture capital
funds and venture backed companies and a substantial investor focus on emerging
sectors. 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, e
xpecting to reap rich rewards by later selling of these outfits to public .But t
he bubble burst the market for the new stock issues tanked --- and by 2003 , ven
ture capital funding had dwindled to $19 billion. The VC showed the signs of s
tabilizing as the industry were bolstered by the 2005’s strong 4thquarter, the f
inancing exceeded the $ 21.5 billion invested in venture-backed companies in 200
4, reaching $22.1billion .While that was far below 2000’s peak, it represents a
more sustainable pace of funding for both entrepreneurs and investors. In anothe
r sign of the industry firming, pension funds, foundations, and other investors
are again getting interested to invest their money in venture funds, which provi
ded seed money for young companies to grow on.
3.2 History & Evolution
Prior to World War Two, the source of capital for entrepreneurs everywhere was e
ither the government, government-sponsored institutions meant to invest in such
ventures, or informal investors (today, termed "angels") that usually had some p
rior relationship to the entrepreneur. In general, throughout history private ba
nks, quite reasonably, have been unwilling to lend money to a newly established
firm, because of the high risk and lack of collateral. After World War Two, in t
he U.S. a set of intermediaries emerged who specialized in investing in fledglin
g firms having the potential for extremely rapid growth. From its earliest beg
innings on the U.S. East Coast, venture capital gradually expanded and became an
increasingly professionalized institution. During this period, the locus of the
venture capital industry shifted from New York and Boston on the East Coast to
Silicon Valley on the West Coast. By the mid 1980s, the ideal-typical venture ca
pital firm was based in Silicon Valley and invested largely in electronics with
lesser sums devoted to biomedical technologies. Until the present, in addition t
o Silicon Valley, the two other major concentrations have been Boston and New Yo
rk City. In both Europe and Asia, there are significant concentrations of ventur
e capital in London, Israel, Hong Kong, Taiwan, and Tokyo. In the U.S., the gove
rnment has played a role in the development of venture capital, though, for the
most part, it was indirect. The indirect role, i.e., the general policies that a
lso benefited the development of the venture capital industry, was probably the
most significant. Some of the most important of these were:
The U.S. government generally practiced sound monetary and fiscal polici
es ensuring relatively low inflation with a stable financial environment and cur
rency.
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 ef
fect on the availability of venture capital.
With the exception of a short period in the 1970s, U.S. pension funds ha
ve been allowed to invest prudent amounts in venture capital funds.
The NASDAQ stock market, which has been the exit strategy of choice for
venture capitalists, was strictly regulated and characterized by increasing open
ness thus limiting investor s fears of fraud and deception.
This created a general macroeconomic environment of transparency and predictabil
ity, reducing risks for investors. Put differently, environmental risks stemming
from government action were minimized -- a sharp contrast to most developing na
tions. Another important policy has been a willingness to invest heavily and co
ntinuously in university research. This investment funded generations of graduat
e students in the sciences and engineering. From this research has come trained
personnel and innovations; some of who formed firms that have been funded by ven
ture capitalists. U.S. universities particularly, MIT, Stanford, and UC Berkeley
played a particularly salient role. The most important direct U.S. government
involvement in encouraging the growth of venture capital was the passage of the
Small Business Investment Act of 1958 authorizing the formation of small busines
s investment corporations (SBICs). This legislation created a vehicle for fundin
g small firms of all types. The legislation was complicated, but for the develop
ment of venture capital the following features were most significant:
It permitted individuals to form SBICs with private funds as paid-in cap
ital 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 their
investment of $150,000 in private capital.
There were also tax and other benefits, such as income and a capital gai
ns pass-through and the allowance of a carried interest as compensation.
The SBIC program became one that many other nations either learned from or emula
ted. The SBIC program also provided a vehicle for banks to circumvent the Depres
sion-Era laws prohibiting commercial banks from owning more than 5 percent of in
dustrial firms. The banks SBIC subsidiaries allowed them to acquire equity in s
mall firms. This made even more capital available to fledgling firms, and was a
significant source of capital in the 1960s and 1970s. The final investment forma
t 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 significa
nt for the venture capital industry The SBIC program experienced serious problem
s from its inception. One problem was that as a government agency it was very bu
reaucratic having many rules and regulations that were constantly changing. Desp
ite the corruption, something valuable also occurred. Namely, and especially, in
Silicon Valley, a number of individuals used their SBICs to leverage their pers
onal capital, and some were so successful that they were able to reimburse the p
rogram and raise institutional money to become formal venture capitalists. The S
BIC program accelerated their capital accumulation, and as important, government
regulations made these new venture capitalists professionalize their investment
activity, which had been informal prior to entering the program. Now-illustriou
s firms such as Sutter Hill Ventures, Institutional Venture Partners, Bank of Am
erica Ventures, and Menlo Ventures began as SBICs The historical record also ind
icates 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 pe
nsion funds, changed Federal pension fund regulations. In their haste to prohibi
t pension fund abuses, Congress passed the Employment Retirement Income Security
Act (ERISA) making pension fund managers criminally liable for losses incurred
in high-risk investments. This was interpreted to include venture capital funds;
as a result pension managers shunned venture capital nearly destroying the enti
re industry. This was only reversed after active lobbying by the newly created
National Venture Capital Association (NVCA). In 1977, it succeeded in starting
a gradual loosening process that was completed in 1982. The new interpretation o
f these pension fund guidelines contributed to first a trickle then a flood of n
ew money into venture capital funds. The most successful case of the export of S
ilicon Valley-style venture capital practice is Israel where the government play
ed an important role in encouraging the growth of venture capital.
The government has a relatively good economic record; there is a minimum of corr
uption, 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 th
e 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 th
e first Israeli venture capital fund. Still, the creation of an Israeli venture
capital industry would wait until the 1990s, when the government funded an organ
ization, Yozma, to encourage venture capital in Israel. Yozma received $100 mill
ion from the Israeli government. It invested $8 million in ten funds that were r
equired to raise another $12 million each from "a significant foreign partner,"
presumably an overseas venture capital firm. Yozma also retained $20 million to
invest itself. These “sibling” funds were the backbone of a now vibrant communit
y 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 proces
s, and the role of the government was limited and contradictory. In Israel the g
overnment played a vital role in a supportive environment in which private-secto
r 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 lar
gely positive in assisting the growth of venture capital, in India the role of t
he government has had to be proactive in removing barriers (Dossani and Kenney 2
001). In every nation, the state has played some role in the development of ven
ture capital. Venture capital is a very sensitive institutional form due to the
high-risk nature of its investments, so the state must be careful to ensure its
policies do not adversely affect its venture capitalists. Put differently, capri
cious governmental action injects extra risk into the investment equation. Howev
er, judicious, well-planned government policies to create incentives for private
sector involvement have in the appropriate lead to the establishment of what be
came an independent self-sustaining venture capital industry.
3.3 Current Industry Trends
Round Class Distribution
The distribution of financing rounds by round class in mature markets is typical
ly 30-40% in the early stage rounds, 20-25% in second round, and 35-40% in later
rounds. In emerging market like China, the round distribution is very different
as 68% in early stage round and 25% in second round. In mature countries, the i
nvestments are made at early start up or product development phase.
Industry shifts
It is perhaps no surprise that the contraction is mostly concentrated in informa
tion technology and the business, consumer and retail industries, give the huge
number of companies financed in the technology and Internet boom of 1999-2000, a
nd the subsequent downturn. The healthcare pool, driven by investment in biophar
maceuticals and medical devices, has actually grown to some degree in the differ
ent geographies .In United States, the healthcare pool has grown consistently ov
er the last several years, both in terms of number of companies and cumulative d
ollars 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 declin
es across the board. In US the number had fallen 54% since 2002 and 54% in Europ
e since 2003 .In Israel; it dropped 67% since 2004.
The number of healthcare companies has grown in U.S. since 2002 by 27% a
nd the capital risen 30% in last five years. Capital investment to the pool of h
ealthcare companies in Europe and Israel has also climbed, although the number o
f 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 we
re 262 clean technology companies with a cumulative invested venture capital of
US $38 billion in 2007.
Mega trends
Several global mega trends will likely have an impact on venture capital in the
next decade:-
Beyond the BRICs: - A new wave of fast growing economies is joining the
global growth leaders like Brazil, China, India, and Russia. The beginning of ve
nture capital activity has been seen in others countries such as Indonesia, Kore
a, Turkey and Vietnam.
The new multinationals: - A new breed of global company is emerging from
developing countries and redefining industries through low-cost advantage, mode
rn infrastructure, and vast customer databases in their home countries. These co
mpanies are potential acquirers of developed market companies at all stages of g
rowth.

Globalization of capital: - Changes in economic and financial landscape

are creating a significant regional shift in IPO activity. These changes have al
so sparked global consolidation alliances among stock exchanges.
Transformation of the CFO’s role and function: - With the globalization
and increasingly complex regulatory environment, CFOs have a wider range of resp
onsibilities and finance function has been transformed to face broader mandates.

Clean Technology: - Clean technology is poised to become the first break

through sector of 21stcentury. Encompassing energy, air and water treatment, in
dustrial efficiency improvements, new material and waste management etc are play
ing 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 i
n conjunction with the National Venture Capital Association and other venture ca
pital associations* throughout the world.
It was administered in April and May 2007 to venture capitalists (VCs) in the Am
ericas, Asia Pacific, Europe, the Middle East, and Africa.
There were 528 responses from general partners, with 45 percent of respondents f
rom the United States and 31 percent from Europe. A complete geographic breakdow
n 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 high
est number of respondents—42 percent—had managed assets totaling less than $100
million; 35 percent managed assets between $100 million and $499 million; 12 per
cent 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 w
hich China, India, Japan, South Korea, other Asia. 45% respondents from Middle E
ast 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 broadl
y embracing global investment. Rather, roughly half of the venture community has
made a commitment to a global investment strategy and those firms are implement
ing that strategy slowly and cautiously. The intentions for growth of foreign in
vestment, as demonstrated by this year’s survey data, are modest at best.
Figure: 3.2 Percentage of venture capitalist currently investing outside home
country (U.S respondent)

Figure: 3.3 Percentage of venture capitalist currently investing outside home co

untry (Non U.S. respondents)
Among U.S. investors, 54 percent indicated that they would be expanding their in
vestment focus outside of their home country or region in the next five years. A
dequate deal flow in their home country was the reason indicated most for not wa
nting to expand globally.
Some venture investors are certainly taking advantage of opportunities outside
their home countries, actual growth in terms of percentage of venture investors
investing globally is occurring much more slowly than is commonly believed. And,
for a lot of firms, they’re 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 critic
al challenges, such as tax and intellectual property issues impact overall perfo
rmance.

3.5 Current strategies

Among 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 only
with other investors who have a local presence.
This underscores the need in venture capital to be physically close to the portf
olio companies in order to work with management. Firms also indicated that to su
cceed, they need to understand local culture, and to do so they must have a loca
l 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 fore
ign investment Focus

3.6 China, India, Israel and Canada are primary target countries for U.S. ventur
e capitalists
There 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 investe
d globally are making investments in China, India, Israel, and Canada. However,
even in these countries, the majority of U.S. respondents are essentially dabbli
ng, making only one to two investments thus far.
Figure: 3.5 foreign investments currently held by
firms
Allocations by U.S. and non-U.S. firms alike for the most part represent less th
an 5 percent of capital invested overseas in fewer than three to five deals. Sur
vey results indicate that there will not be significant change during the next f
ive years.
RESPONSE FROM U.S. RESPONDENTS
Figure: 3.6 Primary focused location for investment (U.S) re
spondents
Here 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 choice
for 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 mark
ets 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, wh
o indicated a strong preference for investing in other parts of Europe (67 perce
nt) and the United States (17 percent), with the remainder focused on Asia. Asia
n respondents had a similar level of interest in the United States (18 percent),
 but looked primarily inward to other Asian countries (78 percent), with the rem
ainder focused on the Middle East. This data shows that while non-U.S. investors
are interested in making deals outside of their home countries, there’s still a
desire 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. There
is 3% ready to invest in South Korea, Japan and South Korea
Resources are critical for international investing
The survey findings indicate that global investing will broaden among U.S. VC fi
rms at a slow pace for the foreseeable future. Of those VCs who indicated they c
urrently have capital deployed abroad, more than half of U.S. respondents (54 pe
rcent) 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 o
utside 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 managem
ent over $1 billion indicated plans to increase their foreign investments. Inter
estingly, among mid-size firms, 47 percent of the VCs with $100 to$499 million c
apital under management are investing outside the U.S. This underscores that glo
bal investing requires additional resources and a sophisticated infrastructure i
n order to manage a global investment strategy. That said, the study also shows
that a significant percentage of mid-size firms recognize that opportunities exi
st outside their home country and are building their franchise in a way that wil
l enable them to take advantage of those opportunities.

Figure: 3.8 Percentage of venture capitalist expecting to expand investment focu

s Outside home country

3.7 Primary reasons why investors expanding globally venture

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

Figure: 3.9 primary reasons why venture investors expanding g

lobally
Above chart reveals that 19% U.S respondents are expand globally for generating
high quality deal flow. And 31% believe that they expand globally for getting be
nefit of emergence of entrepreneurial environment.
While 17% respondents of non U.S are expand globally for diversification of indu
stry and geographic risk. All respondents are least concerned about low cost of
locations.
3.8 Investing globally by investing locally
One way to build a comfort zone for global investing and to take advantage of op
portunities abroad is to invest locally in companies with operations outside the
ir home country, as opposed to investing directly in foreign countries. This yea
r, there was a significant increase in the number of respondents who indicated t
hat a sizeable number of their portfolio companies have a considerable amount of
operations outside the country in which they’re headquartered. A significant n
umber, 88 percent of U.S. respondents and 82 percent of non-U.S. respondents, in
dicated that at least some portion of their portfolio has significant operations
outside of the country of headquarters. Again, moderation is evident as more th
an half of those indicated that less than 25 percent of their portfolio had sign
ificant foreign operations. Nonetheless, these numbers have increased significan
tly from prior years and reflect an increased trend in this method of investment

Figure: 3.10 Percentage of venture capital firm’s portfolio companies that give
significant operation outside the country
Globally and among U.S. respondents, China has become the primary choice for rel
ocating manufacturing operations, while India is the primary choice for R&D oper
ations. Engineering operations tend to land in India as well, but China is also
a popular location. For back office activities, again, the choice is India. Howe
ver, for non-U.S. respondents, the United States is the primary choice for R&D a
nd engineering while European respondents preferred Central and Eastern Europe f
or manufacturing, R&D, and Engineering. One reason why this approach is taking
off is that investors are concerned about intellectual property and liquidity e
vents—and, in general, they feel a need to be closer to top management. This als
o reflects a new reality—that VCs are now investing in companies that operate gl
obally from day one— companies that reflects a larger global entrepreneurial sec
tor. This strategy allows the portfolio companies (and investors) to take advant
age of cost savings and access to talent in foreign markets while protecting int
ellectual property. There are, however, concerns that such a trend could result
in 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 risk
s and challenges abroad. Both U.S. and non-U.S. firms perceive the U.S. as the c
ountry where the cost of complying with regulation is too high. In fact, the per
centage of non-U.S. respondents who indicated this as a concern leaped from 28 p
ercent last year to 41 percent this year. Globally, 4 percent more, 44 percent s
aw this issue as a concern. Forty-six percent of U.S. respondents believe the co
st 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. h
as high cost of complying with Corporate Governance regulation and china, India,
Israel and Canada cost of complying with corporate governance regulation too hi
gh.
CHAPTER 4
VENTURE CAPITAL
IN INDIA

4.1 Evolution of VC Industry in India

The first major analysis on risk capital for India was reported in 1983. It indi
cated that new companies often confront serious barriers to entry into capital m
arket for raising equity finance which undermines their future prospects of expa
nsion and diversification. It also indicated that on the whole there is a need t
o revive the equity cult among the masses by ensuring competitive return on equi
ty investment. This brought out the institutional inadequacies with respect to t
he evolution of venture capital. In India, the Industrial finance Corporation
of India (IFCI) initiated the idea of VC when it established the Risk Capital Fo
undation in 1975 to provide seed capital to small and risky projects. However th
e concept of VC financing got statutory recognition for the first time in the fi
scal budget for the year 1986-87.
The Venture Capital companies operating at present can be divided into four grou
ps:
• 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 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 a
cess of 5% on all payments made for the import of technology know- how projects
requiring funds from rs.5 lacs to Rs 2.5 cr were considered for financing. Promo
ter’s contribution ranged from this fund was available at a concessional interes
t 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 st
arted providing VC finance in 1998 it promoted, along with the Unit Trust of Ind
ia (UTI) Technology Development and Information Company of India (TDICI) as the
first VC company registered under the companies act, 1956. The TDICI may provide
financial assistance to venture capital undertakings which are set up by techno
crat entrepreneurs, or technology information and guidance services. The risk c
apital foundation established by the industrial finance corporation of India (IF
CI) in 1975, was converted in 1988 into the Risk Capital and Technology Finance
company (RCTC) as a subsidiary company of the ifci the rctc provides assistance
in the form of conventional loans, interest –free conditional loans on profit an
d risk sharing basis or equity participation in extends financial support to hig
h technology projects for technological up gradations. The RCTC has been renamed
as IFCI Venture Capital Funds Ltd.(IVCF)
Promoted by State Level Financial Institutions
In India, the State Level financial institutions in some states such as Madhya
Pradesh, Gujarat, Uttar Prades, etc., have done an excellent job and have provid
ed VC to a small scale enterprises. Several successful entrepreneurs have been t
he beneficiaries of the liberal funding environment. In 1990, the Gujarat Indust
rial Investment Corporation, promoted the Gujarat Venture Financial Ltd.(GVFL) a
long with other promoters such as the IDBI, the World Bank, etc. The GVFL provid
es financial assistance to businesses in the form of equity, conditional loans o
r income notes for technologies development and innovative products. It also pro
vides finance assistance to entrepreneurs. The government of Andhra Pradesh has
also promoted the Andhra Pradesh Industrial Development Corporation (APIDC) to
provide VC financing in Andhra Pradesh.
Promoted by commercial banks
Canbank Venture Capital Fund, State Bank Venture Capital Fund and Grindlays bank
Venture Capital Fund have been set up by the respective commercial banks to und
ertake 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 after
the 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 form
of equity and conditional loans.
Private Venture Capital Funds
Several private sector venture capital funds have been established in India suc
h as the 20ThCenture Venture Capital Company, Indus Venture Capital Fund, Infras
tructure 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, ITLInfosy’s 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 the
basis of this management can make future strategies of their business.

Figure: 4.1 Industry life cy

cles
The growth of VC in India has four separate phases:
4.2.1 Phase I - Formation of TDICI in the 80’s and regional funds as GVFL & APID
C in the early 90s.
The first origins of modern venture capital in India can be traced to the settin
g up of a Technology Development Fund in the year 1987-88, through the levy of a
ccess on all technology import payments. Technology Development Fund was started
to provide financial support to innovative and high risk technological programm
es through the Industrial Development Bank of India.
The first phase was the initial phase in which the concept of VC got wider accep
tance. The first period did not really experience any substantial growth of VCs’
. The 1980’s were marked by an increasing disillusionment with the trajectory of
 the economic system and a belief that liberalization was needed.
The liberalization process started in 1985 in a limited way. The concept of vent
ure capital received official recognition in 1988 with the announcement of the v
enture capital guidelines.
During 1988 to 1992 about 9 venture capital institutions came up in India. Thoug
h 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 fundin
g was the World Bank. The initial funding has been provided by World Bank. The m
ost important feature of the 1988 rules was that venture capital funds received
the benefit of a relatively low capital gains tax rate which was lower than the
corporate rate. The 1988 guidelines stipulated 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 so
me 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 reorga
nizing the businesses or through new entities.
All these followed the Government of India guidelines for venture capital activi
ties and have primarily supported technology oriented innovative businesses star
ted by first generation entrepreneurs. Most of these were operated more like a f
inancing operation. The main feature of this phase was that the concept got acce
pted.
VCs became operational in India before the liberalization process started. The c
ontext was not fully ripe for the growth of VCs. Till 1995; the VCs operated lik
e any bank but provided funds without collateral. The first stage of the venture
capital industry in India was plagued by in experienced management, mandates to
invest in certain states and sectors and general regulatory problems. Many publ
ic issues by small and medium companies have shown that the Indian investor is b
ecoming increasingly wary of investing in the projects of new and unknown promot
ers.
The liberation of the economy and toning up of the capital market changed the ec
onomic landscape. The decisions relating to issue of stocks and shares was handl
ed by an office namely: Controller of Capital Issues (CCI). According to 1988 VC
guideline, any organization requiring to start venture funds have to forward an
application 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 Securiti
es 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 work
ing of venture capital funds.
This was done in 1996, through a government notification. The power to control v
enture funds has been given to SEBI only in 1995 and the notification came out i
n 1996. Till this time, venture funds were dominated by Indian firms. The new re
gulations 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. D
uring this period overseas and private domestic venture capitalists began invest
ing in VCF. The new regulations in 1996 helped in this.
Though the changes proposed in 1996 had a salutary effect, the development of ve
nture capital continued to be inhibited because of the regulatory regime and res
tricted the FDI environment.
To facilitate the growth of venture funds, SEBI appointed a committee to recomme
nd 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 a
nd IT growth co-evolved in India
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 6
0% of its value during the second quarter of 2000 and other public markets (incl
uding those in India) also declined substantially. Consequently, during 2001-200
3, the VCs started investing less money and in more mature companies in an effor
t to minimize the risks. This decline broadly continued until 2003.
4.2.4 Phase IV– 2004 onwards - Global VCs firms actively investing in India
Since India’s economy has been growing at 7%-8% a year, and since some sectors,
including the services sector and the high-end manufacturing sector, have been g
rowing 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 increasing
substantially.
4.3 Growth of venture capital in India

Figure: 4.2 Growth of Venture capitals in Indi

a
The venture capital is growing 43% CAGR. However, in spite of the venture capita
l scenario improving, several specific VC funds are setting up shop in India, wi
th 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 b
y 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 a
re 160 venture capital firms/funds in India. In 2006 it is only but in 2007 the
number of venture capital firms is 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 of capital market by 51% from January to November 2008. The No. o
f venture capital funds are 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 Sof
tware and Service Companies)
Venture capital growth and industrial clustering have a strong positive correlat
ion. Foreign direct investment, starting of R&D centres, availability of venture
capital and growth of entrepreneurial firms are getting concentrated into five
clusters. The cost of monitoring and the cost of skill acquisition are lower in
clusters, especially for innovation. Entry costs are also lower in clusters. Cre
ating entrepreneurship and stimulating innovation in clusters have to become a m
ajor concern of public policy makers. This is essential because only when the cu
ltural context is conducive for risk management venture capital will take-of. Cl
usters support innovation and facilitates risk bearing. VCs prefer clusters beca
use the information costs are lower. Policies for promoting dispersion of indust
ries are becoming redundant after the economic liberalization. The venture capi
tal 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 invest
ment-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 venture
capital fund, Canbank.
4.4 Venture Capital investment Q3, 2008.
Venture Capital firms invested $274 million over 49 deals in India during the th
ree months ending September 2008. The VC investment activity during the period w
as significantly higher compared to the same quarter last year (which had witnes
sed 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 200
8 to $661 million (across 108 deals) as against the $648 million (across 97 deal
s) during the corresponding period in 2007.
4.4.1 Top Investments
The largest investment reported during Q3 2008 was the $18 million raised by onl
ine tutoring services provider TutorVista from existing investors Sequoia Capita
l India and LightSpeed Ventures.

Table: 4.1 Top venture capital investments

4.4.2 Investments by Industry

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

Table: 4.2 Venture capital investment by industry

Led by the $12 million investment by Bellwether and others into Chennai-based mi
crofinance firm Equitas, BFSI emerged as the second largest (in value terms) for
VC investments during the period. Other microfinance firms that attracted inves
tments during Q3 ’08 included Kolkata-based Arohan Financial Services (which rai
sed funding from Lok Capital and others) and Guwahati-based Asomi Finance (IFC a
nd Aavishkaar Goodwell).

Figure: 4.4 investment by industry Q3,2008

4.4.3 Investment by Stage
About 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 investment

4.5 Need for growth of venture capital in India
In India, a revolution is ushering in a new economy, wherein entrepreneurs mind
set is taking a shift from risk adverse business to investment in new ideas whi
ch involve high risk. The conventional industrial finance in India is not of muc
h help to these new emerging enterprises. Therefore there is a need of financing
mechanism that will fit with the requirement of entrepreneurs and thus it needs
venture capital industry to grow in India. Few reasons for which active 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 t
ier cities
Patient capital: Not flighty, unlike FIIs
Creating new industry clusters: Media, Retail, Call Centres and back off
ice processing, trickling down to organized effort of support services like offi
ce services, catering, transportation
4.6 Regulatory and legal framework
Definition of Venture Capital Fund :The Venture Capital Fund is now defined as a
fund 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; and
C. To invest in venture capital undertakings in accordance with the regulations.

Definition of Venture Capital Undertaking: Venture Capital Undertaking means a d

omestic company:-
1. Whose shares are not listed on a recognized stock exchange in India
2. Which is engaged in business including providing services, production or
manufacture of articles or things, or does not include such activities or secto
rs which are specified in the negative list by the Board with the approval of th
e 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 I
ndia.
Minimum contribution and fund size: the minimum investment in a Venture Capital
Fund from any investor will not be less than Rs. 5 lacs and the minimum corpus o
f 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 ne
w 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 wh
ose 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 ve
nture capital fund has already made an investment by way of equity.
It has also been provided that Venture Capital Fund seeking to avail benefit un
der the relevant provisions of the Income Tax Act will be required to divest fro
m the investment within a period of one year from the listing of the Venture Cap
ital Undertaking.
Disclosure and Information to Investors:
In order to simplify and expedite the process of fund raising, the requirement o
f filing the Placement memorandum with SEBI is dispensed with and instead the fu
nd will be required to submit a copy of Placement Memorandum/ copy of contributi
on agreement entered with the investors along with the details of the fund raise
d for information to SEBI. Further, the contents of the Placement Memorandum are
strengthened to provide adequate disclosure and information to investors. SEBI
will also prescribe suitable reporting requirement from the fund on their invest
ment 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 th
e SEBI (Venture Capital Fund) Regulations.
Relaxation in Takeover Code:
The acquisition of shares by the company or any of the promoters from the Ventu
re Capital Fund under the terms of agreement shall be treated on the same footin
g as that of acquisition of shares by promoters/companies from the state level f
inancial institutions and shall be exempt from making an open offer to other sha
reholders.
Investments by Mutual Funds in Venture Capital Funds:
In order to increase the resources for domestic venture capital funds, mutual fu
nds are permitted to invest upto 5% of its corpus in the case of open ended sche
mes and upto 10% of its corpus in the case of close ended schemes. Apart from ra
ising the resources for Venture Capital Funds this would provide an opportunity
to small investors to participate in Venture Capital activities through mutual f
unds.
Government of India Guidelines:
The Government of India (MOF) Guidelines for Overseas Venture Capital Investment
in India dated September 20, 1995 will be repealed by the MOF on notification o
f SEBI Venture Capital Fund Regulations.
Hassle Free Entry and Exit:
The Foreign Venture Capital Investors proposing to make venture capital investme
nt under the Regulations would be granted registration by SEBI. SEBI registered
Foreign Venture Capital Investors shall be permitted to make investment on an au
tomatic route within the overall sectoral ceiling of foreign investment under An
nexure III of Statement of Industrial Policy without any approval from FIPB. Fur
ther, SEBI registered FVCIs shall be granted a general permission from the excha
nge control angle for inflow and outflow of funds and no prior approval of RBI w
ould be required for pricing, however, there would be ex-post reporting requirem
ent for the amount transacted.
Trading in unlisted equity:
The Board also approved the proposal to permit OTCEI to develop a trading windo
w for unlisted securities where Qualified Institutional Buyers (QIB) would be pe
rmitted to participate.

4.7 Methods of Venture Financing

Venture capital is typically available in three forms in India, they are:
Equity: All VCFs in India provide equity but generally their contribution does n
ot exceed 49 percent of the total equity capital. Thus, the effective control an
d majority ownership of the firm remains with the entrepreneur. They buy shares
of an enterprise with an intention to ultimately sell them off to make capital
gains.
Conditional Loan: It is repayable in the form of a royalty after the venture is
able to generate sales. No interest is paid on such loans. In India, VCFs charge
royalty ranging between 2 to 15 percent; actual rate depends on other factors o
f the venture such as gestation period, cost-flow patterns, riskiness and other
factors of the enterprise.
Income Note: It is a hybrid security which combines the features of both convent
ional loan and conditional loan. The entrepreneur has to pay both interest and r
oyalty on sales, but at substantially low rates.
Other Financing Methods: A few venture capitalists, particularly in the private
sector, have started introducing innovative financial securities like participat
ing debentures, introduced by TCFC is an example.

4.8 Key considerations

For investor/venture capitalist
Ideal entrepreneur
A venture capital (VC) who is financing the firm would as the first necessity as
sess and gauge the promoters. Because in the case of start-up where the product
or the technology is yet to be tested, the only thing they can trust and their i
nvestment on the people behind it. While investing in a company what a VC is ess
entially looking for is a partnership and therefore the first decision making cr
iterion is the character and personality of the promoters.
However from a venture capitalists perspective, the ideal entrepreneur,
1. is qualified in a ‘hot’ area of interest
2. Delivers sales or technical advances such as FDA approval with reasonable pro
bability
3. Tells a compelling story and is presentable to outside investors,
4. recognizes the need for speed to an IPO for liquidity,
5. has a good reputation and can provide references that show competences and sk
ill,
6. Understand the need for a team with a variety of skill and therefore sees why
equity has to
Be allocated to other people
7. Works diligently toward a goal but maintains flexibility
8. Get along with the investor group
9. Understands the cost of capital and typical deal structures and is not offend
ed by them
10. Is sought after by many VCs
11. Has a realistic expectation about process and outcome.
Besides the ideal entrepreneur, the investor tries to ensure the following for h
imself.
1 Reasonable reward given in the level of risk.
2 Sufficient influence on the management of the company through board representa
tion.
3 Minimization of taxes.
4 Ease in achieving future liquidity on the investment.
5 Flexibility of structure that will allow room to enable additional investment
later, incentives
for future management and retention of stocks if management leaves
6 Balance-sheet attractiveness to suppliers and debt financier 7 Retention of k
ey employees through adequate equity participation
4.9 Venture financing practices and procedures
Entrepreneurs who need VC financing for their enterprises should have sufficien
t information to be able to choose a VC company or fund suitable for their requi
rement and have a broad understanding of the procedures required to be followed
for obtaining financial assistance at different stages of implementation of thei
r projects. Basically they need to develop a business plan or prototype to get v
enture finance.
The business plan is document that conveys a company’s prospects and growth pote
ntial, and thereby sells the business to potential backers. The process is to be
managed just as most other business task is managed. It requires advance prepar
ation, delegation, refinement, and disciplines do most important business functi
ons.
Companies are increasingly being called on to provide written business plans, fi
nancial backers, especially VCs and other private investors , have long sought b
usiness plans before making investment decisions. In addition, organization and
individuals considering long term relationships with the companies, large custom
ers, suppliers and distributors are much more inclined to seek written plans.
The business plan process involves gathering accurate and convincing information
as well as carefully outlining the plan before writing. Executives should also
determine what kind of plan they need, ranging from a summary plan full plan or
an operating plan.
Once all these considerations have been formulated, the plan is ready for final
rewriting and presentation. Extensive editing is recommended, along with careful
attention to presentation details like the cover and concerns of its likely rea
der’s .perhaps most important, the plan should be used to guide the company. Thu
s it should be reviewed and updated.
In project appraisal, feasibility of the project is assessed from different ange
ls with stress on production process and marketability, as the lending instituti
ons are backed by the security of movable and immovable assets of the borrower a
nd chiefly concerned with the return of the investment with interest. In venture
capital financing the venture capitalist has a different approach because of eq
uity participation, risk sharing and involvement in the management of project. I
nvestment by a venture capitalist indifferent stage of enterprise calls for an a
nalysis of factors related to each stage.
However, the order of preference followed by the venture capitalists in evalua
ting of business plan is as under:
1. Analysis of management.
2. Analysis of organization pattern.
3. Analysis of production process.
4. Analysis of marketing & sales.
5. Financial analysis and projections.
6. Analysis of reference information.

CHAPTER 5
COMPREHENSIVE
STUDY OF INDIAN
MARKET

5.1 VENTURE CAPITAL & ALTERNATIVE FINANCING COMPARISON

Figure: 5.1 venture capital & alternative financing compar

ison
If we’ are struggling to find success in our quest for venture capital, may be w
e are looking in the wrong place. Venture capital is not for everybody. For star
ters, venture capitalists tend to be very picky about where they invest.
They are looking for something to dump a lot of money into (usually no less than
$1 million) that will pour even more money right back at them in a short amount
of time (typically 3-7 years). We may be planning for a steady growth rate as o
pposed to the booming, overnight success that venture capitalists tend to gravit
ate toward.
We may not be able to turn around as large of a profit as they are looking for i
n quick enough time. We may not need the amount of money that they offer or our
business may simply not be big enough.
Simply put, venture capital is not the right fit for our business and there are
plenty of other options available when it comes to finding capital.

5.1.1 Substitute in Early stage

1. Angels
Most venture capital funds will not consider investing in anything under $1 mil
lion to $2 million. Angels, however, are wealthy individuals who will provide ca
pital for a startup business. These investors have usually earned their money as
entrepreneurs and business managers and can serve as a prime resource for advic
e on top of capital. On the other hand, due to typically limited resources, ange
ls usually have a shorter investment horizon than venture capitalists and tend t
o have less tolerance for losses.
2. Private Placement
An investment bank or agent may be able to raise equity for our company by plac
ing our unregistered securities with accredited investors. However, you should b
e aware that the fees and expenses associated with this practice are generally h
igher than those that come with venture and angel investors. We will likely rece
ive little or no business counsel from private investors who also tend to have l
ittle tolerance for losses and under-performance.
3. Initial Public Offering
If we are somehow able to gain access to public equity markets than an initial
public offering (IPO) can be an effective way to raise capital. Keep in mind tha
t, while the public market’s high valuations, abundant capital and liquidity
Characteristics make it attractive, the transaction costs are high and there are
ongoing legal expenses associated with public disclosure requirements.
5.1.2 Later Stage Financing
1. Bootstrap Financing
This method is intended to develop a foundation for your business from scratch.
Financial management is essential to make this work. With bootstrap financing y
ou’re building a business from nothing, which means there is little to no margin
for error in the finance department. Keep a rigid account of all transactions a
nd don’t stray from your budget.
A few different methods of bootstrapping include :
Factoring, which generates cash flow through the sale of your accounts receivabl
e to a “factor” at a discounted price forscash.
Trade Credit is an option if you are able to find a vendor or supplier that will
allow you to order goods on net 30, 60 or 90 day terms. If you can sell the goo
ds before the bill comes due then you have generated cash flow without spending
anysmoney. Customers can pay you up front our services.
Leasing your equipment instead of purchasing it outright.
2. Fund From Operations
Look for ways to tweak your business in order to reduce the cash flowing out and
increase the cash flowing in. Funding found in business operations come free of
finance charges, can reduce future financing charges and can increase the value
of your business. Month-by-month operating and cash projections will show how w
ell we have planned, how you can optimize the elements of your business that gen
erate cash and allow you to plan for new investments and contingencies.
3. Licensing
Sell licenses to technology that is non-essential to our company or grant limit
ed licensing to essential technology that can be shared. Through outlicensing we
can generate revenue from up-front fees, access fees, royalties or milestone pa
yments.
4. Vendor Financing
Similar to the trade credit related to bootstrap financing, vendors can play a
big role in financing your new business. Establish vendor relationships through
our trade association and strike deals to offer their product and pay for it at
a date in the near future. Selling the product in time is up to us. In hopes of
keeping you as a customer, vendors may also be willing to work out an arrangemen
t if we need to finance equipment or supplies. Just make sure to look for stabil
ity when you research a vendor’s credentials and reputation before you sign any
kind of agreement. And keep in mind that many major suppliers (GE Small Business
Solutions, IBM Global Financing) own financial companies that can help you.
5. Self Funding
Search between the couch cushions and in old jacket pockets for whatever extra
money you might have lying around and invest it into your business. Obviously lo
ose change will not be enough for extra business funding, but take a look at you
r savings, investment portfolio, retirement funds and employee buyout options fr
om your previous employer. You won’t have to deal with any creditors or interest
and the return on your investment could be much higher.
However, make sure that you consider the risks involved with using your own reso
urces. How competitive is the market that you are about to enter into? How long
will it take to pay yourself back? Will you be able to pay yourself back? Can yo
u afford to lose everything that you are investing if your business were to fail
?
It’s important that your projected returns are more than enough to cover the ris
k that you will be taking.
6. SBIR and STTR Programs
Coordinated by the SBA, SBIR (Small Business Innovation Research) and STTR (Sma
ll business Technology Transfer) programs offer competitive federal funding awar
ds to stimulate technological innovation and provide opportunities for small bus
inesses. You can learn more about these programs at SBIRworld.com.
7. State Funding
If you’re not having any luck finding funding from the federal government take
a look at what your state has to offer. There is a list of links to state develo
pment agencies that offer an array of grants and financial assistance for small
businessessonsAbout.com..
8. Community Banks
These smaller banks may have fewer products than their financial institution co
unterparts but they offer a great opportunity to build banking relationships and
are generally more flexible with payment plans and interest rates.
9. Microloans
These types of loans can range from hundreds of dollars to low six-figure amoun
ts. Although some lenders regard microloans to be a waste of time because the am
ount is so low, these can be a real boon for a start-up business or one that jus
t needs to add some extra cash flow.
10. Finance Debt
It may be more expensive in the long run than purchasing, but financing your eq
uipment, facilities and receivables can free up cash in the short term or reduce
the amount of money that you need to raise.
11. Friends
Ask your friends if they have any extra money that they would like to invest. A
ssure them that you will pay them back with interest or offer them stock options
or a share of the profits in return.
12. Family
Maybe you have a rich uncle or a wealthy cousin that would be willing to lend y
ou some money get your business running or send it to the next level. Again, mak
e it worth their while by offering interest, stocks or a share of the profits.
13. Form A Strategic Alliance
Aligning your business with a corporation can produce funding from upfront or a
ccess fees to your service, milestone payments and royalties. In addition, corpo
rate partners may be able to provide research funding, loans and equity investme
nts.
14. Sell Some Assets
Find an interested party to buy some of your assets (computers, equipment, real
estate, etc…) and then lease them back to you. This provides an instant source o
f cash and you will still be able to use whatever assets you need.
15. Business Lines of Credit
If your business has positive cash flow and has proven that it will cover its d
ebts then you may be eligible for a business line of credit. This type of financ
ing is a common service offered by most business banks and serves as business ca
pital, up to an agreed upon amount, that you can access at any time.
16. Personal Credit Cards
Using personal credit cards to finance a business can be risky but, if you take
the right approach, they can also give your business a lift. You should only co
nsider using this type of financing for acquiring assets and working capital. Ne
ver consider this to be a long-term option. Once your company breaks even or mov
es into the black, ditch the credit cards and move toward traditional bank finan
cing or lease agreements.
17. Business Credit Cards
Business credit cards carry similar risks as personal credit cards but tend to
be a safer alternative. While the activity on this card goes toward your credit
report, a business credit card can help you to build business credit, keep your
business expenses separate from your personal expenses and can make tax season e
asier to manage.

5.2 PEST ANALYSIS:

5.2.1 Political factors:
Venture Capital being a very sensitive institutional form due to the high-risk n
ature of its investments it was prerequisite for the government to be careful to
ensure that its policies do not adversely affect its venture capitalists. There
are number of rules and regulation for VC and these would broadly come under ei
ther of the following heads:
• The Indian Trust Act, 1882 or the company Act,1956 depending on whether the fu
nd is set up as a trust or a company.
• The foreign investment Promotion Board (FIPB) and the RBI in case of an offsho
re fund. These funds have to secure the permission of the FIPB while setting up
in India and need a clearance from the RBI for any repatriation of income.
• The Central Board of Direct Taxation (CBDT) governs the issues pertaining to i
ncome tax on the proceed from VC funding activity. The long term capital gain ta
x is at around 10% in India and the relevant clauses to VC may be found in Secti
on 10(sub section 23)

Figure: 5.2 Major Regulatory frame works for venture capital

industry
Minimum contribution and fund size: the minimum investment in a Venture
Capital Fund from any investor will not be less than Rs. 5 lacs and the minimum
corpus of the fund before the fund can start activities shall be at least Rs. 5
crores.
Short term capital gain: Rate of tax on short term capital gains under S
ection 111A & Section 115AD increased to 15 per cent from earlier 10%
Investment Criteria : The earlier investment criteria has been substitut
ed by a 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:
c. 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;
d. 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 und
er 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 Capi
tal Undertaking.
Disclosure and Information to Investors: In order to simplify and expedi
te the process of fund raising, the requirement of filing the Placement memorand
um 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 i
nvestors along with the details of the fund raised for information to SEBI. Furt
her, the contents of the Placement Memorandum are strengthened to provide adequa
te disclosure and information to investors. SEBI will also prescribe suitable re
porting requirement from the fund on their investment activity.
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 by promot
ers/companies from the state level financial institutions and shall be exempt fr
om making an open offer to other shareholders.
Investments by Mutual Funds in Venture Capital Funds: In order to increa
se the resources for domestic venture capital funds, mutual funds are permitted
to invest upto 5% of its corpus in the case of open ended schemes and upto 10% o
f its corpus in the case of close ended schemes. Apart from raising the resource
s for Venture Capital Funds this would provide an opportunity to small investors
to participate in Venture Capital activities through mutual funds.
Government of India Guidelines: The Government of India (MOF) Guidelines
for Overseas Venture Capital Investment in India dated September 20, 1995 will
be repealed by the MOF on notification of SEBI Venture Capital Fund Regulations.

GUIDELINES FOR OVERSEAS VENTURE CAPITAL INVESTMENT IN INDIA

In recognition of growing importance of Venture Capital as one of the sources o
f finance for Indian industry, particularly for the smaller unlisted companies,
the Government has announced a policy governing the establishment of domestic Ve
nture Capital Funds/Companies. An amendment has also been carried out in the SEB
I Act empowering the Securities and Exchange Board of India (SEBI) to register a
nd regulate Venture Capital Funds (VCFs) and Venture Capital Companies (VCCs) th
rough specific regulations.
With a view to augment the availability of Venture Capital, the Government has d
ecided to allow overseas venture capital investments in India subject to suitabl
e guidelines as outlined below:
a. Offshore investment may invest in approved domestic Venture Capital Fund
s/Companies set up under the new policy after obtaining FIPB approval for the in
vestment. There is no limit to the extent of foreign contribution to a domestic
venture capital company/ fund. An offshore venture capital company may contribut
e 100% of the capital of domestic venture capital fund, and may also set up a do
mestic asset management company to manage the Fund.
b. Establishment of an asset management company with foreign investment to
manage such funds would require FIPB approval and would be subject to the existi
ng norms for foreign investment in non-bank financial services companies.
c. Once the initial FIPB approval has been obtained, the subsequent investm
ent by the domestic venture capital company/fund in Indian companies will not re
quire FIPB approval. Such investments will be limited only by the general restri
ction applicable to venture capital companies viz.-
i. A minimum lock-in period of three years will apply to all such investmen
ts.
ii. VCFs and VCCs shall invest only in unlisted companies and their investme
nt shall be limited to 40% of the paid up capital of the company. The ceiling wi
ll be subject to relevant equity investment limits that may be in force from tim
e to time in relation to areas reserved for the Small Scale Sector.
iii. Investment in any single company by a VCF/VCC shall not exceed 20% of t
he paid-up
d. Corpus of the domestic VCF/VCC. d. The tax exemption available to domes
tic VCFs and VCCs under Section 10(23F) of the Income Tax Act, 1961, will also b
e extended to domestic VCFs and VCCs which attract overseas venture capital inve
stments provided these VCFs/VCCs conform to the guidelines applicable for domest
ic VCFs/VCCs. However, if the VCF/VCC is willing to forego the tax exemptions av
ailable under Section 10(23F) of the Income Tax Act, it would be within its righ
ts to invest in any sector.
e. e. Income paid to offshore investors from Indian VCFs/VCCs will be subje
ct to tax as per the normal rates applicable to foreign investors.
f. f. Offshore investors may also invest directly in the equity of unlisted
Indian companies without going through the route of a domestic VCF/VCC. However
, in such cases each investment will be treated as a separate act of foreign inv
estment and will require separate approval as required under the general policy
for foreign investment proposals.
Hassle free entry/exit for foreign venture capital firm
SEBI registered Foreign Venture Capital Investors shall be permitted to make in
vestment on an automatic route within the overall sectorial ceiling of foreign i
nvestment under Annexure III of Statement of Industrial Policy without any appro
val from FIPB. Further, SEBI registered FVCIs shall be granted a general permiss
ion from the exchange control angle for inflow and outflow of funds and no prior
approval of RBI would be required for pricing, however, there would be ex-post
reporting requirement for the amount transacted.
DTAT (Double Tax Avoidance Treaties)
Foreign funds investing in India directly into Indian portfolio companies will n
ot be affected by the proposed amendment. As most of these funds have been set u
p in tax neutral jurisdictions like Mauritius, they will continue to enjoy tax e
xemption on capital gains tax under the Double Tax Avoidance Agreements, effecti
vely getting the equivalent of a “pass through” notwithstanding which sector the
y invest in.
Controller of Capital Issue
The exist route available to the venture capitalist were restricted to the IPO r
oute. Pricing of the issue was dependent on Controller of Capital Issues (CCI) r
egulations before deregulations. Many of the issues were underpriced. Failure of
OTCEOI so small companies could not hope for BSE/NSE listing.
REALXATION IN IPO NORMS :
The SEBI norms for an IPO by a Venture Capital company / fund be relaxed. The r
equirement of three years track record should be waived off for a Venture Capita
l company / fund registered with SEBI. This will help the Venture Capital compan
y / fund to generate resources locally. .
SEBI registered VCFs have been permitted to invest in equity and equity
linked instruments of offshore venture capital undertakings, subject to overall
limit of USD 500 million and with prior SEBI approval. Investment can be made on
ly in those companies which have an Indian connection and the investment can not
exceed 10% of the VCFs investible funds.
Taxes on emerging sector: As per Union Budget 2007 and its broad guideli
nes, Government proposed to limit pass-through status to venture capital funds (
VCFs) making investment in nine areas. These nine areas are biotechnology, infor
mation technology, nanotechnology, seed research and development, R&D for pharma
sectors, dairy industry, poultry industry and production of bio-fuels. Pass-thr
ough status means that the incomes earned by funds are taxable now.
Liberalization: With the advent of liberalization, India has been showin
g remarkable growth in the economy in the past 10 - 12 years. The government is
promoting growth in capacity utilization of available and acquired resources and
hence entrepreneurship development, by liberalizing norms regarding venture cap
ital. In the year 2000, the finance ministry announced the liberalization of tax
treatment for venture capital funds to promote them & to increase job creation.
This is expected to give a strong boost to the non resident Indians located in
the Silicon valley and elsewhere to invest some of their capital, knowledge and
enterprise in these ventures.
5.2.2
ECONOMIC FACTORS:
MERGER & ACQUISITION:
Venture backed liquidity events by year 2001-2008 through M&A
Table: 5.1 Venture backed liquidity events by year 2001-2008 through M&A
MERGERS AND ACQUISITIONS VOLUME DECLINES
In the second quarter of 2008, 50 venture-backed M&A deals were completed, 14 o
f which had an aggregate deal value of $2.4 billion. M&A volume of 120 transacti
ons in the first half of 2008 was down 28 percent from the first half of 2007 wh
en 169 transactions were completed. The average disclosed deal value for the qua
rter was $171.2 million. Due to this V/C is directly affected negatively because
M&A is the exit route for Venture capital industry. The reason behind decreasin
g No. of M&A deals is crash down of SENSEX by 51%

Table:5.2 Number of IPOs during 2002-2008

Here the No. of IPO is decreased in first two quarter of 2008 as compared to fir
st two quarter of previous two years. The no. of IPO in 1st two quarter of 2007
are 43 and in first two quarter of 2008 are only 5 IPO. Because due to crash dow
n of IPO nobody like to bring IPO. IPO is the exist route for venture capital co
mpany. It comes a barrier for venture capital to exist from a venture capital.
INFLATION RATE
Source : www.rbi.org.in,Macroeconomic and Monetary Development, annual statemen
t on monetary policy, First Quarter Review 2008-09
Figure: 5.4 Inflation V/S Venture capital growt
h rate
IMPACT
In above chart the inflation rate is decreased to 4.5 in 2005 from 7.4 in 2004.
At same time the growth of VC is also declining to 33.33% in 2005 from 251.06%
in 2004. From the above chart we can conclude that inflation and VC has positive
relationship. Now in June 2008 the inflation rate was 11.9 and the NO. of deal
in first two quarter in 2008 was 170 and value of deal was 6390 US$mn and in thi
rd quarter of 2008 there was only four deals. And in October the inflation touch
the 13.01%. Due to increase in inflation rate the people will going to spend mo
re. Thus, their savings will decrease. So more money will come into the market a
nd demand of the products will increase continuously. now due to growth of any s
ector will attract new entrepreneur to enter in the industry. For that they must
 need funds. So there is a great opportunity for venture capital industry to att
ract this new entrepreneur.
GDP GROWTH RATE

Source: CII (Confederation of Indian Indust

ry) July 2008 Presentation
Figure: 5.5 GDP V/S Venture capital growth rate
IMPACT
In above chart there was a positive relation ship there was between GDP growth
rate. But in 2007 the growth of VC was decline to 89.79% from 240.91% in 2006 bu
t here the value of deal was increasing. In 2008 the growth rate is 9% and proje
ct the next year GDP 8% to 9%. So there is a hope, the growth of VC industry can
be increased.
India is the 4th largest economy in terms of PPP. GDP of India is US$ 3787.3 bil
lion in PPP terms.
Taking Indian Purchasing Power Parity (PPP) into consideration, this would be eq
uivalent to $22 billion worth of investment in the US.
Since about $1.75 billion (or approximately 40% of $4.4 billion) has been alread
y raised, even if only $2.2 billion is raised by December 2006.
Evalue serve cautions that there will be a glut of VC money for earlystage inves
tments in India. This will be especially true if the VCs continue to invest only
in currently favourite sectors such as IT, BPO, software and hardware products,
telecom, and consumer Internet.