Venture+Capita (1)

8/8/2019 Venture+Capita (1)

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VENTURE

CAPITAL

RAHUL SHAH

Roll:135

MFM3-B

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INDEX

1. Introduction to Venture Capital.

2. Critical factors for success of venture capital

industry .

3. Business Plans for startups.

4. Comparison with other source of investments.

5. The Venture Investment process.

6. History and evolution of venture capital.

7. Indian Scenario - A Statistical Snapshot.

8. Valuing.

9. Start From the f uture.

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Introduction to Venture Capital.

Venture capital is money provided by professionals who invest

alongside management in young, rapidly growing companies that havethe potential to develop into significant economic contributors. Venturecapital is an important source of equity for start-up companies.

Professionally managed venture capital firms generally are privatepartnerships or closely held corporations funded by private and publicpension funds, endowment funds, foundations, corporations, wealthyindividuals, foreign investors, and the venture capitalists themselves.

In India where the industry is still nascent, the Securities andexchange board of India has laid down those activities that would

constitute eligible business activities qualifying for the concessionavailable to a recognized venture capital fund. Initially, SEBI definedventure capital as an equity supported for the project launched by 1st

generation entrepreneurs using commercially untested butsophisticated technologies. However, this definition has beensubsequently relaxed and the restrictive feature concerningtechnology financing were dispensed with. Venture capital is nowseen as encompassing all kinds of funding of a high technologyintensive undertaking at any stage of its life.

It would appear from the foregoing that venture capital investment

would have one or more of its follow characteristics.

1. Equity or equity featured instrument of investment.

2. Young companies that do have access to public sources of equityor other forms of capital.

3. Industry, products or services that hold potential of better than

normal or average revenue growth rates.

4. Companies with better than normal or average profitability.

5. Product / Services in the early stages of there life cycle.

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6. Higher than average risk levels that do not lend themselves tosystematic quantification through convention technique or tools.

7. Turnaround companies.

8. Long term (more than 3 years) and active involvement withinvestee.

When considering an investment, venture capitalists carefully screenthe technical and business merits of the proposed company. Venture

capitalists only invest in a small percentage of the businesses theyreview and have a long-term perspective. They also actively work withthe company's management, especially with contacts and strategyformulation.

Venture capitalists mitigate the risk of investing by developing aportfolio of young companies in a single venture fund. Many times theyco-invest with other professional venture capital firms. In addition,many venture partnerships manage multiple funds simultaneously. For

decades, venture capitalists have nurtured the growth of America'shigh technology and entrepreneurial communities resulting insignificant job creation, economic growth and internationalcompetitiveness. Companies such as Digital Equipment Corporation,Apple, Federal Express, Compaq, Sun Microsystems, Intel, Microsoftand Genentech are famous examples of companies that receivedventure capital early in their development. (Source: National VentureCapital Association 1999 Yearbook).

In India, these funds are governed by the Securities and ExchangeBoard of India (SEBI) guidelines. According to this, venture capitalfund means a fund established in the form of a company or trust,which raises monies through loans, donations, issue of securities orunits as the case may be, and makes or proposes to make investmentsin accordance with these regulations. (Source: SEBI (Venture CapitalFunds) Regulations, 1996).

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Critical factors for success of venture capital industry:

The following factors are critical for the success of the VC industry inIndia:

(A) The regulatory, tax and legal environment should play anenabling role. Internationally, venture funds have evolved in anatmosphere of structural flexibility, fiscal neutrality and operationaladaptability.

(B) Resource raising, investment, management and exit should beas simple and flexible as needed and driven by global trends

(C) Venture capital should become an institutionalized industry thatprotects investors and investee firms, operating in an environmentsuitable for raising the large amounts of risk capital needed and forspurring innovation through startup firms in a wide range of highgrowth areas.

(D) In view of increasing global integration and mobility of capital itis important that Indian venture capital funds as well as venturefinance enterprises are able to have global exposure and investmentopportunities.

(E) Infrastructure in the form of incubators and R&D need to bepromoted using Government support and private management as hassuccessfully been done by countries such as the US, Israel and Taiwan.This is necessary for faster conversion of R & D and technologicalinnovation into commercial products.

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Recommendations:

Multiplicity of regulations need for harmonization and nodal

Regulator:

Presently there are three set of Regulations dealing with venturecapital activity i.e. SEBI (Venture Capital Regulations) 1996,

Guidelines for Overseas Venture Capital Investments issued byDepartment of Economic Affairs in the MOF in the year 1995 and CBDTGuidelines for Venture Capital Companies in 1995 which was modifiedin 1999. The need is to consolidate and substitute all these with onesingle regulation of SEBI to provide for uniformity, hassle free singlewindow clearance. There is already a pattern available in this regard;the mutual funds have only one set of regulations and once a mutualfund is registered with SEBI, the tax exemption by CBDT and inflow offunds from abroad is available automatically. Similarly, in the case ofFIIs, tax benefits and foreign inflows/outflows are automatically

available once these entities are registered with SEBI. Therefore, SEBIshould be the nodal regulator for VCFs to provide uniform, hassle free,single window regulatory framework. On the pattern of FIIs, ForeignVenture Capital Investors (FVCIs) also need to be registered withSEBI.

Tax pass through for Venture Capital Funds:

VCFs are a dedicated pool of capital and therefore operate infiscal neutrality and are treated as pass through vehicles. In any case,the investors of VCFs are subjected to tax. Similarly, the investeecompanies pay taxes on their earnings. There is a well-establishedsuccessful precedent in the case of Mutual Funds, which onceregistered with SEBI are automatically entitled to tax exemption atpool level. It is an established principle that taxation should be only atone level and therefore taxation at the level of VCFs as well as

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investors amount to double taxation. Since like mutual funds VCF isalso a pool of capital of investors, it needs to be treated as a tax passthrough. Once registered with SEBI, it should be entitled to automatictax pass through at the pool level while maintaining taxation at theinvestor level without any other requirement under Income Tax Act.

.

Mobilisation of Global and Domestic resources:

(A) Foreign Venture Capital Investors (FVCIs):

Presently, FIIs registered with SEBI can freely invest and disinvestwithout taking FIPB/RBI approvals. This has brought positiveinvestments of more than US $10 billion. At present, foreign venturecapital investors can make direct investment in venture capitalundertakings or through a domestic venture capital fund by takingFIPB / RBI approvals. This investment being long term and in thenature of risk finance for start-up enterprises, needs to be encouraged.

Therefore, atleast on par with FIIs, FVCIs should be registered withSEBI and having once registered, they should have the same facility ofhassle free investments and disinvestments without any requirementfor approval from FIPB / RBI. This is in line with the present policy ofautomatic approvals followed by the Government. Further, generallyforeign investors invest through the Mauritius-route and do not pay taxin India under a tax treaty. FVCIs therefore should be provided taxexemption. This provision will put all FVCIs, whether investing throughthe Mauritius route or not, on the same footing. This will help thedevelopment of a vibrant India-based venture capital industry with the

advantage of best international practices, thus enabling a jump-starting of the process of innovation.

The hassle free entry of such FVCIs on the pattern of FIIs is even morenecessary because of the following factors:

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Venture capital is a high-risk area. In out of 10 projects, 8 either fail oryield negligible returns. It is therefore in the interest of the countrythat FVCIs bear such a risk.

For venture capital activity, high capitalization of venture capital

companies is essential to withstand the losses in 80% of the projects.In India, we do not have such strong companies.

The FVCIs are also more experienced in providing the neededmanagerial expertise and other supports.

Augmenting the Domestic Pool of Resources:

The present pool of funds available for venture capital is very limitedand is predominantly contributed by foreign funds to the extent of 80percent. The pool of domestic venture capital needs to be augmentedby increasing the list of sophisticated institutional investors permittedto invest in venture capital funds. This should include banks, mutualfunds and insurance companies upto prudential limits. Later, asexpertise grows and the venture capital industry matures, otherinstitutional investors, such as pension funds, should also bepermitted. The venture capital funding is high-risk investment andshould be restricted to sophisticated investors. However, investing inventure capital funds can be a valuable return-enhancing tool for such

investors while the increase in risk at the portfolio level would beminimal. Internationally, over 50% of venture capital comes frompension funds, banks, mutual funds, insurance funds and charitableinstitutions.

Flexibility in Investment and Exit:

Allowing multiple flexible structures:

Eligibility for registration as venture capital funds should be neutral tofirm structure. The government should consider creating newstructures, such as limited partnerships, limited liability partnershipsand limited liability corporations. At present, venture capital funds canbe structured as trusts or companies in order to be eligible forregistration with SEBI. Internationally, limited partnerships, Limited

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Liability Partnership and limited liability corporations have provided thenecessary flexibility in risk-sharing, compensation arrangementsamongst investors and tax pass through. Therefore, these structuresare commonly used and widely accepted globally specially in USA.Hence, it is necessary to provide for alternative eligible structures.

Flexibility in the matter of investment ceiling and sectoral restrictions:

70% of a venture capital funds investible funds must be invested inunlisted equity or equity-linked instruments, while the rest may beinvested in other instruments. Though sectoral restrictions forinvestment by VCFs are not consistent with the very concept ofventure funding, certain restrictions could be put by specifying anegative list which could include areas such as finance companies, real

estate, gold-finance, activities not legally permitted and any othersectors which could be notified by SEBI in consultation with theGovernment. Investments by VCFs in associated companies shouldalso not be permitted. Further, not more than 25% of a funds corpusmay be invested in a single firm. The investment ceiling has beenrecommended in order to increase focus on equity or equity-linkedinstruments of unlisted startup companies. As the venture capitalindustry matures, investors in venture capital funds will set their ownprudential restrictions.

Changes in buy back requirements for unlisted securities:

A venture capital fund incorporated as a company/ venture capitalundertaking should be allowed to buyback upto 100% of its paid upcapital out of the sale proceeds of investments and assets and notnecessarily out of its free reserves and share premium account orproceeds of fresh issue. Such purchases will be exempt from the SEBItakeover code. A venture-financed undertaking will be allowed tomake an issue of capital within 6 months of buying back its own sharesinstead of 24 months as at present. Further, negotiated deals may be

permitted in unlisted securities where one of the parties to thetransaction is VCF.

Relaxation in IPO norms:

The IPO norms of 3-year track record or the project beingfunded by the banks or financial institutions should be relaxed to

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include the companies funded by the registered VCFs also. The issuercompany may float IPO without having three years track record if theproject cost to the extent of 10% is funded by the registered VCF.Venture capital holding however shall be subject to lock in period ofone year. Further, when shares are acquired by VCF in a preferential

allotment after listing or as part of firm allotment in an IPO, the sameshall be subject to lock in for a period of one year. Those companies,which are funded, by Venture capitalists and their securities are listedon the stock exchanges outside the country, these companies shouldbe permitted to list their shares on the Indian stock exchanges.

Relaxation in Takeover Code:

The venture capital fund while exercising its call or put option as per

the terms of agreement should be exempt from applicability oftakeover code and 1969 circular under section 16 of SC(R)A issued bythe Government of India.

Issue of Shares with Differential Right with regard to voting anddividend:

In order to facilitate investment by VCF in new enterprises, theCompanies Act may be amended so as to permit issue of shares byunlisted public companies with a differential right in regard to voting

and dividend. Such a flexibility already exists under the IndianCompanies Act in the case of private companies which are notsubsidiaries of public limited companies.

QIB Market for unlisted securities: A market for trading in unlistedsecurities by QIBs be developed.

NOC Requirement : In the case of transfer of securities by FVCI to anyother person, the RBI requirement of obtaining NOC from joint venturepartner or other shareholders should be dispensed with.

RBI Pricing Norms: At present, investment/disinvestment by FVCI issubject to approval of pricing by RBI which curtails operationalflexibility and needs to be dispensed with.

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Global integration and opportunities:

(A) Incentives for Employees: The limits for overseas investment byIndian Resident Employees under the Employee Stock Option Schemein a foreign company should be raised from present ceilings ofUS$10,000 over 5 years, and US$50,000 over 5 years for employeesof software companies in their ADRs/GDRs, to a common ceiling ofUS$100,000 over 5 years. Foreign employees of an Indian companymay invest in the Indian company to a ceiling of US$100,000 over 5years.

(B) Incentives for Shareholders: The shareholders of an Indiancompany that has venture capital funding and is desirous of swappingits shares with that of a foreign company should be permitted to do so.Similarly, if an Indian company having venture funding and isdesirous of issuing an ADR/GDR, venture capital shareholders (holdingsaleable stock) of the domestic company and desirous of disinvestingtheir shares through the ADR/GDR should be permitted to do so.Internationally, 70% of successful startups are acquired through astock-swap transaction rather than being purchased for cash or goingpublic through an IPO. Such flexibility should be available for Indianstartups as well. Similarly, shareholders can take advantage of thehigher valuations in overseas markets while divesting their holdings.

(C) Global investment opportunity for Domestic Venture CapitalFunds (DVCF): DVCFs should be permitted to invest higher of 25% ofthe funds corpus or US $10 million or to the extent of foreigncontribution in the funds corpus in unlisted equity or equity-linkedinvestments of a foreign company. Such investments will fall withinthe overall ceiling of 70% of the funds corpus. This will allow DVCFs toinvest in synergistic startups offshore and also provide them withglobal management exposure.

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Infrastructure and R&D :

Infrastructure development needs to be prioritized using governmentsupport and private management of capital through programmessimilar to the Small Business Investment Companies in the United

States, promoting incubators and increasing university and researchlaboratory linkages with venture-financed startup firms. This wouldspur technological innovation and faster conversion of research intocommercial products.

Self Regulatory Organisation (SRO):

A strong SRO should be encouraged for evolution of standard

practices, code of conduct, creating awareness by dissemination ofinformation about the industry.

Implementation of these recommendations would lead to creation ofan enabling regulatory and institutional environment to facilitate fastergrowth of venture capital industry in the country. Apart fromincreasing the domestic pool of venture capital, around US$ 10 billionare expected to be brought in by offshore investors over 3/5 years onconservative estimates. This would in turn lead to increase in the value

of products and services adding upto US$100 billion to GDP by 2005.Venture supported enterprises would convert into quality IPOsproviding over all benefit and protection to the investors. Additionally,judging from the global experience, this will result into substantial andsustainable employment generation of around 3 million jobs in skilledsector alone over next five years. Spin off effect of such activity wouldcreate other support services and further employment. This can putIndia on a path of rapid economic growth and a position of strength inglobal economy.

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Business Plans for Startups

Who reads business plans? Very few people read them thoroughly,including most investors. And even if you submit a well-written plan tothe right parties, you'll be lucky to hold a potential investor's attentionfor even 60 seconds unless you have one very strategic piece in place-- a referral or personal introduction. Marc Friend of U.S. VenturePartners says: "If someone I know refers a business plan to me, it getsmuch more thorough attention. I reason that if the idea is as good andunique as the entrepreneurs say it is, that they should have a networkin place that can verify the validity and uniqueness of that valueproposition by providing a personal introduction." John L. Walecka of

Brentwood Venture Capital agrees: "We entertain a lot of plans, butthe ones that are best qualified come through referrals."

Assuming you clear this hurdle and your business plan actually landson someone's desk, you'll want your plan to be succinct andcompelling. A concise and well-written business plan can do muchmore than give you something to show potential investors. It can alsobe an important tool for attracting strategic partners, identifyingstrengths and weaknesses, and "evangelizing" potential supporters. Ifthe idea behind your business is solid, and you have a personalintroduction from someone with credibility, you will still need the right

"calling card" to get the millions you're looking for. Even afterestablishing a business relationship that begins with a simplehandshake, you'll need something neatly typed on plain paper andpresented in an attractive binder, with numbers that make sense.

Keep It Simple, Direct, and Affirmative

Most business plans are written because investors require them. But

they can also help you to clarify your thinking, measure your market,analyze the competition, and think ahead. In short, the business planis your roadmap to success. Marc Friend approaches it like amathematician: For a business plan to be compelling, he says, "thereshould be a logical progression to each of the steps. You want to get anod of approval at every step of the way so that by the end of theplan, the investor says 'Let's invest!'" And although you may

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occasionally need to make minor adjustments to the plan en route, awell thought out business plan will keep you focused on your ultimatedestination.

Many business plans are boring and nearly unreadable. Yours shouldn't

be. In business plans, as in so many other things, less is often more.It can be an artfully expanded version of your elevator pitch. You cancreate an exciting vision of your new company's future in less timethan it takes to read the sports page in your local newspaper.

Craft a Stellar Executive Summary

The executive summary of your plan is crucially important -- it must

capture and hold the attention of potential investors, because if youlose readers at the outset, you'll never get them back . The executivesummary to your plan should be highly telegraphic -- two to threepages at the most. And you should assume no one will read anyfurther than your executive summary, so everything that makes yourplan a winner should be here -- the details can come later. If you can'twrite up your ideas in clear, compelling prose, hire someone who can.The executive summary to the business plan you write can provide asolid foundation for all future marketing, planning, and promotionaldocuments.

Set Yourself Apart

No matter how artfully executed, a business plan is only as good asthe opportunity it presents and the people behind it. It's theentrepreneurs with vision, originality, and technical acumen who areleading the way.

For starters, you'll need more than a good idea. You'll need an ideathat's big, bold, and innovative if you want to capture the attention ofinvestors. As the Internet grows in quantum leaps, investors arelooking for ideas that alter the game. John Walecka explains: "We lookfor incredibly bright, experienced engineers and entrepreneurs whohave a unique insight on how to change the way people do businesstoday in some important, fundamental way. We're always on thelookout for that sea change that creates opportunity."

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And a bold, innovative idea is only as good as its execution. If theteam behind the project lacks credibility and experience in establishingtheir ideas in the marketplace early on to declare success for the longterm, they won't get far with investors. Marc Friend comments: "I'lltake a brief look at the executive summary to see what they're

proposing, and then I'll flip to the resumes to see who's talking. Whatspecial expertise does this team have that convinces me they canaccomplish the goal they set out to accomplish?"

Play the Numbers

Let's be brutally honest -- numbers seem solid, but they are the mostsuspect piece of a business plan. You must include them, but they

don't mean much -- and investors will challenge them every time.Although you can and should make the numbers look promising, beprepared to defend your startup's strategy for generating revenue.Most plans include projections based on overly optimistic speculation,and venture capitalists take this information with several grains of salt.In your plan, be honest but mildly optimistic -- it may add to yourcredibility in the long run. And always support your numbers andassumptions.

Pitch a Long-Term Dream, Not a Fast-Buck Scheme

Most importantly, make sure you present your business as poised onthe threshold of a long -- or at least reasonably long -- future. Theworld of high tech and Internet startups is already overpopulated withcompanies created by biz school grad students or dropouts looking fora fast buck. Going public with a profitless shell that will never beeconomically viable was last year's idea. Even if you do plan to sell thebusiness at some future point, the most attractive businesses tobuyers will be the ones that have a decent shot at eventual long-termprofitability.

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Comparison with other source of investments.

One of the important characteristics of venture capital fromconventional loan is the participation of VCC / VCF in the managementof VCU. The VCC / VCF intends to increase the value of the VCU byhelping the companies in its marketing and financial aspects, therebyincreasing the profitability of the company. VCF / VCC provides highlyprofessionalised and competent advises on the technical aspect of thefunctioning of the company.

The following are the activities of the VCF / VCC concerning the VCU:

Assist in financing , marketing and strategic planning of the VCU.

Recruiting of key personnel in the initial stages.

Obtaining bank and other financing avenues for the VCU.

Introducing to strategic partners and vendours.

Comparison can be done on the investment patterns in bought outdeals and conventional financing with essentially high risk technologyintensive funding for first generation entrepreneurs.

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Venture capital Bought out deal Conventialloan

financing

Participation High. As the Low. Though the Nil. The

In VCF/VCC has a equity in the lenderdoes

Management. Equity stake in the company is held bynot have the

VCU, it is generally the sponsor, thereexpertise or

Bound to follow the would not any directinterest in

Advice. Also interference in thepromoting the

considering the management except company as

expertise of in exceptional cases. Longas the

VCC/VCF, payment

Participation is high scheduleis

In strategic planning. Followed.

Returns to Extremely high in High. Though the Moderate. As

Investor most of the cases company is not into thepayment

Considering thr high technologically schedule is

Risk in such intensive. Exit from finalizedbefore

Investment. The investment in theinvestment,

Resonabaly certain. There is no

Uncertainty.

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Time period Very long. Exit from Not very long. ExitMay be set

Investment takes from investment is as perchoice

7-10 yrs on an normally done ofthe investor/

average. Immediately after lender.

the expiry of lock-in

. period

Regulations Not high as the High. Bought out Moderate.

Venture capital is deals are reasonably Regulations

Considered well regulated as it cover the

Reasonably nacent concerns listing of safetyof such

For regulation to be security in the stockinvestment/

In place. Also, with exchange wherelending.

High risk being small investors

Inherent in the interests have to be

Investment process, protected.

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Regulations only

Oversee the process

Of such investment

Not the safety.

The Venture Investment process.

Generating a Dealflow

Due Diligence

Investment Valuation

Pricing and structuring the deal

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Value addition and Monitoring; and

Exit

The venture capital process has variances / features that are contextspecific to countries / regions. However, activities in a venture capitalfund follow a typical sequence with a number of commonalties.

Generating a Dealflow

In generating a dealflow, the venture capital investor creates apipeline of deals or investment opportunities that he would considerfor investing in. This is achieved primary through plugging into anappropriate network. The most popular network obviously is thenetwork of venture capital funds / investors. It is also common for

venture capital funds / investors to develop working relationship withR & D institution, academia, etc. which could potentially lead tobusiness opportunities. Understandably, the composition of thenetwork would depend on the investment focus of the venture capitalfund / company. Thus venture capital funds focusing on early stage,technology based deals would develop a network of R&D centersworking in those areas. The network is crucial to the success of theventure capital investor. It is almost imperative for the venture capital

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investor to receive a large number of investment proposals from whichhe can select a few good investment candidates finally. Successfulventure capital investors in the U.S.A examine hundreds of businessplans in order to make three or four investment in a year.

It is important to note the difference between the profile of investmentopportunities that a venture capital would examine and pursued by aconventional credit oriented agency or an investment institution. Bydefinition, as mentioned earlier, the venture capital investor focuseson the opportunities with a high degree of innovativeness.

The dealflow composition and the technique of generating a dealflowcan vary from country to country. In India, different venture capitalfunds / companies have their own methods varying from promotionalseminar with R and D institution and industry associations to directadvertising campaigns targeted at various segments. A clear pattern

between the investment focus of a fund and the constitution of thedeal generation network is discernible even in the India context.

DUE DILIGENCE

Due diligence is the industry jargon for all the activities that areassociated with evaluation an investment proposal. It includes carryingout reference checks on the proposal. It includes carrying outreference checks on the proposal related aspects such as managementteam, products, technology and market. The important feature to noteis that venture capital due diligence focuses on the qualitative aspectsof the investment opportunity.

It is also not unusual for venture capital funds / companies to set upan investment screen. The screen is a set of qualitative ( sometimesquantitative criteria such as revenues are also used ) criteria that helpventure capital funds / companies to quickly decide on whether aninvestment opportunity warrants further diligence. Screen can be

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sometime elaborate and rigorous and sometime specific and brief. Thenature of the screen criteria is also a function of the investment focusof the firm at that point. Venture capital investors rely extensively onthe reference checks with leading lights in the specific area of concernbeing addressed in the due diligence.

INVESTMENT VALUATION

The investment valuation process is an exercise aimed at arriving atan acceptable price for the deal. Typically, in countries where freepricing regimes exist the evaluation process goes through the followingsequence:

Evaluate future revenue and profitability.

Forecast likely future value of the firm based on expected market

capitalization or expected acquisition proceeds depending upon theanticipation exit from the investment.

Target on ownership position in the investee firm so as to achievedesired appreciation on the proposed investment. The appreciationdesired should yield a hurdle rate of return on a discounted cash flowbasis.

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Symbolically the valuation exercise may be represented as follows:NPV = ( cash / post ) x ( patx ( pat ) x k;

Where

NPV = Net present value of the cash flows relationg to the investmentcomprising outflow by way of investment and inflows by way ofinterest / dividends and realization on exit. The rate of return used fordiscounting is the hurdle rate of return set by venture capital investor.

Post = pre + cash

Cash represent the amount of cash being brought into the particularround of financing by the venture capital investor.

Pre is the pre- money valuation of the firm estimated by the investor.While technically it is measured by the intrinsic value of the firm at the

time of raising capital, it is more often a matter of negotiation drivenby the ownership of the company that the venture capital investordesires and the ownership that the founders / management team isprepared to give away for the required amount of capital.

( PAT ) is the forecast of profit after tax in a year and often agreedupon by the founders and the investors.

( PER ) is the price earning multiply that could be expected of acomparable firm in the industry. It is not always possible to fund sucha comparable fit in venture capital situations. That necessitates,

therefore, a significant degree of judgement on the part of the venturecapital to arrive at alternate PER scenarios.

( k ) is the present value interest factor ( corresponding to a discountrate r ) for the investment horizon.

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STRUCTURING THE DEAL

Venture capital investment require and permit innovativeness infinance engineering. While venture capital investment follow no setformula, they attempt to address the needs and concerns of theinvestors and the investee.

The investor tries to ensure the following:

Reasonable reward for the given level of risk;

Sufficient influence on the management of the company through boardrepresentation;

Minimization of taxes;

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Ease in achieving future liquidity on the investment.

The entrepreneur at the same tome seeks to enable:

The creation of the business that he has conceptualized

Financial rewards for creating the business;

Adequate resources needed to achieve their goal;

Voting control;

Common consideration for both sides includes;

Flexibility of structure that will allow room to enable additionalinvestment later, incentives for future management and retention ofstock if management leaves.

Balance sheet attractiveness to suppliers and debt financiers.

Retention of key employees through adequate equity participation.

In the Indian context, one of the primary considerations is retention ofmajority shareholdings often, the promoters do not even wish toencourage external equity participation. These cultural issues have asignificant influence on the structuring of a deal.

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VALUE ADDITION AND MONOTORING

We have seen in our earlier defination of venture capital thatsustained, active involvement over an extended period of time is oneof the distinguishing characteristics of venture capital. This process ofthe venture capital investors involvement in the portfolio company isoften referred to broadly as value addition.

The value that the venture capital brings to the portfolio company canvary from one venture capital profession to another depending uponthe individuals background and approach to venture capital. There areventure capital professional, especially those who invest in vary early

stage situations, whose involvement can go up to providing operatingmanagement support. There are also other whose involvement maynot extent beyond leading and avid ear to the proceedings of quaterlyor monthly board meetings. The extent of involvement could alsodepend upon the venture capital investors stake in the company andhis role in the consortium, when the investment has been syndicatedamong number of investors. In a consortium, it is not an uncommon

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practice for one of the investors to play the role of the lead investortaking upon himself significant responsibilities with respect to theportofolio company, on behalf of himself as well as the co-investor insyndicate. Investment exposure and / or specific ability to add valueand / or geographic presence are some of the usual criteria for a

venture capital investor being designated lead investor.

EXIT

The process of exit from a venture capital is as important as in anyother process in the investment cycle.

The two exit option are:

1. Sale of the venture capital position either along with orsubsequent to a public offering;

2. Acquisition of a company.

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History and evolution of venture capital

Since its humble beginnings in 1946 through the American researchand development corporation of general doriot the institutionalizationof the venture investment process has made significant strides.

Observers of the industry trace the American industry as havingprogressed through distinct phases of evolution in the seventies andeighties. Soon however the concept of professional venture capitalattained popularity in Canada and a number of European countrieswith the British industry in a pioneering role. Presently, Venture capitalin one form or the other come to stay in over thirty five countries. Itmust be highlighted that Venture capital as obtains in some of this

countries is predominantly engaged in providing term finance for smallbusiness in addition to equity and may therefore not confirm to thedefination of Venture capital spelt out elsewhere in paper.

The Second World War produced an abundance of technologicalinnovation, primarily with military applications. They include, forexample, some of the earliest work on micro circuitry. Indeed, J.H.Whitneys investment in Minute Maid was intended to commercialize an

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orange juice concentrate that had been developed to providenourishment for troops in the field.

In the mid-1950s, the U.S. federal government wanted to speed thedevelopment of advanced technologies. In 1957, the Federal Reserve

System conducted a study that concluded that a shortage ofentrepreneurial financing was a chief obstacle to the development ofwhat it called "entrepreneurial businesses." As a response this anumber of Small Business Investment Companies (SBIC) wereestablished to "leverage" their private capital by borrowing from thefederal government at below-market interest rates. Soon commercialbanks were allowed to form SBICs and within four years, nearly 600SBICs were in operation.

At the same time a number of venture capital firms were formingprivate partnerships outside the SBIC format. These partnerships

added to the venture capitalists toolkit, by offering a degree offlexibility that SBICs lack. Within a decade, private venture capitalpartnerships passed SBICs in total capital under management.

The 1960s saw a tremendous bull IPO market that allowed venturecapital firms to demonstrate their ability to create companies andproduce huge investment returns. For example, when DigitalEquipment went public in 1968 it provided ARD with 101% annualizedReturn on Investment (ROI). The US$70,000 Digital invested to startthe company in 1959 had a market value of US$37mn. As a result,venture capital became a hot market, particularly for wealthy

individuals and families. However, it was still considered too risky forinstitutional investors.

In the 1970s, though, venture capital suffered a double-whammy.First, a red-hot IPO market brought over 1,000 venture-backedcompanies to market in 1968, the public markets went into a seven-year slump. There were a lot of disappointed stock market investorsand a lot of disappointed venture capital investors too. Then in 1974,after Congress legislation against the abuse of pension fund money, allhigh-risk investment of these funds was halted. As a result of poorpublic market and the pension fund legislation, venture capital fundraising hit rock bottom in 1975.

Well, things could only get better from there. Beginning in 1978, aseries of legislative and regulatory changes gradually improved theclimate for venture investing. First Congress slashed the capital gainstax rate to 28% from 49.5%. Then the Labor Department issued aclarification that eliminated the pension funds act as an obstacle to

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venture investing. At around the same time, there were a number ofhigh-profile IPOs by venture-backed companies. These includedFederal Express in 1978, and Apple Computer and Genetech Inc in1981. This rekindled interest in venture capital on the part of wealthyfamilies and institutional investors. Indeed, in the 1980s, the venture

capital industry began its greatest period of growth. In 1980, venturefirms raised and invested less than US$600 million. That numbersoared to nearly US$4bn by 1987. The decade also marked theexplosion in the buy-out business.

The late 1980s marked the transition of the primary source of venturecapital funds from wealthy individuals and families to endowment,pension and other institutional funds. The surge in capital in the 1980shad predictable results. Returns on venture capital investmentsplunged. Many investors went into the funds anticipating returns of30% or higher. That was probably an unrealistic expectation to begin

with. The consensus today is that private equity investments generallyshould give the investor an internal rate of return something to theorder of 15% to 25%, depending upon the degree of risk the firm istaking.

However, by 1990, the average long-term return on venture capitalfunds fell below 8%, leading to yet another downturn in venturefunding. Disappointed families and institutions withdrew from ventureinvesting in droves in the 1989-91 period. The economic recovery andthe IPO boom of 1991-94 have gone a long way towards reversing thetrend in both private equity investment performance and partnershipcommitments.

In 1998, the venture capital industry in the United States continued itsseventh straight year of growth. It raised US$25bn in committedcapital for investments by venture firms, who invested over US$16bninto domestic growth companies in all sectors, but primarily focused oninformation technology.

In India Venture capital Industry had its formal introduction in thebugget speech of the finance minister in1988. Though extremelyfocused in its technology development objective, the introductionrecognized the need for a source of patient capital with ability toparticipate in high risk projects in return for high rewards.Coincidentally around the same time, the Industrial credit andInvestment corporation or India Limited ( ICICI ) came forthwithinitiatives for addressing technology intensive projects. One suchinitiative, the Venture capital division, was spun off into Technologydevelopment and information company of India Limited ( TDICI )

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which has since emerged as a significant player and a pioneer in theindustry.

Most of the success stories of the popular Indian entrepreneurs like theAmbanis and Tatas had little to do with a professionally backed up

investment at an early stage. In fact, till very recently, for anentrepreneur starting off on his own personal savings or loans raisedthrough personal contacts/financial institutions.

Traditionally, the role of venture capital was an extension of thedevelopmental financial institutions like IDBI, ICICI, SIDBI and StateFinance Corporations (SFCs). The first origins of modern VentureCapital in India can be traced to the setting up of a TechnologyDevelopment Fund (TDF) in the year 1987-88, through the levy of acess on all technology import payments. TDF was meant to providefinancial assistance to innovative and high-risk technological

programs through the Industrial Development Bank of India. Thismeasure was followed up in November 1988, by the issue of guidelinesby the (then) Controller of Capital Issues (CCI). These stipulated theframework for the establishment and operation of funds/companiesthat could avail of the fiscal benefits extended to them.

However, another form of (ad?)venture capital which was unique toIndian conditions also existed. That was funding of green-field projectsby the small investor by subscribing to the Initial Public Offering (IPO)of the companies. Companies like Jindal Vijaynagar Steel, which raisedmoney even before they started constructing their plants, were

established through this route.

The industrys growth in India can be considered in two phases. Thefirst phase was spurred on soon after the liberalization process beganin 1991. According to former finance minister and harbinger ofeconomic reform in the country, Manmohan Singh, the governmenthad recognized the need for venture capital as early as 1988. That wasthe year in which the Technical Development and InformationCorporation of India (TDICI, now ICICI ventures) was set up, soonfollowed by Gujarat Venture Finance Limited (GVFL). Both theseorganizations were promoted by financial institutions. Sources of thesefunds were the financial institutions, foreign institutional investors orpension funds and high net-worth individuals. Though an attempt wasalso made to raise funds from the public and fund new ventures, theventure capitalists had hardly any impact on the economic scenario forthe next eight years.

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However, it was realized that the concept of venture capital fundingneeded to be institutionalized and regulated. This funding requiresdifferent skills in assessing the proposal and monitoring the progressof the fledging enterprise. In 1996, the Securities and Exchange Boardof India (SEBI) came out with guidelines for venture capital funds has

to adhere to, in order to carry out activities in India. This was thebeginning of the second phase in the growth of venture capital inIndia. The move liberated the industry from a number of bureaucratichassles and paved the path for the entry of a number of foreign fundsinto India. Increased competition brought with it greater access tocapital and professional business practices from the most maturemarkets.

There are a number of funds, which are currently operational in Indiaand involved in funding start-up ventures. Most of them are not trueventure funds, as they do not fund start-ups. What they do is provide

mezzanine or bridge funding and are better known as private equityplayers. However, there is a strong optimistic undertone in the air.With the Indian knowledge industry finally showing signs of readinesstowards competing globally and awareness of venture capitalistsamong entrepreneurs higher than ever before, the stage seems all setfor an overdrive.

The Indian Venture Capital Association (IVCA), is the nodal center forall venture activity in the country. The association was set up in 1992and over the last few years, has built up an impressive database.According to the IVCA, the pool of funds available for investment to its20 members in 1997 was Rs25.6bn. Out of this, Rs10 bn had beeninvested in 691 projects.

Certain venture capital funds are Industry specific(ie they fundenterprises only in certain industries such as pharmaceuticals, infotechor food processing) whereas others may have a much wider spectrum.Again, certain funds may have a geographic focus like Uttar Pradesh,Maharashtra, Kerala, etc whereas others may fund across differentterritories. The funds may be either close-endedschemes (with a fixedperiod of maturity) or open-ended.

Classification

Venture funds in India can be classified on the basis of

Genesis

Financial Institutions Led By ICICI Ventures, RCTC, ILFS, etc.

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Private venture funds like Indus, etc.

Regional funds like Warburg Pincus, JF Electra (mostly operating out ofHong Kong).

Regional funds dedicated to India like Draper, Walden, etc.

Offshore funds like Barings, TCW, HSBC, etc.

Corporate ventures like Intel.

To this list we can add Angels like Sivan Securities, Atul Choksey (exAsian Paints) and others. Merchant bankers and NBFCs who specializedin "bought out" deals also fund companies. Most merchant bankers ledby Enam Securities now invest in IT companies.

Investment Philosophy

Early stage funding is avoided by most funds apart from ICICIventures, Draper, SIDBI and Angels.

Funding growth or mezzanine funding till pre IPO is the segmentwhere most players operate. In this context, most funds in India areprivate equity investors.

Size Of InvestmentThe size of investment is generally less than US$1mn, US$1-5mn,US$5-10mn, and greater than US$10mn. As most funds are of aprivate equity kind, size of investments has been increasing. ITcompanies generally require funds of about Rs30-40mn in an earlystage which fall outside funding limits of most funds and that is whythe government is promoting schemes to fund start ups in general,and in IT in particular.

Value Addition

The venture funds can have a totally "hands on" approach towardstheir investment like Draper or "hands off" like Chase. ICICI Venturesfalls in the limited exposure category. In general, venture funds whofund seed or start ups have a closer interaction with the companiesand advice on strategy, etc while the private equity funds treat theirexposure like any other listed investment. This is partially justified, asthey tend to invest in more mature stories.

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A list of the members registered with the IVCA as of June 1999, hasbeen provided in the Annexure. However, in addition to the organizedsector, there are a number of players operating in India whose activityis not monitored by the association. Add together the infusion of fundsby overseas funds, private individuals, angel investors and a host of

financial intermediaries and the total pool of Indian Venture Capitaltoday, stands at Rs50bn, according to industry estimates!

The primary markets in the country have remained depressed for quitesome time now. In the last two years, there have been just 74 initialpublic offerings (IPOs) at the stock exchanges, leading to aninvestment of just Rs14.24bn. Thats less than 12% of the moneyraised in the previous two years. That makes the conservativeestimate of Rs36bn invested in companies through the VentureCapital/Private Equity route all the more significant.

Some of the companies that have received funding through this routeinclude:

Mastek, one of the oldest software houses in India

Geometric Software, a producer of software solutions for the CAD/CAMmarket

Ruksun Software, Pune-based software consultancy

SQL Star, Hyderabad based training and software developmentcompany

Microland, networking hardware and services company based inBangalore

Satyam Infoway, the first private ISP in India

Hinditron, makers of embedded software

PowerTel Boca, distributor of telecomputing products for the Indianmarket

Rediff on the Net, Indian website featuring electronic shopping, news,

chat, etc

Entevo, security and enterprise resource management softwareproducts

Planetasia.com, Microlands subsidiary, one of Indias leading portals

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Torrent Networking, pioneer of Gigabit-scaled IP routers for inter/intranets

Selectica, provider of interactive software selection

Yantra, ITLInfosys US subsidiary, solutions for supply chainmanagement

Though the infotech companies are among the most favored byventure capitalists, companies from other sectors also feature equallyin their portfolios. The healthcare sector with pharmaceutical, medicalappliances and biotechnology industries also get much attention inIndia. With the deregulation of the telecom sector, telecommunicationsindustries like Zip Telecom and media companies like UTV andTelevision Eighteen have joined the list of favorites. So far, thesetrends have been in keeping with the global course.

However, recent developments have shown that India is maturing intoa more developed marketplace, unconventional investments in agamut of industries have sprung up all over the country. This includes:

Indus League Clothing, a company set up by eight former employeesof readymade garments giant Madura, who set up shop on their ownto develop a unique virtual organization that will license global apparelbrands and sell them, without owning any manufacturing units. Theydream to build a network of 2,500 outlets in three years and to beamong the top three readymade brands.

Shoppers Stop, Mumbais premier departmental store innovates withretailing and decides to go global. This deal is facing some problems ingetting regulatory approvals.

Airfreight, the courier-company which has been growing at a rapidpace and needed funds for heavy investments in technology,networking and aircrafts.

Pizza Corner, a Chennai based pizza delivery company that is set totake on global giants like Pizza Hut and Dominos Pizza with itsinnovative servicing strategy.

Car designer Dilip Chhabria, who plans to turn his studio, where heremodels and overhauls cars into fancy designer pieces of automation,into a company with a turnover of Rs1.5bn (up from Rs40mn today).

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Indian Scenario - A Statistical Snapshot

Contributors Of Funds

Contributors Rs mn Per cent

Foreign Institutional Investors 13,426.47 52.46%

All India Financial Institutions 6,252.90 24.43%

Multilateral Development Agencies 2,133.64 8.34%

Other Banks 1,541.00 6.02%

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Foreign Investors 570 2.23%

Private Sector 412.53 1.61%

Public Sector 324.44 1.27%

Nationalized Banks 278.67 1.09%

Non Resident Indians 235.5 0.92%

State Financial Institutions 215 0.84%

Other Public 115.52 0.45%

Insurance Companies 85 0.33%

Mutual Funds 4.5 0.02%

Total 25,595.17 100.00%

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Methods Of Financing

Instruments Rs million Per cent

Equity Shares 6,318.12 63.18

Redeemable Preference Shares 2,154.46 21.54

Non Convertible Debt 873.01 8.73

Convertible Instruments 580.02 5.8

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Other Instruments 75.85 0.75

Total 10,000.46 100

Financing By Investment Stage

Investment Stages Rs million Number

Start-up 3,813.00 297

Later stage 3,338.99 154

Other early stage 1,825.77 124

Seed stage 963.2 107

Turnaround financing 59.5 9

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Total 10,000.46 691

Financing By Industry

Industry Rs million Number

Industrial products, machinery 2,599.32 208

Computer Software 1,832 87

Consumer Related 1,412.74 58

Medical 623.8 44

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Food, food processing 500.06 50

Other electronics 436.54 41

Tel & Data Communications 385.09 16

Biotechnology 376.46 30

Energy related 249.56 19

Computer Hardware 203.36 25

Miscellaneous 1,380.85 113

Total 10,000.46 691

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Financing By States

Investment Rs million Number

Maharashtra 2,566 161

Tamil Nadu 1531 119

Andhra Pradesh 1372 89

Gujarat 1102 49

Karnataka 1046 93

West Bengal 312 22

Haryana 300 22

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Delhi 294 21

Uttar Pradesh 283 29

Madhya Pradesh231 2

Kerala 135 15

Goa 105 16

Rajasthan 87 11

Punjab 84 6

Orissa 35 5

Dadra & Nagar Haveli 32 1

Himachal Pradesh 28 3

Pondicherry 22 2

Bihar 16 3

Overseas 413 12

Total 9994 691

Source IVCA

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Problems With VCs In The Indian Context

One can ask why venture funding is so successful in USA and faced anumber of problems in India. The biggest problem was a mindsetchange from "collateral funding" to high risk high return funding. Most

of the pioneers in the industry were people with credit background andexposure to manufacturing industries. Exposure to fast growingintellectual property business and services sector was almost zero. Allthese combined to a slow start to the industry. The other issues thatled to such a situation include:

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Valuing

Valuation of any business has always been complicated. With thegrowing prominence of service businesses, valuing businesses hasbecome all the trickier.

Consider the straightforward issue of valuation of any manufacturingconcern. The basic material required for such an exercise is readily

available. For example, the financial records of the company, itsproduct line the industry in which it operates its competitive position,etc.

But even here, there are a number of thorny issues. For one, whatshould be the discounting rate? Even experts find it difficult to come toa conclusion on the most appropriate rate of discounting to be applied.Or for that matter, the method of valuation. To twist the tale a littlefurther, what if a steel maker gets into the business of resellingcomputer hardware?

On the other hand, service businesses are a different ball game all

together. The investment required to set up a service business isgenerally far lesser than that required for a manufacturing business.Moreover, predominant assets deployed by service business areintangible. Human capital usually forms a very vital part of suchintangible assets.

And how do you value human capital? That is the question mostaccounting bodies the world over are grappling with. The fact is that

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most traditional parameters used to value companies simply cannot beapplied to these new age companies!

Most often, these companies operate in unknown markets and withbrand new technologies. There are no precedents to follow. There areno established norms. There are only ideas and more ideas. Only avery small percentage of the entrepreneurs diligently implement theirideas and give birth to path breaking businesses. How do you valuecompanies that have had no past and only hold the promise of thefuture?

It is in this context that valuation of software companies; Internetcompanies and Dotcoms have come to pose formidable challenges toboth regulatory bodies and valuers. Regulators the world over havetried to set some guidelines, which will help in the valuation of suchconcerns.

But don't traditional valuation methods focus on these anyway? Don'tthe existing statutory requirements necessitate the furnishing of suchinformation through annual reports and statement of results and otherdeclarations to various authorities?

The point is this: you cannot differentiate a Dotcom from any anothercompany. Ultimately, every business entity has to create and enhancestakeholder value. Any business that does not do this does not deserveto exist.

Hence, all normal disclosure norms and valuation methods should beapplied to Dotcom and Internet companies.

In fact, only the strict application of investment prudence and normalbusiness principles can safeguard the interests of all involved.

For example, the management team factor is said to be the mostimportant ingredient for the success of an Internet company or aDotcom. Or for that matter, for any business concern. Any businessventure will be on a sticky wicket if its management team is not up tothe mark. But, how will statutory norms ensure this?

Therefore, regulators need to ensure that all pertinent information thatis necessary for all companies disclose informed decision-making.

Policy framework, accounting policies to be followed and stringentaction plan against defaulters (that are implemented!) the other areasregulatory bodies need to put in place.

As far as investors are concerned, one cardinal principle must never beforgotten: caveat emptor!

After all, aren't valuation exercises a game of betting on the future?

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In early 2000, Internet entrepreneurs had succeeded in quicklytransforming their business ideas into billion dollar valuations thatseemed to defy common wisdom about profits, multiples, and theshort tem focus on capital markets. Below mentioned is an attempt tounderstand how Dotcoms are valued.

The most common critique one hears about the valuation of Internetcompanies is that their values balloon as their loss balloon. Thisrelationship is driven by 2 factors: supernormal growth; andinvestments running through the income statement. Many Internetrelated start-ups experience annual growth rates exceeding 100percent. This hyper-growth when fuelled by investments that havebeen expensed rather than capitalized will create ever-increasinglosses until growth rates slow.

Internet companies typically do not require heavy investments of thetype that get capitalized, such as factories, plant and equipment, etc.their investment is in customer acquisition, which has to be expensedthrough the income statement. For e.g., if the acquisition cost percustomer, through advertisements and direct mails of CD- ROMs is $40per customer and a company successfully builds its customer basefrom 1 million in 1 year to 3 million in the second year, to 6 million inthe third year, its acquisition costs will rise from $40 million in the firstyear to 120 million in the third year.

In a bricks and mortar retailer case, much of the customer acquisitioncosts will comprise of costs consist of securing a store location,furniture fixtures etc. these expenses are largely capitalized and

expensed over their useful life. Hence the physical retailer will breakeven years earlier than the virtual retailer with the same investment.Provided that the virtual retailer will earn a positive net present valueon its customer acquisition investments, increasing losses because ofaccelerating customer acquisition will raise the value of the company.

These conditions of super normal growth and investment through theincome statement render short hand valuation approaches includingprice to earnings and revenue multiplies, meaningless. The best way ofvaluing Internet companies is the DCF (Discounted Cash Flow)approach, which makes the distinction between expensed and

capitalized investments unimportant because

Accounting treatments dont affect cash flows. The absence ofmeaningful historical data and positive earnings also dont matter,because the DCF approach relies solely on forecasts of performancesand can easily capture the worth of value creating businesses thathave had several years of initial losses.

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A three-stage approach is used to make DCF more useful for valuingInternet companies starting from a fixed point in the future andworking back to the present using probability- weighted scenarios toaddress high uncertainty in an explicit way, and exploiting classicanalytical techniques to understand the underlying economics of these

companies and to forecast their future performance.

The above approach is illustrated with a valuation of AMAZON.COM,the archetypal Internet company, as of November 1999. From itslaunch in 1995 it built a customer base of 10 million and expanded itsofferings from books to toys, CDs, videos etc. it also invested inbranded Internet players like pet.com and Drugstore.com. Thiscompany is a symbol of the new economy. It has a very high marketcapitalization of 25 US$ as at November 1999 and yet the companyhas never made profits and has lost $390 million in 1999. Thecompany has become a focus of debate whether Internet stocks were

greatly overvalued.

Start From The Future

Instead from starting from the present the usual practice in DCFvaluations is to start from the future what the company and theindustry could look like when they evolve from todays very highgrowth, unstable condition to a sustainable moderate growth state inthe future and extrapolate it back to current performance. The futuregrowth rate should be defined by metrics such as penetration rate,

average revenue per customer, and sustainable growth margins.For the purpose of understanding this concept, let us create anoptimistic scenario. Let Amazon.com be the next Wal-Mart. Say by2010, Amazon.com continues to be; and has established itself as theleading on line retailer; in both online and off line markets. Assumethe company has a 13% share of the total U.S books and musicmarket; it would have revenues of appx. $60 billion (based on todaysmarket share) by 2010. Let us assume that Amazon.com earns anaverage operating margin of 11% since due to its size will have abetter purchasing power and also incur fewer associated costs. Also in

the optimistic scenario Amazon.com will require less working capitaland fewer fixed assets than traditional retailers do. We also assumethat Amazon.coms capital turnover will be 3.4.

Hence based on the above we get the following financials forecasts forAmazon.com for the year 2010.

1. Revenues - $60 billion.

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2. Operating profit - $7 billion.

3. Total capital $ 18 billion.

To estimate Amazon.coms current value we discount the projectedfree cash flows back to the present. Its present value is $37 billion.

What went wrong? What happened to the multi million-dollarvaluations? Where did all the money go?

Let us try and first understand what the Internet stands for, what theInternet was intended for. The Internet is intended to increase

efficiencies and effectiveness that would aid in business transactions.It is a tool to build efficiencies. How can one build a business modelaround it? It is like building a business model around a fax machine ora telephone. Some may argue that Direct Marketing is a businessmodel built around the telephone. But Direct Marketing is a channel, ameans for marketing and not the end and be all of the businessfunctions. Direct Marketing is used to enhance current business. Butwhat happened with the Internet? An entire business model was builtaround the Internet. The Internet was intended to take over all thefunctions in the supply chain and do away the human aspect ofbusiness. We must understand the Internet is intended to AID human

beings, reduce human interference and hence the inefficienciesassociated with it, NOT do away completely with them. Nocommunication medium can become the root foundation of a businessmodel besides that for a service provider of that communicationmedium. What was the main foundation of the Dotcoms? If you havean idea that can be converted into a web application that caters tomost of the business functions the business will succeed. It wasassumed that the people would prefer to buy online rather than offline. But what they forgot is that people dont buy a product becauseof good technology or that what the need is available just one click

away. People need other people. They need the human aspect.

These days, whenever I think of Dotcom, I think of a ticket to anoverpriced experience race. More than 90 per cent of the Dotcomstartups announced in the last 1-2 years, only a handful has evenmade it to the starting post - leave alone run the final race. Eventualfailure is nothing new for sunrise industries in any sector. Old Economyor New. Most industries grow by kindling a hundred entrepreneurial

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dreams; only handfuls survive in the end. Nature's law will thus takecare of the Dotcoms in the usual way. Most Indian Dotcoms have triedto mimic the assumed early success in US and elsewhere instead ofasking series of fundamental questions:

What is it that I am offering that is not already being offered by

others? What will be my revenue sources?

If there are many players in the field what will be thedifferentiating factor?

The answer, currently, is very little. Whether it is groceries, or textiles,or anything I would require regularly, I don't see the net as a greatplace to buy. Given cheap Indian labor, almost all such things can bedone more easily over the phone. I can order dinner - sometimes evena small order like a plate of idlis - from any nearby restaurant at no

extra cost in most Indian cities. I can order groceries from shops in thevicinity of my home with a mere phone call. I would not order a shirtor jewellery over the net for fear of not getting what I want (who will Ichase in case of wrong delivery as the word customer service is aliento most Indian companies). Would I buy a TV or PC on the net?Maybe. But only if the price advantage over the conventionalshowroom is very clear supported with a good customer serviceagreement. Not otherwise.

Net business models, especially in the B2C area, will work best inareas where there are no physical products to be moved. Meaning,

they should work well in areas like broking, banking and financialtrading-and not so well in grocery or garments. Reason: there is nophysical product that I need to cart from factory to consumer, fromMumbai to Delhi. On the other hand, whether I am in Mumbai or Delhi,in areas like share trading the net clearly facilitates transactions andbrings down costs. I can buy or sell a share more easily and at lowercost on the net. I can also do most of my banking from home or theoffice, or even through my cellphone.

A business will work on the net if its products are sufficiently

standardized. The reason why Dell sells a lot of PCs through the net isbecause the things going into PCs are no more than glorifiedcommodities - the same Intel chips, the same Microsoft software, andthe same add-on hardware. You can also sell high quality brandedproducts through the net, but risk commoditisation in the process. Thereason: the net allows the consumer to see all similar products on thesame shelf. Thus it would put a Titan watch and a Piaget on the samepedestal. Good for Titan. But for Piaget?

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The once robust Dotcom sector has seen a stunning reversal offortunes in the past several months. And no one knows how manymore are quietly cutting expenses. Where has IndiaInfo gone now?What is SatyamOnline doing? Whether a company shuts down

completely or simply cuts back, its advertising budget invariablysuffers. Marketing is the first thing to go. Dotcoms can't live by adsalone.

Dot-com closures are accelerating, with Internet startups now closingat the rate of about one a day, according to a new report. The figuresbring clarity to the endless announcements of young companiesshutting down -- some of which launched amid great fanfare onlyearlier this year.

In the next five years, out of all the companies existing in the IndianInternet space (estimated to be around 500), 90 per cent will die andthe rest 10 per cent will survive through consolidation. Theconsolidation will be done primarily through mergers and acquisitionsactivity between companies that are technology driven and thosehaving strong business models. Only 12 per cent of all the IndianInternet companies have received a venture capital funding and theseare primarily the ones that will experience consolidation activity. Thereason why incubation of start-up companies has not taken off in Indiais that most of the incubator companies and venture capital fundsthemselves are less than one-year old. Primarily financial compulsions,

rather than being driven by complimentary synergies between variouscompanies drive the merger and acquisition activity in India. This isbecause the Indian start-up ecosystem is not yet mature, and theventure capitalists are themselves learning.

The valuations of Dotcom companies have dropped by 50 per cent ascompared to those six months back. In fact, the valuations havebecome more realistic today. There is no parameter to measurevaluations, but the stock market. But this is also not real, as the stockmarket is not applicable to a Dotcom company (because the presence

of a Dotcom company in the stock market is very far away, only whenit goes public Valuations of the Internet companies are more of aperception and are driven by sentiment.

Then why was there a mad rush to invest in Dotcoms? Why

were million of dollars pumped into these ventures? Didntpeople realize that this might not work?

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Over 80 percent of the 350 companies that have gone public under theguise of the Internet are not showing profits. Because they don't haveprofits, its hard to know how to value them. Amazon.com has beenvalued like Microsoft on steroids. The reason that Microsoft has a highvaluation is that it has 37 percent to 40 percent operating profit

margins, whereas a company like Amazon, which is just a distributioncompany, can never expect those kinds of margins. Microsoft is anintellectual property company. An Amazon is just a distributor --distribution companies typically generate 2 percent profit margins. Butsince they weren't generating any profits, people didn't know what toexpect, so they thought -- oh, maybe they're going to be the nextMicrosoft.

Now, people are starting to understand who are the real companiesand what are the real business models.

Clearly, the bubble has burst. Things will never be the same. What'shappened is a lot of people have lost a lot of money and is going toscar them for a long time, and they're going to realize that it's nowback to fundamentals. Its back to rationality.

The bottom line is that there was this game of musical chairs that wasbeing played. I think that intuitively people knew that the market wasartificially propped up, but everyone has been making so much moneyin the market in the last two or three years, so no one wanted themusic to stop and it kind of took on a life of its own. E-tailing

companies plus the Web media companies got caught recently.

The e-tailing companies were caught with people realizing that they'renever going to make the kind of profits that a Microsoft or atechnology company would. As for the Web media companies: WhenAOL merged with Time Warner, it was kind of like the smartest guy inthe Web media business, As Steve Case, said that in order to moveforward successfully I need old economy capability. So, a lot of thesepure-play Internet media companies, such as TheStreet.com andiVillage, got kind of left hanging out there.

Bubble or boom, the dot still fascinates, and the rush to set up Dotcomportals continues unabated. Evidently, the pot of gold at the end of aventure capital rainbow is too strong a temptation to resist.

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