Concept Game

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MRP on venture capital industry in India

CHAPTER 1

INTRODUCTION OF

PROJECT NAME

S.V .Institute Of Management, Kadi 1


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1.1 Objective GAME:

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 Venturecapital activity in Indian Economy.

To find out opportunity and threats those hinder and encourage Venture CapitalIndustry in India.

To know the impact of political and economical factors on Venture Capitalinvestment.

1.2 Limitation of project

Limitations:

A study of this type cannot be without limitations. It has been observed that venture capitalsare very secretive about their performance as well as about their investments. This attitudehas been a major hurdle in data collection. However venture capital funds/companies that

are members of Indian venture capital association are included in the study. Financialanalysis has been restricted by and large to members of IVCA.

1.3 Design & Instruments

In India neither venture capital theory has been developed nor are there manycomprehensive books on the subject. Even the number of research papers available is verylimited. The research design used is descriptive in nature. (The attempt has been made tocollect maximum facts and figures available on the availability of venture capital in India,

nature of assistance granted, future projected demand for this financing, analysis of theproblems faced by the entrepreneurs in getting venture capital, analysis of the venturecapitalists and social and environmental impact on the existing framework.)

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

Scanning the business papers filled the gaps in information. The Economic times, FinancialExpress and Business Standards were scanned for any article or news item related toventure capital. Sufficient amount of data about the venture capital has been derived fromthese reports.



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Scope POWER:

The scope of the research includes all type of venture capital firms whether setup as acompany or a trust fund. Venture capital companies and funds irrespective of the fact thatthey are registered with SEBI of India or not are part of this study. Angel investors have

been kept out of the study as it was not feasible to collect authenticated information aboutthem.



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CHAPTER 2

CONCEPT GAME

2.1 Concept of Venture Capital



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The term venture capital comprises of two words that is, Venture and Capital. Ventureis a course of processing, the outcome of which is uncertain but to which is attended therisk or danger of loss. Capital means recourses to start an enterprise. To connote therisk and adventure of such a fund, the generic name Venture Capital was coined.

Venture capital is considered as financing of high and new technology based enterprises. Itis said that Venture capital involves investment in new or relatively untried technology,initiated by relatively new and professionally or technically qualified entrepreneurs withinadequate funds. The conventional financiers, unlike Venture capitals, mainly finance

proven technologies and established markets. However, high technology need not be pre-requisite for venture capital.

Venture capital has also been described as unsecured risk financing. The relatively highrisk of venture capital is compensated by the possibility of high returns usually throughsubstantial capital gains in the medium term. Venture capital in broader sense is not solelyan 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 associationwith successive stages of companys development under highly risk investment conditions,with distinctive type of financing appropriate to each stage of development. Investors jointhe entrepreneurs as co-partners and support the project with finance and business skills toexploit the market opportunities.

Venture capital is not a passive finance. It may be at any stage of business/production cycle,that is, start up, expansion or to improve a product or process, which are associated with

both risk and reward. The Venture capital makes higher capital gains through appreciationin the value of such investments when the new technology succeeds. Thus the primaryreturn sought by the investor is essentially capital gain rather than steady interest income ordividend yield.

The most flexible definition of Venture capital is-

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

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

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

2.2 Features of Venture Capital

2.2.1 High Risk



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By definition the Venture capital financing is highly risky and chances of failure are high asit provides long term start up capital to high risk-high reward ventures. Venture capitalassumes 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 inincreased cost decreased gross margins.

2.2.2 High TechAs opportunities in the low technology area tend to be few of lower order, and hi-tech

projects generally offer higher returns than projects in more traditional areas, venturecapital investments are made in high tech. areas using new technologies or producinginnovative goods by using new technology. Not just high technology, any high riskventures where the entrepreneur has conviction but little capital gets venture finance.Venture capital is available for expansion of existing business or diversification to a highrisk area. Thus technology financing had never been the primary objective but incidental toventure capital.

2.2.3 Equity Participation & Capital Gains

Investments are generally in equity and quasi equity participation through direct purchaseof shares, options, convertible debentures where the debt holder has the option to convertthe loan instruments into stock of the borrower or a debt with warrants to equityinvestment. The funds in the form of equity help to raise term loans that are cheaper sourceof funds. In the early stage of business, because dividends can be delayed, equityinvestment implies that investors bear the risk of venture and would earn a returncommensurate with success in the form of capital gains.

2.2.4 Participation In Management

Venture capital provides value addition by managerial support, monitoring and follow upassistance. It monitors physical and financial progress as well as market developmentinitiative. It helps by identifying key resource person. They want one seat on the companys

board of directors and involvement, for better or worse, in the major decision affecting thedirection of company. This is a unique philosophy of hands on management whereVenture capitalist acts as complementary to the entrepreneurs. Based upon the experienceother companies, a venture capitalist advise the promoters on project planning, monitoring,financial management, including working capital and public issue. Venture capital investor

cannot interfere in day today management of the enterprise but keeps a close contact withthe promoters or entrepreneurs to protect his investment.



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2.2.5 Length of Investment

Venture capitalist help companies grow, but they eventually seek to exit the investment inthree to seven years. An early stage investment may take seven to ten years to mature, while

most of the later stage investment takes only a few years. The process of having significantreturns takes several years and calls on the capacity and talent of venture capitalist andentrepreneurs to reach fruition.

2.2.6 Illiquid Investment

Venture capital investments are illiquid, that is, not subject to repayment on demand orfollowing a repayment schedule. Investors seek return ultimately by means of capital gainswhen the investment is sold at market place. The investment is realized only on enlistmentof security or it is lost if enterprise is liquidated for unsuccessful working. It may takeseveral years before the first investment starts to locked for seven to ten years. Venture

capitalist understands this 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 industrieswithout much consideration of use of new technology or new entrepreneurial venture buthaving a focus on underdeveloped areas (locations). In majority of cases it is in the form of

loan capital and proportion of equity is very thin. Development finance is security orientedand liquidity prone. The criteria for investment are proven track record of company and itspromoters, and sufficient cash generation to provide for returns (principal and interest). Thedevelopment bank safeguards its interest through collateral.

They have no say in working of the enterprise except safeguarding their interest by having anominee director. They do not play any active role in the enterprise except ensuring flow ofinformation and proper management information system, regular board meetings,adherence to statutory requirements for effective management control where as Venturecapitalist remain interested if the overall management of the project o account of high riskinvolved I the project till its completion, entering into production and making available

proper exit route for liquidation of the investment. As against this fixed payments in theform of installment 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 asthe latter two form part of broader meaning of Venture capital. Difference between themarises on account of application of funds and terms and conditions applicable. The seedcapital and risk funds in India are being provided basically to arrange promoterscontribution to the project. The objective is to provide finance and encourage professionalsto become promoters of industrial projects. The seed capital is provided to conventional

projects on the consideration of low risk and security and use conventional techniques forappraisal. Seed capital is normally in the form of low interest deferred loan as against



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equity investment by Venture capital. Unlike Venture capital, Seed capital providers neitherprovide any value addition nor participate in the management of the project. Unlike Venturecapital Seed capital provider is satisfied with low risk-normal returns and lacks anyflexibility in its approach.

Risk capital is also provided to established companies for adapting new technologies.Herein the approach is not business oriented but developmental. As a result on one hand thesuccess rate of units assisted by Seed capital/RiskFinance has been lower than those provided with venture capital. On the other hand thereturn to the seed/risk capital financier had been very low as compared to venture capitalist.

Seed Capital Scheme Venture capital SchemeBasis Income or aid Commercial viabilityBeneficiaries Very small entrepreneurs Medium and large

entrepreneurs are alsocovered

Size of assistance Rs. 15 Lac (Max) Up to 40 percent of promoters equity

Appraisal process Normal Skilled and specializedEstimates returns 20 percent 30 percent plusFlexibility Nil Highly flexibleValue addition Nil Multiple waysExit option Sell back to promoters Several ,including Public

offerFunding sources Owner funds Outside contribution allowed

Syndication Not done PossibleTax concession Nil ExemptedSuccess rate Not good Very satisfactory

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

2.3.3 Venture Capital Vs Bought Out Deals

The important difference between the Venture capital and bought out deals is that bought-outs are not based upon high risk- high reward principal. Further unlike Venture capital

they do not provide equity finance at different stages of the enterprise. However both have acommon expectation of capital gains yet their objectives and intents are totally different.

2.4 The Venture Capital

The growth of an enterprise follows a life cycle as shown in the diagram below. Therequirements of funds vary with the life cycle stage of the enterprise. Even before a

business plan is prepared the entrepreneur invests his time and resources in surveying themarket, finding and understanding the target customers and their needs. At the seed stage



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the entrepreneur continue to fund the venture with his own or family funds. At this stage thefunds are needed to solicit the consultants services in formulation of business plans,meeting potential customers and technology partners. Next the funds would be required fordevelopment of the product/process and producing prototypes, hiring key people and

building up the managerial team. This is followed by funds for assembling the

manufacturing and marketing facilities in that order. Finally the funds are needed to expandthe business and attaint the critical mass for profit generation. Venture capitalists cater tothe needs of the entrepreneurs at different stages of their enterprises. Depending upon thestage they finance, venture capitalists are called angel investors, venture capitalist or privateequity supplier/investor.

Figure 2.1: Venture Capital Spectrum

Venture capital was started as early stage financing of relatively small but rapidly growingcompanies. However various reasons forced venture capitalists to be more and moreinvolved in expansion financing to support the development of existing portfoliocompanies. With increasing demand of capital from newer business, Venture capitalists

began to operate across a broader spectrum of investment interest. This diversity ofopportunities enabled Venture capitalists to balance their activities in term of timeinvolvement, risk acceptance and reward potential, while providing on going assistance todeveloping business.


FamilyPartners

IPO

Start up

PersonalAngelInvestor

VentureCapital

PrivateEquity

PublicEquity

Public Equity forRestructuringBuyouts

TimeConcept

Product

Development

Expansion

Building a sustainable business

BusinessPlan

Seed Capital


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

1. Early Stage Finance

Seed Capital Start up Capital Early/First Stage Capital Later/Third Stage Capital

2. Later Stage Finance Expansion/Development Stage Capital Replacement Finance

Management Buy Out and Buy ins Turnarounds Mezzanine/Bridge Finance

Not all business firms pass through each of these stages in a sequential manner. Forinstance seed capital is normally not required by service based ventures. It applies largely tomanufacturing or research based activities. Similarly second round finance does not alwaysfollow early stage finance. If the business grows successfully it is likely to developsufficient 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 financeSeed

7-10 Extreme For supporting a concept or idea or R & D for productdevelopment

Start up 5-9 Very high Initializing operations or developing prototypes

First stage 3-7 High Start commercial productionand marketingSecond stage 3-5 Sufficiently

highExpand market & growingworking capital need

Later stage finance 1-3 Medium Market expansion,acquisition & productdevelopment for profitmaking company

Buy out-in 1-3 Medium Acquisition financing

Turnaround 3-5 Medium to high Turning around a sick

companyMezzanine 1-3 Low Facilitating public issue



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Table 2.2: Venture Capital- Financing Stages

2.4.1 Seed Capital

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

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

Absence of ready product market Absence of complete management team Product/ process still in R & D stage Initial period / licensing stage of technology transfer

Broadly speaking seed capital investment may take 7 to 10 years to achieve realization. It isthe earliest and therefore riskiest stage of Venture capital investment. The new technologyand 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 theiradaptation, commencement and eventual success. However, while the earliest stage offinancing is fraught with risk, it also provides greater potential for realizing significantgains in long term. Typically seed enterprises lack asset base or track record to obtainfinance from conventional sources and are largely dependent upon entrepreneurs personalresources. Seed capital is provided after being satisfied that the entrepreneur has used up hisown resources and carried out his idea to a stage of acceptance and has initiated research.

The asset underlying the seed capital is often technology or an idea as opposed to humanassets (a good management team) so often sought by venture capitalists.

Volume of Investment Activity

It has been observed that Venture capitalist seldom make seed capital investment and theseare relatively small by comparison to other forms of venture finance. The absence ofinterest in providing a significant amount of seed capital can be attributed to the followingthree factors: -

a) Seed capital projects by their very nature require a relatively small amount of capital.

The success or failure of an individual seed capital investment will have little impact onthe performance of all but the smallest venture capitalists portfolio. Larger venturecapitalists avoid seed capital investments. This is because the small investments areseen to be cost inefficient in terms of time required to analyze, structure and managethem.

b) The time horizon to realization for most seed capital investments is typically 7-10 yearswhich is longer than all but most long-term oriented investors will desire.

c) The risk of product and technology obsolescence increases as the time to realization isextended. These types of obsolescence are particularly likely to occur with high

technology investments particularly in the fields related to Information Technology.



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2.4.2 Start up Capital

It is stage 2 in the venture capital cycle and is distinguishable from seed capitalinvestments. An entrepreneur often needs finance when the business is just starting. The

start up stage involves starting a new business. Here in the entrepreneur has moved closertowards establishment of a going concern. Here in the business concept has been fullyinvestigated and the business risk now becomes that of turning the concept into product.

Start up capital is defined as: Capital needed to finance the product development, initialmarketing and establishment of product facility.

The characteristics of start-up capital are:-

i. Establishment of company or business. The company is either being organized or isestablished recently. New business activity could be based on experts, experience or a spin-

off from R & D.

ii. Establishment of most but not all the members of the team. The skills and fitness tothe job and situation of the entrepreneurs team is an important factor for start up finance.

iii. Development of business plan or idea. The business plan should be fully developedyet the acceptability of the product by the market is uncertain. The company has not yetstarted trading.

In the start up preposition venture capitalists investment criteria shifts from idea to peopleinvolved in the venture and the market opportunity. Before committing any finance at thisstage, Venture capitalist however, assesses the managerial ability and the capacity of theentrepreneur, besides the skills, suitability and competence of the managerial team are alsoevaluated. If required they supply managerial skills and supervision for implementation.The time horizon for start up capital will be typically 6 or 8 years. Failure rate for start up is2 out of 3. Start up needs funds by way of both first round investment and subsequentfollow-up investments. The risk tends t be lower relative to seed capital situation. The riskis controlled by initially investing a smaller amount of capital in start-ups. The decision onadditional financing is based upon the successful performance of the company. However,the term to realization of a start up investment remains longer than the term of financenormally provided by the majority of financial institutions. Longer time scale for using exit

route demands continued watch on start up projects.

Volume of Investment Activity

Despite potential for specular returns most venture firms avoid investing in start-ups. Onereason for the paucity of start up financing may be high discount rate that venture capitalistapplies to venture proposals at this level of risk and maturity. They often prefer to spreadtheir risk by sharing the financing. Thus syndicates of investors often participate in start upfinance.

2.4.3 Early Stage Finance



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

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

British Venture Capital Association has vividly defined early stage finance as: Financeprovided to companies that have completed the product development stage and requirefurther funds to initiate commercial manufacturing and sales but may not be generating

profits.

The characteristics of early stage finance may be: -

Little or no sales revenue. Cash flow and profit still negative. A small but enthusiastic management team which consists of people with technical

and specialist background and with little experience in the management of growingbusiness.

Short term prospective for dramatic growth in revenue and profits.

The early stage finance usually takes 4 to 6 years time horizon to realization. Early stagefinance is the earliest in which two of the fundamentals of business are in place i.e. fullyassembled management team and a marketable product. A company needs this round of

finance because of any of the following reasons: -

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

The firm needs additional equity funds, which are not available from other sources thusprompting venture capitalist that, have financed the start up stage to provide furtherfinancing. The management risk is shifted from factors internal to the firm (lack ofmanagement, lack of product etc.) to factors external to the firm (competitive pressures, insufficient will of financial institutions to provide adequate capital, risk of productobsolescence etc.)

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

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

a) The early stage firms may have drawn the attention of andincurred the challenge of a larger competition.



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

2.4.4 Second Stage Finance

It is the capital provided for marketing and meeting the growing working capital needs ofan enterprise that has commenced the production but does not have positive cash flowssufficient to take care of its growing needs. Second stage finance, the second trench ofEarly State Finance is also referred to as follow on finance and can be defined as the

provision of capital to the firm which has previously been in receipt of external capital butwhose financial needs have subsequently exploded. This may be second or even thirdinjection of capital.

The characteristics of a second stage finance are:

A developed product on the market A full management team in place Sales revenue being generated from one or more products There are losses in the firm or at best there may be a break even but thesurplus generated is insufficient to meet the firms needs.

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

Negative reasons include:

I Cost overruns in market development.II Failure of new product to live up to sales forecast.III Need to re-position products through a new marketing

campaign.IV Need to re-define the product in the market place once the

product deficiency is revealed.

Positive reasons include:

I Sales appear to be exceeding forecasts and the enterprise needs to acquire assets to gearup for production volumes greater than forecasts.II High growth enterprises expand faster than their working capital permit, thus

needing additional finance. Aim is to provide working capital for initial expansion of anenterprise to meet needs of increasing stocks and receivables.

It is additional injection of funds and is an acceptable part of venture capital. Oftenprovision for such additional finance can be included in the original financing package asan option, subject to certain management performance targets.

2.4.5 Later Stage Finance



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

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

Funds are utilized for further plant expansion, marketing, working capital or developmentof improved products. Third stage financing is a mix of equity with debt or subordinatedebt. As it is half way between equity and debt in US it is called mezzanine finance. It isalso called last round of finance in run up to the trade sale or public offer.

Venture capitalist s prefer later stage investment vis a vis early stage investments, as therate of failure in later stage financing is low. It is because firms at this stage have a past

performance data, track record of management, established procedures of financial control.The time horizon for realization is shorter, ranging from 3 to 5 years. This helps the venturecapitalists to balance their own portfolio of investment as it provides a running yield toventure capitalists. Further the loan component in third stage finance provides taxadvantage and superior return to the investors.

There are four sub divisions of later stage finance.

Expansion / Development Finance Replacement Finance

Buyout Financing Turnaround Finance

Expansion / Development Finance

An enterprise established in a given market increases its profits exponentially by achievingthe economies of scale. This expansion can be achieved either through an organic growth,that is by expanding production capacity and setting up proper distribution system or byway of acquisitions. Anyhow, expansion needs finance and venture capitalists support bothorganic growth as well as acquisitions for expansion.

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

Realization horizon for expansion / development investment is one to three years. It isfavored by venture capitalist as it offers higher rewards in shorter period with lower risk.Funds are needed for new or larger factories and warehouses, production capacities,developing improved or new products, developing new markets or entering exports byenterprise with established business that has already achieved break even and has startedmaking profits.

Replacement Finance



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It means substituting one shareholder for another, rather than raising new capital resultingin the change of ownership pattern. Venture capitalist purchase shares from theentrepreneurs and their associates enabling them to reduce their shareholding in unlistedcompanies. They also buy ordinary shares from non-promoters and convert them 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 makesa capital gain in a period of 1 to 5 years.

Buy - out / Buy - in Financing

It is a recent development and a new form of investment by venture capitalist. The fundsprovided to the current operating management to acquire or purchase a significant shareholding in the business they manage are called management buyout.

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

It is the most popular form of venture capital amongst later stage financing. It is less riskyas venture capitalist in invests in solid, ongoing and more mature business. The funds are

provided for acquiring and revitalizing an existing product line or division of a majorbusiness. MBO (Management buyout) has low risk as enterprise to be bought have existedfor some time besides having positive cash flow to provide regular returns to the venturecapitalist, who structure their investment by judicious combination of debt and equity. Oflate there has been a gradual shift away from start up and early finance to wards MBOopportunities. This shift is because of lower risk than start up investments.

Turnaround Finance

It is rare form later stage finance which most of the venture capitalist avoid because ofhigher degree of risk. When an established enterprise becomes sick, it needs finance as wellas management assistance foe a major restructuring to revitalize growth of profits.Unquoted company at an early stage of development often has higher debt than equity; itscash flows are slowing down due to lack of managerial skill and inability to exploit themarket potential. The sick companies at the later stages of development do not normallyhave high debt burden but lack competent staff at various levels. Such enterprises arecompelled to relinquish control to new management. The venture capitalist has to carry outthe recovery process using hands on management in 2 to 5 years. The risk profile and

anticipated rewards are akin to early stage investment.

Bridge Finance

It is the pre-public offering or pre-merger/acquisition finance to a company. It is the lastround of financing before the planned exit. Venture capitalist help in building a stable andexperienced management team that will help the company in its initial public offer. Most of

the time bridge finance helps improves the valuation of the company. Bridge finance often



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has a realization period of 6 months to one year and hence the risk involved is low. Thebridge finance is paid back from the proceeds of the public issue.

2.5 Capital Investment Process

Venture capital investment process is different from normal project financing. In order tounderstand the investment process a review of the available literature on venture capitalfinance is carried out. Tyebjee and Bruno in 1984 gave a model of venture capitalinvestment activity which with some variations is commonly used presently.

As per this model this activity is a five step process as follows:

1. Deal Organization2. Screening3. Evaluation or due Diligence4. Deal Structuring5. Post Investment Activity and Exit



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Figure 2.2: Venture Capital Investment Process



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Deal origination:

In generating a deal flow, the VC investor creates a pipeline of deals or investmentopportunities that he would consider for investing in. Deal may originate in various ways.referral system, active search system, and intermediaries. Referral system is an important

source of deals. Deals may be referred to VCFs by their parent organisaions, trade partners,industry associations, friends etc. Another deal flow is active search through networks,trade fairs, conferences, seminars, foreign visits etc. Intermediaries is used by venturecapitalists in developed countries like USA, is certain intermediaries who match VCFs andthe potential entrepreneurs.

Screening:

VCFs, before going for an in-depth analysis, carry out initial screening of all projects on thebasis of some broad criteria. For example, the screening process may limit projects to areasin which the venture capitalist is familiar in terms of technology, or product, or market

scope. The size of investment, geographical location and stage of financing could also beused as the broad screening criteria.

Due Diligence:

Due diligence is the industry jargon for all the activities that are associated with evaluatingan investment proposal. The venture capitalists evaluate the quality of entrepreneur beforeappraising the characteristics of the product, market or technology. Most venture capitalistsask for a business plan to make an assessment of the possible risk and return on the venture.Business plan contains detailed information about the proposed venture. The evaluation ofventures by VCFs in India includes;

Preliminary evaluation: The applicant required to provide a brief profile of the proposedventure to establish prima facie eligibility.

Detailed evaluation: Once the preliminary evaluation is over, the proposal is evaluated ingreater detail. VCFs in India expect the entrepreneur to have:- Integrity, long-term vision,urge to grow, managerial skills, commercial orientation.

VCFs in India also make the risk analysis of the proposed projects which includes: Productrisk, Market risk, Technological risk and Entrepreneurial risk. The final decision is taken in

terms of the expected risk-return trade-off as shown in Figure.

Deal Structuring:

In this process, the venture capitalist and the venture company negotiate the terms of thedeals, that is, the amount, form and price of the investment. This process is termed as dealstructuring. The agreement also include the venture capitalist's right to control the venturecompany and to change its management if needed, buyback arrangements, acquisition,making initial public offerings (IPOs), etc. Earned out arrangements specify theentrepreneur's equity share and the objectives to be achieved.



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Post Investment Activities:

Once the deal has been structured and agreement finalised, the venture capitalist generallyassumes the role of a partner and collaborator. He also gets involved in shaping of thedirection of the venture. The degree of the venture capitalist's 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 venturecapitalist 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 initialinvestment. They play a positive role in directing the company towards particular exitroutes. A venture may exit in one of the following ways:

There are four ways for a venture capitalist to exit its investment:

Initial Public Offer (IPO) Acquisition by another company Re-purchase of venture capitalists share by the investee company Purchase of venture capitalists share by a third party

Promoters Buy-back

The most popular disinvestments route in India is promoters buy-back. This route is suitedto Indian conditions because it keeps the ownership and control of the promoter intact. The

obvious limitation, however, is that in a majority of cases the market value of the shares ofthe venture firm would have appreciated so much after some years that the promoter wouldnot be in a financial position to buy them back.

In India, the promoters are invariably given the first option to buy back equity of theirenterprises. For example, RCTC participates in the assisted firms equity with suitableagreement for the promoter to repurchase it. Similarly, Canfina-VCF offers an opportunityto the promoters to buy back the shares of the assisted firm within an agreed period at a

predetermined price. If the promoter fails to buy back the shares within the stipulatedperiod, Canfina-VCF would have the discretion to divest them in any manner it deemedappropriate. SBI capital Markets ensures through examining the personal assets of the

promoters and their associates, which buy back, would be a feasible option. GVFL wouldmake disinvestments, in consultation with the promoter, usually after the project has settleddown, to a profitable level and the entrepreneur is in a position to avail of finance underconventional schemes of assistance from banks or other financial institutions.Initial Public Offers (IPOs)

The benefits of disinvestments via the public issue route are, improved marketability andliquidity, better prospects for capital gains and widely known status of the venture as wellas market control through public share participation. This option has certain limitations inthe Indian context. The promotion of the public issue would be difficult and expensive

since the first generation entrepreneurs are not known in the capital markets. Further,difficulties will be caused if the entrepreneurs business is perceived to be an unattractive



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investment proposition by investors. Also, the emphasis by the Indian investors on short-term profits and dividends may tend to make the market price unattractive. Yet anotherdifficulty in India until recently was that the Controller of Capital Issues (CCI) guidelinesfor determining the premium on shares took into account the book value and the cumulativeaverage EPS till the date of the new issue. This formula failed to give due weight age to the

expected stream of earning of the venture firm. Thus, the formula would underestimate thepremium. The Government has now abolished the Capital Issues Control Act, 1947 andconsequently, the office of the controller of Capital Issues. The existing companies are nowfree to fix the premium on their shares. The initial public issue for disinvestments of VCFsholding can involve high transaction costs because of the inefficiency of the secondarymarket in a country like India. Also, this option has become far less feasible for smallventures on account of the higher listing requirement of the stock exchanges. In February1989, the Government of India raised the minimum capital for listing on the stockexchanges from Rs 10 million to Rs 30 million and the minimum public offer from Rs 6million to Rs 18 million.

Sale on the OTC Market

An active secondary capital market provides the necessary impetus to the success of theventure capital. VCFs should be able to sell their holdings, and investors should be able totrade shares conveniently and freely. In the USA, there exist well-developed OTC marketswhere dealers trade in shares on telephone/terminal and not on an exchange floor. Thismechanism enables new, small companies which are not otherwise eligible to be listed onthe stock exchange, to enlist on the OTC markets and provides liquidity to investors. The

National Association of Securities Dealers Automated Quotation System (NASDAQ) in theUSA daily quotes over 8000 stock prices of companies backed by venture capital.

The OTC Exchange in India was established in June 1992. The Government of India hadapproved the creation for the Exchange under the Securities Contracts (Regulations) Act in1989. It has been promoted jointly by UTI, ICICI, SBI Capital Markets, Can bank FinancialServices, GIC, LIC and IDBI. Since this list of market-makers (who will decide daily pricesand appoint dealers for trading) includes most of the public sector venture financiers, itshould pick up fast, and it should be possible for investors to trade in the securities of newsmall and medium size enterprises.

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

The growth of an enterprise follows a life cycle as shown in the diagram below. Therequirements of funds vary with the life cycle stage of the enterprise. Even before a

business plan is prepared the entrepreneur invests his time and resources in surveying themarket, finding and understanding the target customers and their needs. At the seed stagethe entrepreneur continue to fund the venture with his own or family funds. At this stage thefunds are needed to solicit the consultants services in formulation of business plans,meeting potential customers and technology partners. Next the funds would be required fordevelopment of the product/process and producing prototypes, hiring key people and

building up the managerial team. This is followed by funds for assembling themanufacturing and marketing facilities in that order. Finally the funds are needed to expand

the business and attaint the critical mass for profit generation. Venture capitalists cater tothe needs of the entrepreneurs at different stages of their enterprises. Depending upon the



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stage they finance, venture capitalists are called angel investors, venture capitalist or privateequity supplier/investor.

The players:

Figure: 2.3 players in venture capital industry

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


Idea EstablishedThe company

Expansion Troubleshooting

Business

Concept

Break

Even-point

Investing

Intechnology

IPO Turnaround

MediumventurefundsCorporate

investors

Smallventurefunds

Angels

Big venture funds + Financial funds


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Angels are wealthy individuals who invest directly into companies. They can formangel clubs to coordinate and bundle their activities. Besides the money, angels often

provide their personal knowledge, experience and contacts to support their investees.With average deals sizes from USD 100,000 to USD 500,000 they financecompanies in their early stages. Examples for angel clubs are Media Club, DinnerClub , Angel's Forum

Small and Upstart Venture Capital Funds

These are smaller Venture Capital Companies that mostly provide seed and start-upcapital. The so called "Boutique firms" are often specialised in certain industries ormarket segments. Their capitalization is about USD 20 to USD 50 million (is thisdeals size or total money under management or money under management per

fund?). As for the small and medium Venture Capital funds strong competitionwill clear the marketplace. There will be mergers and acquisitions leading to aconcentration of capital. Funds specialised in different business areas will formstrategic partnerships. Only the more successful funds will be able to attract newmoney. Examples are:

Artemis Comaford Abbell Venture Fund Acacia Venture Partners

Medium Venture FundsThe 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. Singlefunds have up to USD 5 billion under management. An example is Accel Partners

Large Venture FundsAs the medium funds, large funds operate in all business sectors and provide alltypes of capital for companies after seed stage. They often operate internationallyand finance deals up to USD 500 million The large funds will try to improve their

position by mergers and acquisitions with other funds to improve size, reputation

and their financial muscle. In addition they will to diversify. Possible areas to enterare other financial services by means of M&As with financial services corporationsand the consulting business. For the latter one the funds have a rich resource ofexpertise and contacts in house. In a declining market for their core activity and withlots of tumbling companies out there is no reason why Venture Capital funds shouldoffer advice and consulting only to their investees.

Examples are: AIG American International Group



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Cap Vest Man 3i

Corporate Venture FundsThese Venture Capital funds are set up and owned by technology companies. Theiraim is to widen the parent company's technology base in an win-win-situation for

both, the investor and the investee. In general, corporate funds invest in growing ormaturing companies, often when the investee wishes to make additional investmentsin echnology or product development. The average deals size is between USD 2million and USD 5 million.The large funds will try to improve their position bymergers and acquisitions with other funds to improve size, reputation and theirfinancial muscle. In addition they will to diversify. Possible areas to enter are otherfinancial services by means of M&As with financial services corporations and theconsulting business. For the latter one the funds have a rich resource of expertise and

contacts in house. In a declining market for their core activity and with lots oftumbling companies out there is no reason why Venture Capital funds should offeradvice and consulting only to their investees. Examples are: Oracle Adobe Dell Kyocera

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

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

Financial funds:

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

recovery customers might prefer less risky alternatives.



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CHAPTER 3

GLOBAL SCENARIO OFVENTURE CAPITAL

INDUSTRY



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3.1 Overview

Over the last 18 months, the venture capital industry around the globe hasexperienced a welcome acceleration in the mature investment hotbeds UnitedStates, Europe and Israel and in the emerging venture capital hotbeds China andIndia. Global venture capital investment last year reached US $ 35.2 billion, thehighest level since 2001, and is maintaining a robust pace in year 2007. Theacceleration has been bolstered by the increasing globalization of both venturecapital funds and venture backed companies and a substantial investor focus onemerging sectors.

As the dotcom market of the late 1990 has gathered the momentum, venture capitalstood at the nexus of hype and hope. In 2000 , they poured nearly $95 billion intomostly young , untested companies , some no more than ideas, expecting to reaprich rewards by later selling of these outfits to public .But the bubble burst themarket for the new stock issues tanked --- and by 2003 , venture capital funding haddwindled to $19 billion.

The VC showed the signs of stabilizing as the industry were bolstered by the 2005sstrong 4th quarter, the financing exceeded the $ 21.5 billion invested in venture-

backed companies in 2004, reaching $22.1billion .While that was far below 2000speak, it represents a more sustainable pace of funding for both entrepreneurs andinvestors. In another sign of the industry firming, pension funds, foundations, andother investors are again getting interested to invest their money in venture funds,which provided seed money for young companies to grow on.

3.2 History & Evolution

Prior to World War Two, the source of capital for entrepreneurs everywhere waseither the government, government-sponsored institutions meant to invest in suchventures, or informal investors (today, termed "angels") that usually had some priorrelationship to the entrepreneur. In general, throughout history private banks, quitereasonably, have been unwilling to lend money to a newly established firm, becauseof the high risk and lack of collateral. After World War Two, in the U.S. a set ofintermediaries emerged who specialized in investing in fledgling firms having the

potential for extremely rapid growth.

From its earliest beginnings on the U.S. East Coast, venture capital graduallyexpanded and became an increasingly professionalized institution. During this

period, the locus of the venture capital industry shifted from New York and Bostonon the East Coast to Silicon Valley on the West Coast. By the mid 1980s, the ideal-typical venture capital firm was based in Silicon Valley and invested largely inelectronics with lesser sums devoted to biomedical technologies. Until the present,

in addition to Silicon Valley, the two other major concentrations have been Bostonand New York City.



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In both Europe and Asia, there are significant concentrations of venture capital inLondon, Israel, Hong Kong, Taiwan, and Tokyo. In the U.S., the government has

played a role in the development of venture capital, though, for the most part, it wasindirect. The indirect role, i.e., the general policies that also benefited thedevelopment 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 policiesensuring relatively low inflation with a stable financial environment andcurrency.

U.S. tax policy, though it evolved, has been favorable to capital gains, and anumber of decreases in capital gains taxes may have had some positive effect

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

The NASDAQ stock market, which has been the exit strategy of choice forventure capitalists, was strictly regulated and characterized by increasingopenness thus limiting investor's fears of fraud and deception.

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

stemming from government action were minimized -- a sharp contrast to mostdeveloping nations.

Another important policy has been a willingness to invest heavily and continuouslyin university research. This investment funded generations of graduate students inthe sciences and engineering. From this research has come trained personnel andinnovations; some of who formed firms that have been funded by venture capitalists.U.S. universities particularly, MIT, Stanford, and UC Berkeley played a particularlysalient role.

The most important direct U.S. government involvement in encouraging the growthof venture capital was the passage of the Small Business Investment Act of 1958authorizing the formation of small business investment corporations (SBICs). Thislegislation created a vehicle for funding small firms of all types. The legislation wascomplicated, but for the development of venture capital the following features weremost significant:

It permitted individuals to form SBICs with private funds as paid-incapital 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.



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

The SBIC program became one that many other nations either learned from oremulated. The SBIC program also provided a vehicle for banks to circumvent theDepression-Era laws prohibiting commercial banks from owning more than 5

percent of industrial firms. The banks' SBIC subsidiaries allowed them to acquireequity in small firms. This made even more capital available to fledgling firms, andwas a significant source of capital in the 1960s and 1970s. The final investmentformat 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 significantfor the venture capital industry

The SBIC program experienced serious problems from its inception. One problemwas that as a government agency it was very bureaucratic having many rules andregulations that were constantly changing. Despite the corruption, somethingvaluable also occurred. Namely, and especially, in Silicon Valley, a number ofindividuals used their SBICs to leverage their personal capital, and some were sosuccessful that they were able to reimburse the program and raise institutionalmoney to become formal venture capitalists. The SBIC program accelerated theircapital accumulation, and as important, government regulations made these newventure capitalists professionalize their investment activity, which had been informal

prior to entering the program. Now-illustrious firms such as Sutter Hill Ventures,Institutional Venture Partners, Bank of America Ventures, and Menlo Venturesbegan as SBICs

The historical record also indicates that government action can harm venture capital.The most salient example came in 1973 when the U.S. Congress, in response towidespread corruption in pension funds, changed Federal pension fund regulations.In their haste to prohibit pension fund abuses, Congress passed the EmploymentRetirement Income Security Act (ERISA) making pension fund managers criminallyliable for losses incurred in high-risk investments. This was interpreted to include

venture capital funds; as a result pension managers shunned venture capital nearlydestroying the entire industry.

This was only reversed after active lobbying by the newly created National VentureCapital Association (NVCA). In 1977, it succeeded in starting a gradual loosening

process that was completed in 1982. The new interpretation of these pension fundguidelines contributed to first a trickle then a flood of new money into venturecapital funds. The most successful case of the export of Silicon Valley-style venturecapital practice is Israel where the government played an important role inencouraging the growth of venture capital.



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The government has a relatively good economic record; there is a minimum ofcorruption, 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 thecreation of the Israeli venture capital system should not be underestimated.

For example, the well-known U.S. venture capitalist, Fred Adler, began investing inIsraeli startups in the early 1970s, and in 1985 was involved in forming the firstIsraeli venture capital fund. Still, the creation of an Israeli venture capital industrywould wait until the 1990s, when the government funded an organization, Yozma, toencourage venture capital in Israel.

Yozma received $100 million from the Israeli government. It invested $8 million inten funds that were required to raise another $12 million each from "a significantforeign partner," presumably an overseas venture capital firm. Yozma also retained$20 million to invest itself. These sibling funds were the backbone of a nowvibrant community that invested in excess of $1 billion in Israel in 1999(Pricewaterhouse 2000). In the U.S., venture capital emerged through an organictrial-and-error process, and the role of the government was limited andcontradictory. In Israel the government played a vital role in a supportiveenvironment in which private-sector venture capital had already emerged.The role of government differs. In the U.S. the most important role of thegovernment was indirect, in Israel it was largely positive in assisting the growth ofventure capital, in India the role of the government has had to be proactive inremoving barriers (Dossani and Kenney 2001).

In every nation, the state has played some role in the development of venture capital.Venture capital is a very sensitive institutional form due to the high-risk nature of itsinvestments, so the state must be careful to ensure its policies do not adversely affectits venture capitalists. Put differently, capricious governmental action injects extrarisk into the investment equation. However, judicious, well-planned government

policies to create incentives for private sector involvement have in the appropriatelead to the establishment of what became an independent self-sustaining venturecapital industry.

3.3 Current Industry Trends

Round Class Distribution

The distribution of financing rounds by round class in mature markets is typically30-40% in the early stage rounds, 20-25% in second round, and 35-40% in laterrounds. In emerging market like China, the round distribution is very different as68% in early stage round and 25% in second round. In mature countries, theinvestments are made at early start up or product development phase.



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Industry shifts

It is perhaps no surprise that the contraction is mostly concentrated in informationtechnology and the business, consumer and retail industries, give the huge number ofcompanies financed in the technology and Internet boom of 1999-2000, and thesubsequent downturn. The healthcare pool, driven by investment in

biopharmaceuticals and medical devices, has actually grown to some degree in thedifferent geographies .In United States, the healthcare pool has grown consistentlyover the last several years, both in terms of number of companies and cumulativedollars 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 declinesacross the board. In US the number had fallen 54% since 2002 and 54% inEurope since 2003 .In Israel; it dropped 67% since 2004.

The number of healthcare companies has grown in U.S. since 2002 by 27% and

the capital risen 30% in last five years. Capital investment to the pool ofhealthcare companies in Europe and Israel has also climbed, although thenumber of companies dropped by 9%in Europe since 2003 and 9% in Israelsince 2004.

Clean technology is a small but increasing element of the pool. There were 262clean 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 nextdecade:-

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

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

developing countries and redefining industries through low-cost advantage,modern infrastructure, and vast customer databases in their home countries.



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These companies are potential acquirers of developed market companies at allstages of growth.

Globalization of capital:- Changes in economic and financial landscape arecreating a significant regional shifts in IPO activity. These changes have alsosparked global consolidation alliances among stock exchanges.

Transformation of the CFOs role and function:- With the globalization andincreasingly complex regulatory environment, CFOs have a wider range ofresponsibilities and finance function has been transformed to face broadermandates.

Clean Technology: - Clean technology is poised to become the first breakthrough sector of 21st century. Encompassing energy, air and water treatment,industrial efficiency improvements, new material and waste management etc are

playing very vital role globally because of which VC investors are enjoyingrewards.



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3.4 GLOBAL TREND IN VENTURE CAPITAL INDUSTRY

The 2007 Global Venture Capital Survey was sponsored by Deloitte & Touche LLPin conjunction with the National Venture Capital Association and other venturecapital associations* throughout the world. It was administered in April and May2007 to venture capitalists (VCs) in the Americas, Asia Pacific, Europe, the MiddleEast, and Africa.

There were 528 responses from general partners, with 45 percent of respondentsfrom the United States and 31 percent from Europe. A complete geographic

breakdown of respondents is as follows:

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

The breadth of assets under management by these respondents was varied. Thehighest number of respondents42 percenthad managed assets totaling less than$100 million; 35 percent managed assets between $100 million and $499 million; 12

percent managed assets between $500 million to $1 billion; and 11 percent morethan $1 billion in assets under managementThere are 13 % respondents from APAC in which China, India, Japan, South Korea,

other Asia. 45% respondents from Middle East include Israel and other area ofMiddle 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 broadlyembracing global investment. Rather, roughly half of the venture community hasmade a commitment to a global investment strategy and those firms are



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implementing that strategy slowly and cautiously. The intentions for growth offoreign investment, as demonstrated by this years survey data, are modest at best.

46

54

% OF VENTURE CAPITALISTCURRENTLY INVESTINGOUTSIDE HOME COUNTRY(U.S. RESPONDENTS)

YES NO

Figure: 3.2 Percentage of venture capitalist currently investing outside home country(U.S. respondents)

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

Among U.S. investors, 54 percent indicated that they would be expanding theirinvestment focus outside of their home country or region in the next five years.Adequate deal flow in their home country was the reason indicated most for notwanting to expand globally.

Some venture investors are certainly taking advantage of opportunities outside theirhome 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 offirms, theyre not diving deep into investing in other countries, but dipping a toe in



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with one or two deals. This cautious approach allows the venture firms to furtherassess the investment environment, evaluate how their strategy may need to beadjusted and how critical challenges, such as tax and intellectual property issuesimpact overall performance.

3.5 Current strategies

Among those VCs who are currently investing abroad, 48 percent of them havedeveloped strategic alliances with a foreign-based firm and 51 percent invest onlywith other investors who have a local presence. This underscores the need in venturecapital to be physically close to the portfolio companies in order to work withmanagement. Firms also indicated that to succeed, they need to understand localculture, and to do so they must have a local presence in their target countries to takeadvantage of in-country expertise. To this end, they also are hiring investment staff

with expertise in target countries (41 percent) and requiring their partners to travelmore (58 percent).

Figure: 3.4 Current business practices used by venture capitalist to manage foreign investmentFocus

3.6 China, India, Israel and Canada are primary target countries for


Current business practises used by venture capitalist to manage foreign investment

focus

4851

11

58

7 8

33

4136

44 40

7

63

812

40

52

41

50

58

14

55

6 6

2934 33

0

10

20

30

40

50

60

70

strategic

alliances

with foreign

firms

invest only

with other

investors

that have a

local

presence

acquire

foreign

based firms

require

partners to

travel m ore

require

partners to

transfer to

foreign

location

relocate HQ

of portfolio

co.to be

near our

firm

open new

offices in

foreign

location

hire

investment

staff with

expertise in

target

countries

imvest in

local

portfolio co.

with

significant

operations

outside

country

global US Non US


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U.S. venture capitalists

There continues to be a consensus among U.S. venture capitalists regarding wherethe most opportunities exists globally. Most of the U.S. firms who have invested

globally are making investments in China, India, Israel, and Canada. However, evenin these countries, the majority of U.S. respondents are essentially dabbling, makingonly one to two investments thus far.

FOREIGN INVESTMENT CURRENTLY HELD BY FIRMS

53%

23%

8%

4%

12%

1-2 investment

3-5 investment

6-10 investment

11-15investment

16+ investment

Figure: 3.5 Foreign investment currently held by firms

Allocations by U.S. and non-U.S. firms alike for the most part represent less than 5percent of capital invested overseas in fewer than three to five deals. Survey resultsindicate that there will not be significant change during the next five years.

RESPONSE FROM U.S. RESPONDENTS



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Primary locations where investors would like

to expand investment focus (U.S.

respondents)

34%

24%

11%

9%

6%

4%

7%5%

china

India

canda

UK & Ireland

Israel

other Asia

other Europe

others

Figure: 3.6 Primary focused location for investment (U.S) respondents

Here from the above chart we can see that the highest percent of respondents areinterested in China for setting up their businesses. India is the second choice for theglobal investors.

RESPONSE FROM (APAC) RESPONDENTS



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37

27

18

9

33 3

PRIMARY LOCATION WHERE INVESTOR WOULD LIKETO EXPAND INVESTMENT FOCUS (APAC)

RESPONDENTS

CHINA

OTHER ASIA

U.S.

INDIA

MIDDLE EAST

SOUTH KOREA

JAPAN

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

While China, India, Israel, and Canada are by far the most seductive target marketsfor investment by U.S. firms, venture capitalists in non-US countries have a differentfocus. By far the greatest contrast is among European respondents, who indicated a

strong preference for investing in other parts of Europe (67 percent) and the UnitedStates (17 percent), with the remainder focused on Asia. Asian respondents had asimilar level of interest in the United States (18 percent), but looked primarilyinward to other Asian countries (78 percent), with the remainder focused on theMiddle East. This data shows that while non-U.S. investors are interested in makingdeals outside of their home countries, theres still a desire to remain somewhat closeto home and do business with cultures close to theirs. Most of APAC respondentslike 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 firms at aslow pace for the foreseeable future. Of those VCs who indicated they currently havecapital deployed abroad, more than half of U.S. respondents (54 percent) expect to expandtheir global investment focus over the next five years, and 61 percent of non-U.S. firms alsosee a future in investing outside of their home country. Not surprising, larger VC firms aremost likely to be investing outside the United States and plan to increase their overseasinvestment. In fact, 85 percent of U.S. firms and 92 percent of non-U.S. firms with capitalmanagement over $1 billion indicated plans to increase their foreign investments.

Interestingly, among mid-size firms, 47 percent of the VCs with $100 to $499 millioncapital under management are investing outside the U.S. This underscores that global



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investing requires additional resources and a sophisticated infrastructure in order to managea global investment strategy. That said, the study also shows that a significant percentage ofmid-size firms recognize that opportunities exist outside their home country and are

building their franchise in a way that will enable them to take advantage of thoseopportunities.

% OF VENTURE CAPITALIST EXPECTING TO EXPAND

INVESTMENT FOCUS OUTSIDE HOME COUNTRY

4858

68

86

34

47

69

85

5565 65

92

0

20

40

60

80

100

Less than $100

million

$100-$499

million

$500-$1 billion Greater than $1

billion

RESPON

DENTS(%

GLOBAL U.S Non U.S.

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

Outside home country

3.7 Primary reasons why venture investors expanding globally

Among the primary reasons VCs around the world are interested in investingglobally is to take advantage of higher quality deal flowparticularly in the UnitedStates, China, parts of Europe, and Israel. This is especially true for non-U.S. firms.A second reason is the emergence of an entrepreneurial environment, again andnotably in China, but also India. Among U.S. firms, this latter rationale is the most

significant motivation for investing globally. Other motivators include access toquality entrepreneurs, diversification of industry and geographic risk and access toforeign markets.



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Figure: 3.9 primary reasons why venture investors expanding globally

Above chart reveals that 19% U.S respondents are expand globally for generating highquality deal flow. And 31% believe that they expand globally for getting benefit ofemergence of entrepreneurial environment. While 17% respondents of non U.S are expandglobally for diversification of industry and geographic risk. All respondents are leastconcerned 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 ofopportunities abroad is to invest locally in companies with operations outside theirhome country, as opposed to investing directly in foreign countries. This year, therewas a significant increase in the number of respondents who indicated that a sizeablenumber of their portfolio companies have a considerable amount of operationsoutside the country in which theyre headquartered.

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


PRIMARY REASONS WHY VENTURE INVESTORS

EXPANDING GLOBALLY

28

12

22

14 14

5 5

19

12

31

11 12 96

34

1216 17 16

2 3

05

10152025303540

higher

qualitydeal

flow

accesstoquality

entr

epreneurs

emergenceof

entrepre

neurialenvi

ronment

diver

sificationof

ind

ustryand

geographicrisk

acces

stoforeign

m

arkets

lowerco

stlocations

extensive

competitionfordeal

flowin

ourlocal

market

global

US

Non US


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Figure: 3.10 Percentage of venture capital firms portfolio companies that give significantoperation outside the country

Globally and among U.S. respondents, China has become the primary choice forrelocating manufacturing operations, while India is the primary choice for R&Doperations. Engineering operations tend to land in India as well, but China is also a

popular location. For back office activities, again, the choice is India. However, fornon-U.S. respondents, the United States is the primary choice for R&D andengineering while European respondents preferred Central and Eastern Europe formanufacturing, R&D, and Engineering.

One reason why this approach is taking off is that investors are concerned aboutintellectual property and liquidity eventsand, in general, they feel a need to becloser to top management. This also reflects a new realitythat VCs are nowinvesting in companies that operate globally from day one companies that reflecta larger global entrepreneurial sector. This strategy allows the portfolio companies(and investors) to take advantage of cost savings and access to talent in foreignmarkets while protecting intellectual property. There are, however, concerns thatsuch 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 risks andchallenges abroad. Both U.S. and non-U.S. firms perceive the U.S. asthe country where the cost of complying with regulation is toohigh. In fact, the percentage of non-U.S. respondents whoindicated this as a concern leaped from 28 percent last year to 41percent this year. Globally, 4 percent more, 44 percent, saw thisissue as a concern. Forty-six percent of U.S. respondents believe

the cost of complying with corporate governance is too high.



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TOP MARKETS WHERE THE COST OF COMPLYING WITH CORPORATE

GOVERNANCE REGULATION TOO HIGH

44

8 7 5 5 4 3 3 3 3

46

9 9 7 5 3 5 5 3 2

41

7 52

5 52 2 4

5

05

101520253035404550

U.S.

UK&Ir

eland

ca

nada

India

Austria,

Germ

any,

Switze

rland

Israel

China

No

rdic

cou

ntries

Fr

ance,

Itally

Benelux

global

US

Non US

Figure: 3.11 Top markets where the cost of complying with corporate governanceregulation too high

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



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CHAPTER 4

VENTURE CAPITALIN INDIA

4.1 Evolution of VC Industry in India



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The first major analysis on risk capital for India was reported in 1983. It indicated that newcompanies often confront serious barriers to entry into capital market for raising equityfinance which undermines their future prospects of expansion and diversification. It alsoindicated that on the whole there is a need to revive the equity cult among the masses byensuring competitive return on equity investment. This brought out the institutional

inadequacies with respect to the evolution of venture capital.

In India, the Industrial finance Corporation of India (IFCI) initiated the idea of VC when itestablished the Risk Capital Foundation in 1975 to provide seed capital to small and risky

projects. However the concept of VC financing got statutory recognition for the first time inthe fiscal budget for the year 1986-87.

The Venture Capital companies operating at present can be divided into four groups: Promoted by All India Development Financial Institutions Promoted by State Level Financial Institutions Promoted by Commercial banks Private venture Capitalists.

Promoted by all India development financial institutions

The IDBI started a VC fund in 19876 as per the long term fiscal policy of government ofIndia, 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.5lacs to rs 2.5 cr were considered for financing. Promoters contribution ranged from thisfund was available at a concessional interest rate of 9% ( during gestation period) whichcould be increased at later stages.

The ICICI provided the required impetus to VC activities in India, 1986, it startedproviding VC finance in 1998 it promoted, along with the Unit Trust of India (UTI)Technology Development and Information Company of India (TDICI) as the first VCcompany registered under the companies act, 1956. The TDICI may provide financialassistance to venture capital undertakings which are set up by technocrat entrepreneurs, ortechnology information and guidance services.

The risk capital foundation established by the industrial finance corporation of India (IFCI)in 1975, was converted in 1988 into the Risk Capital and Technology Finance company(RCTC) as a subsidiary company of the ifci the rctc provides assistance in the form of

conventional loans, interest free conditional loans on profit and risk sharing basis or equityparticipation in extends financial supoort to high technology projects for technologicalupgradations. The RCTC has been renamed as IFCI Venture Capital Funds Ltd.(IVCF)

Promoted by State Level Financial InstitutionsIn India, the State Level financial institutions in some states such as Madhya Pradesh,Gujarat, Uttar Prades, etc., have done an excellent job and have provided VC to a smallscale enterprises. Several successful entrepreneurs have been the beneficiaries of the liberalfunding environment. In 1990, the Gujarat Industrial Investment Corporation, promotedthe Gujarat Venture Financial Ltd.(GVFL) along with other promoters such as the IDBI, theWorld Bank, etc. The GVFL provides financial assistance to businesses in the form of



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equity, conditional loans or income notes for technologies development and innovativeproducts. It also provides finance assistance to entrepreneurs.

The government of Andhra Pradesh has also promoted the Andhra Pradesh IndustrialDevelopment Corporation (APIDC) venture capital ltd. To provide VC financing in Andhra

Pradesh.

Promoted by commercial banks

Canbank Venture Capital Fund, State Bank Venture Capital Fund and Grindlays bankVenture Capital Fund have been set up by the respective commercial banks to undertake vcactivities.

The State Bank Venture Capital Funds provides financial assistance for bought out deal aswell as new companies in the form of equity which it disinvests after the commercializationof the project.

Canbank Venture Capital Fund provides financial assistance for proven but yet to bcommercially exploited technologies. It provides assistance both in the form of equity andconditional loans.

Private Venture Capital Funds

Several private sector venture capital funds have been established in India such as the 20 th

Centure Venture Capital Company, Indus Venture Capital Fund, Infrastructure Leasing and

Financial Services Ltd.Some of the companies that have received funding through this route include:

Mastek, on of the oldest softwear house in India Ruskan software, Pune based software consultancy SQL Star, Hyderabad-based training and

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