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Chapter 1 INTRODUCTION TO VENTURE CAPITAL FUNDS 1.1 1.2 1.3 1.4 1.5 1.

.6 Introduction The Origin Background Meaning and Definition Characteristics Types of VCF

INTRODUCTION to Venture Capital

Small businesses never seem to have enough money. Bankers and Suppliers, naturally, are important in financing small business growth through loans and credit, but an equally important source of long term. Growth Capital is the venture capital firm. Venture Capital financing may have an extra bonus, for if a small firm has an adequate equity base; banks are more willing to extend credit. Venture capital is money provided by professionals who invest alongside management in young, rapidly growing companies that have the potential to develop into significant economic contributors. Venture capital is an important source of equity for start-up companies. Venture capital is capital typically provided by outside investors for financing of new, growing or struggling businesses. Venture capital investments generally are high risk investments but offer the potential for above average returns and/or a percentage of ownership of the company. A venture capitalist (VC) is a person who makes such investments. A venture capital fund is a pooled investment vehicle (often a partnership) that primarily invests the financial capital of third-party investors in enterprises that are too risky for the standard capital markets or bank loans. The term Venture Capital is understood in many ways. In a narrow sense, it refers to, investment in new and tried enterprises that are lacking a stable record of growth. In a broader sense, venture capital refers to the commitment of capital as shareholding, for the formulation and setting up of small firms specializing in new ideas or new technologies. It is not merely an injection of funds into a new firm, it is a simultaneous input of skill needed to set up the firm, design its marketing strategy and organize and manage it. It is an association with successive stages of firms development with distinctive types of financing appropriate to each stage of development.

According to International Finance Corporation (IFC), venture capital is equity or equity featured capital seeking investment in new ideas, new companies, new production, new process or new services that offer the potential of high returns on investments. As defined in Regulation 2(m)of SEBI (Venture Capital Funds) Regulation , 1996 "venture capital fund means a fund established in the form of a company or trust which raises monies through loans, donations issue of securities or units as the case may be, and makes or proposes to make investments in accordance with these regulations. Thus venture capital is the capital invested in young, rapidly growing or changing companies that have the potential for high growth. The VC may also invest in a firm that is unable to raise finance through the conventional means. Professionally managed venture capital firms generally are private partnerships or closely-held corporations funded by private and public pension funds, endowment funds, foundations, corporations, wealthy individuals, foreign investors, and the venture capitalists themselves. Venture capitalists generally:

Finance new and rapidly growing companies; Purchase equity securities; Assist in the development of new products or services; Add value to the company through active participation; Take higher risks with the expectation of higher rewards; Have a long-term orientation

When considering an investment, venture capitalists carefully screen the technical and business merits of the proposed company. Venture capitalists only invest in a small percentage of the businesses they review and have a long-term perspective. Going forward, they actively work with the company's management by contributing their experience and business savvy gained from helping other companies with similar growth challenges.

Venture capitalists mitigate the risk of venture investing by developing a portfolio of young companies in a single venture fund. Many times they will co-invest with other professional venture capital firms. In addition, many venture partnership will manage multiple funds simultaneously. For decades, venture capitalists have nurtured the growth of America's high technology and entrepreneurial communities resulting in significant job creation, economic growth and international competitiveness. Companies such as Digital Equipment Corporation, Apple, Federal Express, Compaq, Sun Microsystems, Intel, Microsoft, Yahoo, Airtel and Genentech are famous examples of companies that received venture capital early in their development. Venture Capital is the business of establishing an investment fund in the form of equity financing via investments in the common stocks, preferred stocks and convertible debentures of various companies. These companies are seen to have a high growth potential and are able to be listed on the stock exchange in order to gain the highest returns in dividends and capital gain.

1.2 The Origin of Venture Capital

In the 1920's & 30's, the wealthy families of and individuals investors provided the start up money for companies that would later become famous. Eastern Airlines and Xerox are the more famous ventures they financed. Among the early VC funds set up was the one by the Rockfeller Family which started a special fund called VENROCK in 1950, to finance new technology companies. USA is the birth place of Venture Capital Industry as we know it today. During most its historical evolution, the market for arranging such financing was fairly informal, relying primarily on the resources of wealthy families. In 1946, American Research and Development Corporation (ARD), a publicly traded, closed-end investment company was formed. ARD's best known investment was the start-up financing it provided in 1958 for computer maker Digital Equipment Corp. ARD was eventually profitable, providing its original investors with a 15.8 percent annual rate of return over its twenty-five years as an independent firm. General Doriot, a professor at Harvard Business School, set up the ARD, the first firm, as opposed to private individuals, at MIT to finance the commercial promotion of

advanced technology developed in the US Universities. ARD's approach was a classic VC in the sense that it used only equity, invested for long term, and was prepared to live with losers. ARD's investment in Digital Equipment Corporation (DEC) in 1957 was a watershed in the history of VC financing. The number of such specialized investment firms, eventually to be called venture capital firms, began to boom in the late 1950s.The growth was aided in large part by the creation in 1958 of the federal Small Business Investment Company program. Hundreds of SBICs were formed in the 1960s, and many remain in operation today. Slow Growth in 1960s & early 1970s, and the First Boom Year in 1978 During the 1960s and 1970s, venture capital firms focused their investment activity primarily on starting and expanding companies. More often than not, these companies were exploiting breakthroughs in electronic, medical or data-processing technology. As a result, venture capital came to be almost synonymous with technology finance. Venture capital firms suffered a temporary downturn in 1974, when the stock market crashed and investors were naturally wary of this new kind of investment fund. 1978 was the first big year for venture capital. The industry raised approximately $750 million in 1978. Highs & Lows of the 1980s In 1980, legislation made it possible for pension funds to invest in alternative assets classes such as venture capital firms. 1983 was the boom year - the stock market went through the roof and there were over 100 initial public offerings for the first time in U.S. history. That year was also the year that many of today's largest and most prominent firms were founded. Due to the excess of IPOs and the inexperience of many venture capital fund managers, VC returns were very low through the 1980s. VC firms retrenched, working hard to make their portfolio companies successful. The work paid off and returns began climbing back up.

Boom Times in the 1990s The 1990s have been, by far the best years for the Venture Capital Industry. The engine for growth has been the favourable economic climate in the US coupled with the advent of the Internet boom. During this decade, the interest rates were low and the P/Es were very high compared to historical averages. Finally, the rate of M&A activity has increased dramatically in the 1990s, creating more opportunities for small, venture-backed companies to exit (cash out) at high prices. The advent of the Internet as a new medium for both personal and business communications and commerce created an avalanche of opportunities for venture capitalists in the mid and late 1990s. As a result, the industry has experienced extraordinary growth in the past few years, both in the number of firms, and in the amount of capital they have raised.

1.3 The Background In September 1995, Government of India issued guidelines for overseas venture capital investment in India whereas the Central Board of Direct Taxes (CBDT) issued guidelines for tax exemption purposes. (The Reserve Bank of India governs the investment and flow of foreign currency in and out of India.) As a part of its mandate to regulate and to develop the Indian capital markets, Securities and Exchange Board of India (SEBI) framed the SEBI (Venture Capital Funds) Regulations, 1996. Pursuant to the regulatory framework, some domestic VCFs were registered with SEBI. Some overseas investments also came through the Mauritius route. However, the venture capital industry, understood globally as 'independently managed, dedicated pools of capital that focus on equity or equity linked investments in privately held, high growth companies' (The Venture Capital Cycle, Gompers and Lerner, 1999) is still relatively in a nascent stage in India. Figures from the Indian Venture Capital Association (IVCA) reveal that, till 2000, around Rs. 2,200 crore (US$ 500 million) had been committed by the domestic VCFs and offshore funds

which are members of IVCA. Figures available from private sources indicate that overall funds committed are around US$ 1.3 billion. Funds that can be invested were less than 50 percent of the committed funds and actual investments were lower still. At the same time, due to economic liberalisation and increasing global outlook in India, an increased awareness and interest of domestic as well as foreign investors in venture capital was observed. While only 8 domestic VCFs were registered with SEBI during 1996-98, more than 30 additional funds have already been registered in 2000-01. Institutional interest is growing and foreign venture investments are also on the increase. Given the proper environment and policy support, there is a tremendous potential for venture capital activity in India.

The Finance Minister, in the Budget 2000 speech announced, "For boosting high tech sectors and supporting first generation entrepreneurs, there is an acute need for higher investments in venture capital activities." He also said that the guidelines for the registration of venture capital activity with the Central Board of Direct Taxes would be harmonized with those for registration with the Securities and Exchange Board of India. SEBI decided to set up a committee on venture capital to identify the impediments and suggest suitable measures to facilitate the growth of venture capital activity in India. Keeping in view the need for global perspective, it was decided to associate Indian entrepreneur from Silicon Valley in the committee. The setting up of this committee was primarily motivated by the need to play a facilitating role in tune with the mandate of SEBI, to regulate as well as develop the market. The committee headed by K. B. Chandrasekhar, Chairman, Exodus Communications Inc., submitted its report on 8 January 2000.

1.4 (a)Meaning of Venture Capital Venture capital is long-term risk capital to finance high technology projects which involve risk but at the same time has strong potential for growth. Venture capitalist pools their resources including managerial abilities to assist new entrepreneur in the early years of the project. Once the project reaches the stage of profitability, they sell their equity holdings at high premium.

(b) Definition of the Venture Capital Company

A venture capital company is defined as a financing institutions which joints an entrepreneur as a co-promoter in a project and shares the risks and rewards of the enterprise.

1.5 Characteristics of Venture Capital

The three primary characteristics of venture capital funds which may them eminently suitable as a source of risk finance are: (1) that it is equity or quasi equity investments; (2) it is long-term investment; and (3) it is an active from of investment. First, venture capital is equity or quasi equity because the investor assumes risk. There is no security for his investment. Venture capital funds by participating in the equity capital institutionalize the process of risk taking which promotes successful domestic technology development. Investors of venture capital have no liquidity for a period of time. Venture capitalist or funds hope that the company they are backing will thrive and after five to seven years from making the investment it will be large and profitable enough to sell its shares in the stock market. But a reward is thee for liquidity and waiting. The venture

capitalists hope to sell their share for many times what they paid for. If the unit fails the venture capitalists losses everything. The probability distribution of expected returns for most venture capital investment is highly skewed to the right. The success rate is 10-20 percent. Secondly, venture capital is long-term investment involving both money and time. Finally, venture capital investment involves participation in the management of the company. Venture capitalist participates in the Board and guides the firm on strategic and policy matters. The features of venture capital generally are, financing new and rapidly growing companies; purchase of equity shares; assist in transformation of innovative technology based ideas into products and services; and value to company by active participation; assume risks in the expectation of large rewards; and possess a long-term perspective. These features of venture capital render it eminently suitable as a source of risk capital for domestically developed technologies. New venture proposals in high technology area are attractive because of the perceived possibility of substantial growth and capital gains. Although venture capital evolved as a method of early sage financing it includes development, expansion and buyout financing for units which are unable to raise funds through normal financing channels. Units in developing countries need funds for financing various stages of development. Such a broad approach would help venture funds to diversify their investment and spread risks.

1.6 Types of Venture Capital Firms

Venture Capital can be divided into many different types according to the characteristics of the shareholders and sources of investment -- such as private equity firms, banks, financial institutions, private corporations, the government or insurance companies. Generally there are three types of organized or institutional venture capital funds: venture capital funds set up by angel investors, that is, high net worth individual investors; venture capital subsidiaries of corporations and private venture capital firms/ funds. Venture capital subsidiaries are established by major corporations, commercial bank holding companies and other financial institutions. Venture funds in India can be classified on the basis of the type of promoters.

Financial institutions led by ICICI ventures, ILFS, etc. Private venture funds like Indus, etc. Regional funds: Warburg Pincus, JF Electra (mostly operating out of Hong Kong). Regional funds dedicated to India: Draper, Walden, etc. Offshore funds: Barings, TCW, HSBC, etc. Corporate ventures: venture capital subsidiaries of corporations. Angels: high net worth individual investors. Merchant bankers and NBFCs who specialize in "bought out" deals also fund companies.

On the basis of geographical focus

Regional Global IT and IT-enabled services Software Products (Mainly Enterprise-focused) Wireless/Telecom/Semiconductor Banking

On the basis of industry specialty

Media/Entertainment Bio Technology/Bio Informatics Pharmaceuticals Contract Manufacturing Retail

On the basis of funding stage:

Seed/early Late/mbo Pipe

The Venture Capital firms in India can be categorized into the following four groups: 1. All-India DFI-sponsored VCFs such as Technology Development and Information Company of India Ltd. (TDICI) by ICICI, Risk Capital and Technology Finance Corporation Ltd. (RCTFC) by IFCI and Risk Capital Fund by IDBI 2. SFC-sponsored VCFs such as Gujarat Venture Capital Ltd. (GVCL) by GIIC and Andhra Pradesh Venture Capital Ltd. (APVCL) by APSFC 3. Bank-sponsored VCFs such as Canfina and SBI Caps 4. Private VCFs supported by private sector companies such as Indus Venture

Capital Fund, Credit Capital Venture Fund.

Chapter 2 Development of VCF in International Arena and INDIA 2.1 VCF in International Arena 2.2 Venture Capital in India 2.3 Future of Venture Capital in India

Development of Venture Capital 2.1 The International arena

The modern venture capital industry began taking shape in the post World War II years. It is often said that people decide to become entrepreneurs because they see role models in other people who have become successful entrepreneurs. Much the same thing can be said about venture capitalists.

The history of the venture capital in US traces back to the period after World War II when a few wealthy family groups like Rockefeller, Andrew Carnegie and others took the initiative. The venture capital industry was started by George Detroit who collaborated in establishing Corporation at Boston. From 1965 to 1972 nearly 40 venture capital companies were formed with committed assets of $500 million. It is noted that in the US, the venture capital industry has been associated with technology development. In the 1980s, the US venture industry began to establish its business overseas at large.

In the UK, the development of venture capital owes to the professionally managed specialist fund Charter House set up in 1980 for providing risk equity finance for young and growing small business. In 1983, British Venture Capital Association was established with a membership of 33 funds, which rose to 115 in 1992.

In 1963, 3 Government assisted companies were established in Tokyo, Osaka and Nagoya, to provide venture capital t small and medium industries. Leading financial institutions in Japan started venture capital companies for financing high technology industrial units. The rapid growth of industry in Japan is credited to the easy availability of venture capital.


This activity in the past was possibly done by the developmental financial institutions like IDBI, ICICI and State Financial Corporations. These institutions promoted entities in the private sector with debt as an instrument of funding. For a long time funds raised from public were used as a source of VC. This source however depended a lot on the market vagaries. And with the minimum paid up capital requirements being raised for listing at the stock exchanges, it became difficult for smaller firms with viable projects to raise funds from public. In India, the need for VC was recognised in the 7th five year plan and long term fiscal policy of GOI. In 1973 a committee on Development of small and medium enterprises highlighted the need to faster VC as a source of funding new entrepreneurs and technology. VC financing really started in India in 1988 with the formation of Technology Development and Information Company of India Ltd. (TDICI) promoted by ICICI and UTI. The first private VC fund was sponsored by Credit Capital Finance Corporation (CFC) and promoted by Bank of India, Asian Development Bank and the Commonwealth Development Corporation viz. Credit Capital Venture Fund. At the same time Gujarat Venture Finance Ltd. and APIDC Venture Capital Ltd. were started by state level financial institutions. Sources of these funds were the financial institutions, foreign institutional investors or pension funds and high net-worth individuals. Though an attempt was also made to raise funds from the public and fund new ventures, the venture capitalists had hardly any impact on the economic scenario for the next eight years

GROWTH OF FIRMS IN INDIA Year 1995 1996 1997 1998 1999 2000 No. of Funds 4 7 10 6 5 47 Year 2001 2002 2003 2004 2005 2006 No. of Funds 12 6 2 3 1 2

Source: AVCJ/IVCA India is prime target for venture capital and private equity today, owing to various factors such as fast growing knowledge based industries, favourable investment opportunities, cost competitive workforce, booming stock markets and supportive regulatory environment among others. The sectors where the country attracts venture capital are IT and ITES, software products, banking, PSU disinvestments, entertainment and media, biotechnology, pharmaceuticals, contract manufacturing and retail. An offshore venture capital company may contribute upto 100 percent of the capital of a domestic venture capital fund and may also set up a domestic asset management company to manage the fund. Venture capital funds (VCFs) and venture capital companies (VCC) are permitted upto 40 percent of the paid up corpus of the domestic unlisted companies. This ceiling would be subject to relevant equity investment limit in force in relation to areas reserved for SSI. Investment in a single company by a VCF/VCC shall not exceed 5 percent of the paid up corpus of a domestic VCF/VCC. The automatic route is not available.

2.3Future of Venture Capital in India

Rapidly changing economic environment accelerated by the high technology explosion, emerging needs of new generation of entrepreneurs in the process and inadequacy of the existing venture capital funds/schemes are indicative of the tremendous scope for venture capital in India and pointers to the need for the creation of a sound and broad-based venture capital movement India. There are many entrepreneurs in India with a good project idea but no previous entrepreneurial track record to leverage their firms, handle customers and bankers. Venture capital can open a new window for such entrepreneurs and help them to launch their projects successfully. With rapid international march of technology, demand for newer technology and products in India has gone up tremendously. the pace of development of new and indigenous technology in the country has been slack in view of the fact that several process developed in laboratories are not commercialized because of unwillingness of people to take entrepreneurial risks, i.e. risk their funds as also undergo the ordeal of marketing the products and process. In such a situation, venture financing assumes more significance. It can act not only act as a financial catalyst but also provide strong impetus for entrepreneurs to develop products involving newer technologies and commercialize them. This will give a boost to the development of new technology and would go a long way in broadening the industrial base, creation of jobs, provide a thrust to exports and help in the overall enrichment of the economy. Another type of situation commonly found in our country is where the local group and a multi-national company may be ready to enter into a joint venture but the former does not have sufficient funds to put up its share of the equity and the latter is restricted to a certain percentage. For the personal reasons or because of competition, the local group may not be keen to invite any one in its industry or any major private investor to contribute equity and may prefer a venture capital company, as a less intimately involved and temporary shareholder. Venture capitalists can also lend their expertise and standing to the entrepreneurs.

In service sector, which has immense growth prospects in India, venture capitalists can play significant role in tapping its potentiality to the full. For instance, venture capitalists can provide capital and expertise to organizations selling antique, remodeled jewellery, builders of resort hotels, baby and health care market, retirement homes and small houses. In view of the above, it will be desirable to establish a separate national venture capital fund tow which the financial institutions and banks can contribute. In scope and content such a national venture capital fund should cover: (i) all the aspects of venture capital financing in all the three stages of conceptual, developmental an exploitation phases in the process of commercialization of the technological innovation and (ii) as may of the risk stages-development, manufacturing, marketing, management and growth as possible under Indian Conditions. The fund should offer a comprehensive package of technical, commercial, managerial and financial assistance and services to building entrepreneurs and be a position to offer innovative solutions to the varied problems faced by them in business promotion, transfer and innovation. To this end, the proposed national venture capital fund should have at its command multi-disciplinary technical expertise. The major thrust of this fund should be on the promotion of viable new business in India to take advantage of the on coming high technology revolution and setting up of high growth industries so as to take the Indian economy to commanding heights.

Chapter 3 Venture Capital Investment Process 3.1 3.2 3.3 3.4 3.5 3.6 3.7 3.8 3.9 3.10 Investment Procedure Investment in VC by Banks Angle Corporate Venturing Consortium Financing Favourites of the Investors Promotion Strategies Incentives Initiatives Special Purpose Vehicle

Venture Capital Investment Process

3.1 Investment Procedure
In generating a deal flow, the venture capital investor creates a pipeline of deals or investment opportunities that he would consider investing in. This is achieved primarily through plugging into an appropriate network. The most popular network obviously is the network of venture capital funds/investors. It is also common for venture capitals to develop working relationships with R&D institutions, academia, etc, which could potentially lead to business opportunities. Understandably the composition of the network would depend on the investment focus of the venture capital funds/company. Thus venture capital funds focusing on early stage technology based deals would develop a network of R&D centers working in those areas. The network is crucial to the success of the venture capital investor. It is almost imperative for the venture capital investor to receive a large number of investment proposals from which he can select a few good investment candidates finally. Before making any investment, the goal as venture capitalists is to understand virtually every aspect of the target company: the experience and capabilities of the management team, the business plan, the nature of its operations, its products and/or services, the methods by which sales are made, the market for the products and/or services, the competitive landscape, and other factors that may affect the outcome of the investment. While due diligence investigations are viewed by many as mundane and irritating tasks, the process enables venture capitalists to address areas of concern, is an important tool in determining a fair pre-investment valuation, and may help to avoid significant and otherwise unexpected liability following the investment. The venture capitalists view the due diligence process as a means of identifying and becoming comfortable with the risks to which their capital will be exposed. The due diligence process involves an assessment of both the microeconomic and macroeconomic factors that can affect the earnings growth of the target company. The due diligence process also includes a review of the corporate and legal records, including the documentation supporting any previous issuances of the company's securities.

Only one or two business plans in 100 result in successful financing. And of every 10 investments made, only one or two are successful. But this is enough to recover investments made by the venture capital (VC) in all 10 start-ups in addition to an average 40-50% return! Securing an investment from an institutional venture capital fund is extremely difficult. It is estimated that only five business plans in 100 are viable investment opportunities and only three in 100 results in successful financing. In fact, the odds could be as low as one in 100. More than half of the proposals to venture capitalists are usually rejected after a 20-30 minute scanning, and 25 per cent are discarded after a lengthier review. The remaining 15 per cent are looked at in more detail, but at least 10 per cent of these are dismissed due to irreconcilable flaws in the management team or the business plan. A Venture Capitalist looks at various aspects before investing in any venture. First, you need to work out a business plan. The business plan is a document that outlines the management team, product, marketing plan, capital costs and means of financing and profitability statements. 1. Initial Evaluation: This involves the initial process of assessing the feasibility of the project. 2. Due diligence: In this stage an in-depth study is conducted to analyse the

feasibility of the project. 3. Deal structuring and negotiation: Having established the feasibility, the instruments that give the required return are structured. 4. 5. Investment valuation: In this stage, final amount for deal is decided. Documentation: This is the process of creating and executing legal documents to

protect the interest of the venture. 6. Monitoring and Value addition: In this stage, the project is monitored by

executives from the venture fund and undesirable variations from the business plan are dealt with. 7. Exit Policies: There are mainly 3 exit policies followed by VCFs in general.


Initial Evaluation:

Before any in depth analysis is done on a project, an initial screening is carried out to satisfy the venture capitalist of certain aspects of the project. These include Competitive aspects of the product or service Outlook of the target market and their perception of the new product Abilities of the management team Availability of other sources of funding Expected returns Time and resources required from the venture capital firm

Through this screening the venture firm builds an initial overview about the Technical skills, experience, business sense, temperament and ethics of the promoters The stage of the technology being used, the drivers of the technology and the direction in which it is moving Location and size of market and market development costs, driving forces of the market, competitors and share, distribution channels and other market related issues Financial facts of the deal Competitive edge available to the the company and factors affecting it significantly Advantages from the deal for the venture capitalist Exit options available

2. Due diligence
Due diligence is term used that includes all the activities that are associated with investigating an investment proposal to assess feasibility. It includes carrying out indepth reference checks on the proposal related aspects such as management team, products, technology and market. Additional studies and collection of project-based

data are done during this stage. The important feature to note is that venture capital due diligence focuses on the qualitative aspects of an investment opportunity. Areas of due diligence would include

General assessment business plan analysis contract details collaborators corporate objectives SWOT analysis Time scale of implementation

People Managerial abilities, past performance and credibility of promoters Financial background and feedback about promoters from bankers and previous


Details of Board of Directors and their role in the activities Availability of skilled labour Recruitment process Products/services, technology and process

In this category the type of questions asked will depend on the nature of the industry into which the company is planning to enter. Some of the areas generally considered are Technical details, manufacturing process and patent rights

Competing technologies and comparisons Raw materials to be used, their availability and major suppliers, reliability of

these suppliers

Machinery to be used and its availability Details of various tests conducted regarding the new product Product life-cycle Environment and pollution related issues Secondary data collection on the product and technology, if so available Market

The questions asked under this head also vary depending on the type of product. Some of the main questions asked are main customers future demand for the product competitors in the market for the same product category and their strategy pricing strategy supplier and buyer bargaining power channels of distribution marketing plan to be followed future sales forecast.

Market survey could be conducted to gather further more accurate and relevant data.

Finance Financial forecasts for the next 3-5 years Analysis of financial reports and balance sheets of firms already promoted or run

by the promoters of the new venture Cost of production Wage structure details Accounting process to be used Financial report of critical suppliers Returns for the next 3-5 years and thereby the returns to the venture fund Budgeting methods to be adopted and budgetary control systems External financial audit if required

Sometimes, companies may have experienced operational problems during their early stages of growth or due to bad management. These could result in losses or cash flow drains on the company. Sometimes financing from venture capital may end up being used to finance these losses. They avoid this through due diligence and scrutiny of the business plan.

3. Structuring a deal
Structuring refers to putting together the financial aspects of the deal and negotiating with the entrepreneurs to accept a venture capitals proposal and finally closing the deal. Also the structure should take into consideration the various commercial issues (ie what the entrepreneur wants and what the venture capital would require to protect the investment).

The instruments to be used in structuring deals are many and varied. The objective in selecting the instrument would be to maximize (or optimize) venture capitals returns/protection and yet satisfy the entrepreneurs requirements. The instruments could be as follows: Instrument Equity shares Issues new or vendor shares par value partially-paid shares redeemable (conditions under Company Act) participating par value nominal shares clean vs secured Interest bearing vs non interest bearing convertible vs one with features (warrants) 1st Charge, 2nd Charge, loan vs loan stock maturity exercise price, expiry period exercise price, expiry period, call, put

Preference shares


Warrants Options

In India, straight equity and convertibles are popular and commonly used. Nowadays, warrants are issued as a tool to bring down pricing.

A variation that was first used by PACT and TDICI was "royalty on sales". Under this, the company was given a conditional loan. If the project was successful, the company had to pay a percentage of sales as royalty and if it failed then the amount was written off. In structuring a deal, it is important to listen to what the entrepreneur wants, but the venture capital comes up with his own solution. Even for the proposed investment amount, the venture capital decides whether or not the amount requested, is appropriate and consistent with the risk level of the investment. The risks should be analyzed, taking into consideration the stage at which the company is in and other factors relating to the project. (eg exit problems, etc). A typical proposal may include a combination of several different instruments listed above. Under normal circumstances, entrepreneurs would prefer venture capitals to invest in equity as this would be the lowest risk option for the company. However from the venture capitals point of view, the safest instrument, but with the least return, would be a secured loan. Hence, ultimately, what you end up with would be some instruments in between which are sold to the entrepreneur. A number of factors affect the choice of instruments, such as Categories Company specific Promoter specific Factors influencing the choice of Instrument Risk, current stage of operation, , expected profitability, future cash flows, investment liquidity options Current financial position of promoters, performance track-record,

willingness of promoters to dilute stake Product/Project specific Future market potential, product life-cycle, gestation period Macro environment Tax options on different instruments, legal framework, policies adopted by competition


Investment valuation

The investment valuation process is an exercise aimed at arriving at an acceptable price for the deal. Typically in countries where free pricing regimes exist, the valuation process goes through the following steps: 1. Evaluate future revenue and profitability 2. Forecast likely future value of the firm based on experienced market capitalization or expected acquisition proceeds depending upon the anticipated exit from the investment. 3. Target ownership positions in the investee firm so as to achieve desired appreciation on the proposed investment. The appreciation desired should yield a hurdle rate of return on a Discounted Cash Flow basis. In certainty the valuation of the firm is driven by a number of factors. The more significant among these are: Overall economic conditions: A buoyant economy produces an optimistic long- term outlook for new products/services and therefore results in more liberal pre-money valuations. Demand and supply of capital: when there is a surplus of venture capital of venture capital chasing a relatively limited number of venture capital deals, valuations go up. This can result in unhealthy levels of low returns for venture capital investors. Specific rates of deals: such as the founders/management teams track record, innovation/ unique selling propositions (USPs), the product/service size of the potential market, etc affects valuations in an obvious manner. The degree of popularity of the industry/technology in question also influences the pre-money. Computer Aided Skills Software Engineering (CASE) tools and Artificial Intelligence were one time darlings of the venture capital community that have now given place to biotech and retailing.

The standing of the individual venture capital Well established venture capitals who are sought after by entrepreneurs for a number of reasons could get away with tighter valuations than their less known counterparts. Investors considerations could vary significantly. A study by an American venture capital, Venture One, revealed the following trend. Large corporations who invest for strategic advantages such as access to technologies, products or markets pay twice as much as a professional venture capital investor, for a given ownership position in a company but only half as much as investors in a public offering. Valuation offered on comparable deals around the time of investing in the deal. 5.


It is the process of creating and executing legal agreements that are needed by the venture fund for guarding of investment. Based on the type of instrument used the different types of agreements are Equity Agreement Income Note Agreement Conditional Loan Agreement Optionally Convertible Debenture Agreement etc.

There are also different agreements based on whether the agreement is with the promoters or the company. The different legal documents that are to be created and executed by the venture firm are Shareholders agreement - This agreement is made between the venture

capitalist, the company and the promoters. The agreement takes into account Capital structure.

Transfer of shares: This lays the condition for transfer of equity between the

equity holders. The promoters cannot sell their shares without the prior permission of the venture capitalist. Appointment of Board of Directors Provisions regarding suspension/cancellation of the investment. The issues under

which such cancellation or suspension takes place are default of covenants and conditions, supply of misleading information, inability to pay debts, disposal and removal of assets, refusal of disbursal by other financial institutions, proceedings against the company, and liquidation or dissolution of the company. Equity subscription agreement - This is the agreement between the venture

capitalist and the company on Number of shares to be subscribed by the venture capitalist Purpose of the subscription Pre-disbursement conditions that need to be met Submission of reports to the venture capitalist Currency of the agreement Deed of Undertaking - The agreement is signed between the promoters and the

venture capitalist wherein the promoter agrees not to withdraw, transfer, assign, pledge, hypothecate etc their investment without prior permission of the venture capitalist. The promoters shall not diversify, expand or change product mix without permission. Income Note Agreement - It contains details of repayment, interest, royalty,

conversion, dividend etc. Conditional Loan Agreement - It contains details on the terms and conditions

of the loan, security of loan, appointment of nominee directors etc.

Deed of Hypothecation, Shortfall Undertaking, Joint and Several Personal

Guarantee Power of Attorney etc. Whenever there is a modification in any of the agreements, then a Supplementary Agreement is created for the same.


Monitoring and follow up

The role of the venture capitalist does not stop after the investment is made in the project. The skills of the venture capitalist are most required once the investment is made. The venture capitalist gives ongoing advice to the promoters and monitors the project continuously. It is to be understood that the providers of venture capital are not just financiers or subscribers to the equity of the project they fund. They function as a dual capacity, as a financial partner and strategic advisor. Venture capitalists monitor and evaluate projects regularly. They are actively involved in the management of the of the investor unit and provide expert business counsel, to ensure its survival and growth. Deviations or causes of worry may alert them to potential problems and they can suggest remedial actions or measures to avoid these problems. As professional in this unique method of financing, they may have innovative solutions to maximize the chances of success of the project. After all, the ultimate aim of the venture capitalist is the same as that of the promoters the long term profitability and viability of the investor company. The various styles are: Hands-on Style suggests supportive and direct involvement of the venture capitalist in the assisted firm through Board representation and regularly advising the entrepreneur on matters of technology, marketing and general management. Indian venture capitalists do not generally involve themselves on a hands-on basis bit they do have board representations.

Hands-off Style involves occasional assessment of the assisted firms management and its performance with no direct management assistance being provided. Indian venture funds generally follow this approach. Intermediate Style venture capital funds awe entitled to obtain on a regular basis information about the assisted projects. Venture capital target companies with superior products or services focussed at fast-growing or untapped markets. Venture capitalists must be confident that the firm has the quality and depth in the management team to achieve its aspirations. They will want to ensure that the investee company has the willingness to adopt modern corporate governance standards. Firms strong in factors relating to patents, management, idea, and potential are more likely to obtain VC financing and willing partners to support commercialisation activities.

7. EXIT strategies adopted by VCFs:

A venture capital firm enters a relationship with a company with the expectation that a significant return of investment will result when the firm exits the investment. The firm plans for that exit to take place within a certain amount of time, usually from three to six years, depending on the development stage of the company in which it is investing. Depending on the investment focus and strategy of the venture firm, it will seek to exit the investment in the portfolio company. While the initial public offering may be the most glamorous and heralded type of exit for the venture capitalist and owners of the company, most successful exits of venture investments occur through a merger or acquisition of the company by either the original founders or another company. Again, the expertise of the venture firm in successfully exiting its investment will dictate the success of the exit for themselves and the owner of the company.

There are several common exit strategies: IPO The initial public offering is the most glamorous and visible type of exit for a venture investment. In recent years technology IPOs have been in the limelight during the IPO boom of the last six years. At public offering, the venture firm is considered an insider and will receive stock in the company, but the firm is regulated and restricted in how that stock can be sold or liquidated for several years. Once this stock is freely tradable, usually after about two years, the venture fund will distribute this stock or cash to its limited partner investor who may then manage the public stock as a regular stock holding or may liquidate it upon receipt. Over the last twenty-five years, almost 3000 companies financed by venture funds have gone public. Mergers and Acquisitions Mergers and acquisitions represent the most common type of successful exit for venture investments. In an era of large companies dominating industry landscapes, acquisition is often the targeted and most common exit strategy. Smaller companies have, in essence, become the research and development arm of larger companies who often look to buy them once their innovations can contribute to their own profitability. In the case of a merger or acquisition, the venture firm will receive stock or cash from the acquiring company and the venture investor will distribute the proceeds from the sale to its limited partners. IPO Mergers and Acquisitions Redemption

Redemption Another alternative is that the company may be required to buy back a venture capital firm's stock at cost plus a certain premium. Often a venture capital firm will put a redemption clause (sometimes referred to as a "buy-back clause") in the investment terms which allows them to exit their investment in your company in the event that an IPO or acquisition does not happen within a designated time period.

2.2 Investment in Venture Capital by Banks

To encourage the flow of finance for venture capital commercial banks are allowed to invest in venture capital without any limit since April 1999. The monetary and credit policy for the year 1999-2000 provides that the overall ceiling of investment by banks in ordinary shares, convertible debentures of corporate and units of mutual funds which is currently at 5 per cent of their incremental deposits will stand automatically enhanced to the extent of banks investments in venture capital. Further, the Monetary and Credit Policy (1999-2000) provides for the inclusion of investment in venture capital under priority sector lending.

2.3 Angels
Angels are people with less money orientation, but who play an active role in making an early-stage company work. They are people with enough hands-on experience and are experts in their fields. They understand the field from an operational perspective. An entrepreneur needs this kind of expertise. He also needs money to make things happen. Angels bring both to the table of an entrepreneur. Angels are important links in the entire process of venture capital funding. This is because they support a fledging enterprise at a very early stage sometime even before commercialization of the product or service offering. Typically, an angel is an experienced industry-bred individual with high net worth. Angels provide funding by "first round" financing for risky investments risky because they are a young /start-up company or because their financial track record is unstable.

This venture capital financing is typically used to prepare the company for "second round" financing in the form of an initial public offering (IPO). Example A company may need "first round" financing to develop a new product line, (viz a new drug which would require significant research & development funding) or make a strategic acquisition to achieve certain levels of growth & stability. It is important to choose the right Angel because they will sit on your Board of Directors, often for the duration of their investment and will assist in getting "second round" financing. When choosing an 'Angel', it is imperative to consider their experience in a relevant industry, reputation, qualifications and track record.

Corporate Venturing
Even though corporate venturing is an attractive alternative, most companies find it difficult to establish systems, capabilities and cultures that make good venture capital firms. Corporate managers seldom have the same freedom to fund innovative projects or to cancel them midstream. Their skills are honed for managing mature businesses and not nurturing start up companies. If a firm is to apply the venture capital model, it must understand the characteristics of the model and tailor its venture capital program to its own circumstances without losing sight of these essentials. Success of venture capital firms rest on the following characteristics: Focus on specific industry niches Although corporate managers have a clear focus in their business, they run into ambiguity with venture programs. Their biggest challenge is to establish clear, prioritized objectives. Simply making a good financial return is not sufficient. Manage portfolios ruthlessly; abandon losers, whereas abandoning ventures has never been easy for large corporations, whose projects are underpinned by personal relationships, political concerns.

Venture capital firms share several attributes with start up they fund. They tend to be small, flexible and quick to make decisions. They have flat hierarchies and rely heavily on equity and incentive pay. Apple Computers established a venture fund in 1986 with the dual objectives of earning high financial return and supporting development of Macintosh software. They structured compensation mechanisms, decision criteria and operating procedures on those of top venture capital firms. While they considered Macintosh as an initial screening factor, its funding decisions were aimed at optimizing financial returns. The result was an IRR of 90 per cent but little success in improving the position of Macintosh. New ventures can be powerful source of revenues, diversification and flexibility in rapidly changing environments. The company should create an environment that encourages venturing. An innovative culture cannot be transplanted but must evolve within the company. Venture investing requires different mindset from typical corporate investors.

How relevant is corporate venturing in the Indian scenario?

The firms, which launched the successful corporate ventures had created new products in the market operating at the higher end of the value chain and had attained a certain size in the market. Most Indian companies are yet to move up the value chain and consolidate their position as players in the global market. Corporate venturing models would probably benefit Indian companies who are large players in the Indian market in another five to 10 years by enabling them to diversify and at the same time help start up companies. Multinationals led by Intel are the best examples of corporate venturing in an Indian context.

Consortium Financing
Where the project cost is high (Rs 100 million or more) and a single fund is not in a position to provide the entire venture capital required then venture funds may act in consortium with other funds and take a lead in making investment decisions. This helps in diversifying risk but however it has not been very successful in the India case.

In the organized sector, there are a number of players operating in India whose activity is not monitored by the association. Add together the infusion of funds by overseas funds, private individuals, angel investors and a host of financial intermediaries and the total pool of Indian Venture Capital today, stands at Rs50bn, according to industry estimates! The primary markets in the country have remained depressed for quite some time now. In the last two years, there have been just 74 initial public offerings (IPOs) at the stock exchanges, leading to an investment of just Rs14.24bn. Thats less than 12% of the money raised in the previous two years. That makes the conservative estimate of Rs36bn invested in companies through the Venture Capital/Private Equity route all the more significant. Some of the companies that have received funding through this route include: Mastek, one of the oldest software houses in India Geometric Software, a producer of software solutions for the CAD/CAM market Ruksun Software, Pune-based software consultancy Hinditron, makers of embedded software PowerTel Boca, distributor of telecomputing products for the Indian market Rediff on the Net, Indian website featuring electronic shopping, news, chat, etc

2.6 Favourites of the Investors

Though the InfoTech companies are among the most favored by venture capitalists, companies from other sectors also feature equally in their portfolios. The healthcare sector with pharmaceutical, medical appliances and biotechnology industries also get much attention in India. With the deregulation of the telecom sector, telecommunications industries like Zip Telecom and media companies like UTV and Television Eighteen have joined the list of favorites. So far, these trends have been in keeping with the global course.

However, recent developments have shown that India is maturing into a more developed marketplace; unconventional investments in a gamut of industries have sprung up all over the country. This includes: Indus League Clothing, a company set up by eight former employees of readymade garments giant Madura, who set up shop on their own to develop a unique virtual organization that will license global apparel brands and sell them, without owning any manufacturing units. They dream to build a network of 2,500 outlets in three years and to be among the top three readymade brands. Shoppers Stop, Mumbais premier departmental store innovates with retailing and decides to go global. This deal is facing some problems in getting regulatory approvals. Airfreight, the courier-company which has been growing at a rapid pace and needed funds for heavy investments in technology, networking and aircrafts. Pizza Corner, a Chennai based pizza delivery company that is set to take on global giants like Pizza Hut and Dominos Pizza with its innovative servicing strategy. Car designer Dilip Chhabria, who plans to turn his studio, where he remodels and overhauls cars into fancy designer pieces of automation, into a company with a turnover of Rs1.5bn (up from Rs40mn today).

2.7 Promotion Strategies

There is inadequate flow of applications for venture financing in India. The need is promotional efforts not only to increase the flow of applications but also to popularize the generic idea of venture financing. The promotion efforts of venture capital funds in India could be classified as Contacting R&D organisations Conducting seminars and industrial meets where the salient features of venture capital schemes can be presented to prospective entrepreneurs Creation of information services

Promotion of entrepreneurial activities Venture Fairs in which the members of the VC industry listen to entrepreneurs about their new ideas and business propositions Venture Capital Networks and Associations

2.8 Incentives
Recognizing the importance of venture capital, the government introduced major liberalisation of tax treatment for venture capital funds and simplification of procedures. These included the following:

SEBI was recognized as the single nodal agency. A new clause (23FB) in Section 10 of Income Tax Act was introduced with effect from 1st March 2000. This clause stated that any income, of a venture capital company or a venture capital fund, from any investments made in venture capital undertaking, would not be included in computing the total income.

Section 115U was also introduced in the Income Tax Act with effect from the assessment year 2001-02 to establish a VC pass through. This means that the VC profits will not be taxed twice. The regulated VC Fund (with SEBI) would be exempted from tax (subject to certain conditions) but the VC investor will have to pay tax.

Earlier on, if a VCF wished to avail certain tax benefits, the VCF had to exit from investments made in a venture capital undertaking (VCU) within twelve months of the VCU obtaining a listing. However, this requirement was done away around November 2000. The Finance Bill 2001, proposes to amend section 10 (23 FB) so as to provide that a VCC / VCF will continue to be eligible for exemption under section 10 (23 FB), even if the shares of the VCU, in which the VCC / VCF has made the initial investment, are subsequently listed in a recognized stock exchange in India.

2.9 Initiatives
There have been a number of initiatives by the Government as well as the industry to pave way for a business and regulatory environment that is conducive to new venture development and to innovation at the user end. Some of the initiatives in the past have included those by the Ministry of Finance, the Securities, Exchange Board of India (SEBI), Ministry of Information Technology (formerly Department of Electronics), State Governments, Financial Institutions, the Indian Venture Capital Association. These initiatives resulted in the availability of more than US$ 500 million of venture funds for Indian ventures during 1999-2000. With the growing realisation of the immense potential offered by Indian technology companies, funding opportunities are rapidly increasing. The Government of India has already taken laudable steps to facilitate the creation of an environment that is conducive for venture capital funds and start-ups in India. These include:

introduction of sweat equity, allowing venture capital funds to offset losses incurred in one company against profits from another and establishment of government facilitated venture capital funds.

However, the present regulatory framework is still not enough to provide for an environment that lays stress on encouraging the flow of venture funds, easy exit options (for either party), mentoring, non-qualified availability of funds, and flow of public funds for enterprise building in India.

India needs to encourage the growth of risk capital by acting on three fronts: 1. The Government of India and Indian financial institutions should catalyse the process by creating Israel's Yozma-like funds. This will stimulate competition but also protect entrepreneurs from inevitable risks.

2. India should amend its regulatory framework so that the VC funds can earn a reasonable return on their risk capital. 3. India should actively promote the infusion of VC skills and capabilities, either by attracting global VC funds or attracting managers from these funds. However, the above moves need to be substantiated with the earliest implementation of the recommendations of the SEBI Committee on Venture Capital.


An account, administered by a third party that holds shares bought back by themanagement in trust.

THE ADVANTAGES Greater security for lenders improves credit rating Lowers the cost of capital

THE DISADVANTAGES Less control over cash flows generated by project Tax treatment of SPV still unclear

Better management of debtAdministration fees can be high repayment Enables new ventures to raise funds. Requires intensive monitoring by trustee


An account, administered by a third party that holds shares bought back by the management in trust.

THE ADVANTAGES Greater security for lenders improves credit rating Lowers the cost of capital

THE DISADVANTAGES Less control over cash flows generated by project Tax treatment of SPV still unclear

Better management of debtAdministration fees can be high repayment Enables new ventures to raise funds. Requires intensive monitoring by trustee

Chapter 4 Venture Capitalist A key player 4.1 Role of Venture Capitalist managers/banker

4.2 Difference between VC and money


4.1 Role of venture Capitalists
Conventional financing generally extends loans to companies, while VC financing invests in equity of the company. Conventional financing looks to current income i.e. dividend and interest, while in VC financing returns are by way of capital appreciation. Assessment in conventional financing is conservative i.e. lower the risk, higher the chances of getting loan. On the other hand VC financing is a risk taking finance where potential returns outweigh risk factors. Venture Capitalists also lend management support and provide entrepreneurs with many other facilities. They even participate in the management process. VCs generally invest in unlisted companies and make profit only after the company obtains listing. VCs extend need based support in a number of stages of investments unlike single round financing by conventional financiers. VCs are in for long run and rarely exit before 3 years. To sustain such commitment VC and private equity groups seek extremely high returns a return of 30% in rupee terms. A bank or an FI will fund a project as long as it is sure that enough cash flow will be generated to repay the loans. VC is not a lender but an equity partner. Venture capitalists take higher risks by investing in an early-stage company with little or no history, and they expect a higher return for their high-risk equity investment. Internationally, VCs look at an internal rate of return (IRR) north of 40% plus. In India, the ideal benchmark is in the region of an IRR of 25% for general funds and more than 30% for IT-specific funds. With respect to investing in a business, institutional venture capitalists look for average returns of at least 40 per cent to 50 per cent for start-up funding. Second and later stage funding usually requires at least a 20 per cent to 40 per cent return compounded per annum. Most firms require large portions of equity in exchange for start-up financing.

The VC Philosophy As against Bought out deals (BODs), VCs carry out very detailed due diligence and make 2-7 year investments. The VCs also hand-hold and nurture the companies they invest in besides helping them reach IPO stage when valuations are favourable. VCFs help entrepreneurs at four stages: idea generation, start-up, ramp-up and finally in the exit. According to Indian Venture Capital Association, almost 41% (Rs 5146.40 m) of the total venture capital investment is in start-up projects followed by Rs 4478.60 m in later stage projects and only Rs 82.95 in turnaround projects . Majority have invested in only three stages of investment, indicating that most VCs in India have not started developing niches for investing with regard to the stages of projects. The main difficulty in early stage funding are related to lack of exit opportunities as probability of an IPO or buy out by of VC stake is less due to lack of understanding for evaluation of the knowledge based companies compared to the companies in the traditional sectors. Some such VCs are: ICICI ventures, Draper, SIDBI and Angels. Apart from finance, venture capitalists provide networking, management and marketing support as well. The venture capitalist is a business partner, sharing the risks and rewards and provides strategic, operational and financial advice to the company based on experience with other companies in similar situations.

Management of investee firms The venture funds add value to the company by active involvement in running of enterprises in which they invest. This is called "hands on" or "pro-active" approach. Draper falls in this category. Incubator funds like e-ventures also have a similar approach towards their investment. However there can be "hands off" approach like that of Chase. ICICI Ventures falls in the limited exposure category. In general, venture funds who fund seed or start ups have a closer interaction with the companies and advice on strategy, etc while the private equity funds treat their exposure like any other listed investment. This is partially justified, as they tend to invest in more mature stories. 4.2 Difference between a venture capitalist and bankers/money

Banker is a manager of other people's money while the venture capitalist is basically an investor. Venture capitalist generally invests in new ventures started by technocrats who generally are in need of entrepreneurial aid and funds. Venture capitalists generally invest in companies that are not listed on any stock exchanges. They make profits only after the company obtains listing. The most important difference between a venture capitalist and conventional investors and mutual funds is that he is a specialist and lends management support and also

Financial and strategic planning Obtain bank and other debt financing Access to international markets and technology

Introduction to strategic partners and acquisition targets in the region Regional expansion of manufacturing and marketing operations Obtain a public listing


Points Objective Holding period Instruments Pricing Collateral Ownership Control

Venture Finance Maximize return 2-5 years

Debt Finance Interest payment Short/long term

Common shares, convertible bonds,Loan, factoring, leasing options, warrants Price earnings ratio, net tangible assets Interest spread Very rare Yes Yes No

Minority shareholders, rights protection,Covenants board members Increased leverage

Impact on Balance sheetReduced leverage of financed Exit Mechanism

Public offering, sale to third party, sale toLoan repayment entrepreneur

Chapter 5 Pros and Quos of VCF 5.1 5.2 5.3 Success factors Critical factor Problems faces by VCF

5.1 Success factors of VCFs

1. Industry-specific concentration of investments yields better returns than geographically concentrated investments. 2. Networking with industrial partners is important since these target companies are potential clients and exit partners. 3. Networking with universities and research institutes helps identify new technologies and investment targets. 4. Concentrating investments in carefully selected companies showing international promise will yield better returns than distributing the capital across several smaller investments. It is crucial that venture capitalists actively support the growth and internationalisation of the companies through their industry-specific know-how and international contacts. 5. With respect to the returns from the fund, it is vital that adequate capital is reserved for further investment in the best investment targets and for maintaining the holdings until the exit. 6. Joint investments with partners providing added value contribute to the success of the target companies and improve the returns from the fund.

5.2 Critical Factors

In 1999, SEBI (Securities and Exchange Board of India) had set up a committee under the Chairmanship of Mr. K. B. Chandrasekhar to look into the issues of venture capital in India. The Report of the K. B. Chandrasekhar Committee on venture capital identified the following as critical factors for the success of VC industry in India:

The regulatory, tax and legal environment should play an enabling role. This emphasizes the facilitating and promotional role of regulation. Internationally, venture funds have evolved in an atmosphere of structural flexibility, fiscal neutrality and operational adaptability. And we need to provide regulatory simplicity and structural flexibility on the same lines. There is also the need for a level playing field between domestic and offshore venture capital investors. This has already been done for the mutual fund industry in India.

Investment, management and an exit option should provide flexibility to suit the business requirements and should also be driven by global trends. Venture capital investments have typically come from high net worth individuals who have risk taking capacity. Since high risk is involved in venture financing, venture investors globally seek investment and exit on very flexible terms, which provides them with certain levels of protection. Such exit should be possible through IPOs and mergers / acquisitions on a global basis and not just within India.

There is also the need for identifying and increasing the domestic pool of funds for venture capital investment. In US, apart from high net worth individuals and angel investors, pension funds, insurance funds, mutual funds etc. provide a very big source of money. The share of corporate funding is also increasing and it was as high as 25.9 percent in the year 1998 as compared to 2 percent in 1995. Corporations are also setting up their own venture capital funds. Similar avenues need to be identified in India also.

With increasing global integration and mobility of capital it is important that Indian venture capital firms as well as venture financed enterprises be able to have

opportunities for investment abroad. This would not only enhance their ability to generate better returns but also add to their experience and expertise to function successfully in a global environment. We need our enterprises to become global and create their own success stories. Therefore, automatic, transparent and flexible norms need to be created for such investments by domestic firms and enterprises.

Venture capital should become an institutionalised industry financed and managed by successful entrepreneurs, professional and sophisticated investors. Globally, venture capitalists are not merely finance providers but are also closely involved with the investee enterprises and provide expertise by way of management and marketing support. This industry has developed its own ethos and culture. Venture capital has only one common aspect that cuts across geography i.e. it is risk capital invested by experts in the field. It is important that venture capital in India be allowed to develop via professional and institutional management

Infrastructure development also needs to be prioritised using government support and private management. This involves creation of technology as well as knowledge incubators for supporting innovation and ideas. R&D also needs to be promoted by government as well as other organisations.

The above report was well received by the Government and few issues have already been resolved.


Problems generally associated with Venture Capital

1. The risk associated with true venture capital is greater than when providing capital to an established business. Despite the best efforts and intentions, some start-ups will not succeed. That is simply part of the game. In today's market, though, especially if dealing with highly leveraged corporations, we have seen there is substantial risk associated with well established businesses as well as with start-ups. The risk is different, though, and people providing true venture capital recognizes this riskreward trade-off. 2. Most investors have an unrealistic view of venture capital. They expect the high returns publicized with respect to successful new ventures but do not want to take the attendant risk. Consequently, such investors go into the marketplace looking for opportunities, claiming to offer venture capital, but never finding an investment that meets their requirements. 3. Most venture fund managers come from banking, professional money management or corporate management; while some come directly from business school and have been employees of venture capital firms for their entire career. Consequently, the vast majority of venture capital company employees - at any level - have no actual "venture" or entrepreneurial experience, particularly with start-ups. A lack of experience and understanding translates into a lack of comfort with the creation phase of a business and a reluctance to invest in such deals. 4. Entrepreneurs, in general, have different goals, motivations and personalities than bankers or corporate executives, who may expect to see people like themselves as clients. These differences can often create a gap between the venture capitalist and the entrepreneur sufficient to result in a rejection of the business proposal irrespective of the merits of the business. 5. The principal source of capital for most entrepreneurs is friends and family. Once that source runs out (if it exists at all), venture capital companies may be the only alternative to obtain funding which, most likely, are small or insufficient in comparison to the cost of, for instance, building a factory or buying a profitable going concern. Few venture capital companies want to spend the time evaluating small deals

when, within the constraints of their investing limits and in the same amount of time, they could participate in fewer but larger deals. 6. Three key elements to a successful new venture are (not in order of priority): a good idea, adequate capital and good management. A failure of any one of these elements can doom the enterprise. Due primarily to a lack of experience in the creation or start-up phase, venture capital companies are often lacking in their ability to evaluate and recognize: (a) a "good idea" because ideas and the projections associated with them are so intangible, unlike - so they think - the projections of an established company; (b) "adequate capital" for a start-up because traditional venture capital companies may not have the experience to understand whether the entrepreneur's goals can be achieved with the capital requested or to help the entrepreneur determine the appropriate capital requirements for a start-up; (c) the presence or absence of adequate entrepreneurial management, which can be different than that of a large established corporation; a good example of which was the changing need of Apple Computers when it replaced Steven Jobs with John Sculley. 7. Despite the fact that many fund managers will say that inadequate management is the primary reason for business failure, they will rarely devote time to assist management to help achieve a greater likelihood of success. Consequently, some investments are destined to fail from the start; and many firms use everyone else's failures as a reason for them to avoid start-ups. 8. Many companies and individuals complain that they have money to invest in "good" projects, but none can be found. First, what is "good" for one person or firm may not be "good" for another. That definition is guided by goals and requirements of the individual investor. An older investor may be looking for income while a younger investor may be looking for appreciation. Often, those goals are unrealistic as applied to venture capital.

Chapter-6 Case Studies 6.1 6.2 6.3 Case study-1 Case study-2 Case study-3

Case Studies
6.1 Case Study-1: Rise of UK economy
The economic impact of private equity and venture capital on the UK: Keeping London and the UK the centre of the European industry Private Equity and venture capital makes a valuable contribution to the economy generally by having a positive effect on the companies in which private equity is invested. In addition, the industry makes a very significant contribution to the financial services industry and in particular plays an important role in maintaining the City of London as Europe's premier financial centre and helping to build it as the world's premier financial centre. The industry has shown incredible growth over the last few years, both in terms of the funds it has raised and the capital it manages and in the level of investment that is made, with growth comes responsibility as well as opportunity. The growth of the industry has increased its profile and with that profile comes a legitimate interest in what the industry is doing from the public, the press and of course the regulatory authorities. The industry is currently facing two major reviews - by the FSA in the Discussion paper they recently published and by the Treasury focusing on the taxation, not just of capital gains made by the industry, but also the capital gains made by the risk-taking entrepreneurs and management team that as an industry VCF back. Achieving the right outcome for the industry from the tax review and continuing to ensure regulation is appropriate and not burdensome are two vital tasks the British Venture Capital Association (BVCA) and the industry faces. The BVCA and its work The BVCA is the industry body that represents the UK private equity and venture capital industry.

Private equity means the equity financing of companies at many stages in the life of a company from start-up through expansion all the way through to buy-outs of established companies that in today's world can be very significant and large transactions. Venture capital as a term typically covers early stages of start-up or growth funding or expansion capital. The term buy-outs (MBO, MBI, etc) refers to using - private equity to finance the change in ownership of a company. The common threads - and hence the term private equity - is that the investments made in unquoted equity (i.e. not publicly quoted equity) and into companies that have real growth potential which can be turned around or transformed under private equity ownership as opposed to being constantly in the spotlight that having a quoted share price means for a public company. The BVCA represents the whole cross section of the private equity industry in the UK - from small seed stage venture funds all the way through to the large private equity firms who focus almost exclusively on buy-outs and who are almost becoming household names today. BVCA membership comprises well over 90% of all UK-based private equity and venture capital funds and their advisors. The role of the BVCA is to ensure that the UK industry is properly represented to politicians and policy makers here at Westminster, across the UK and in Brussels. The industry's economic impact The survey shows once again that private equity-backed companies are a significant driver in the UK economy and its global competitiveness. Key findings of this report show once again that in the five years to 2005/2006: The growth of employment in private equity-backed companies was faster than both FTSE 100 and FTSE 250 companies (9% pa vs 1% and 2% respectively)

Sales grew faster in private equity-backed companies compared with FTSE 100 and 250 companies (9% vs. 7% and 5%) Exports from private equity-backed companies grew at a faster rate than the national growth rate (6% vs. 2%) Investment grew faster than the national average (18% vs 1%) It is now well established that the performance of private equity-backed companies significantly strengthens the UK economy and improves international competitiveness and creates jobs at a considerably faster rate than other private sector companies. It is now estimated that companies that have received private equity funding account for the employment of around 2.8 million people in the UK, equivalent to 19% of UK private sector employees. It is also significant to note that 92% of companies that responded to the survey said that without private equity the business would not have existed at all or would have developed less rapidly. The reason for this is that private equity investment is more than just the provision of capital. Respondents to the survey noted that strategic direction, financial advice and help with contacts were key ways in which private equity firms had helped with the development of their businesses. It is estimated that companies which have been private equity-backed generated total sales of 424 billion, exports of 48 billion and contributed over 26 billion in taxes. The figures in the Economic Impact Survey demonstrate clearly that private equitybacked businesses are active across all regions of the UK and are valuable contributors to the wealth of these regions.

The impact of the private equity industry as a UK financial service The UK private equity industry is playing an increasingly significant role as a source of revenue for firms operating within the broader financial and professional services industry, contributing to the overall impetus that these industries provide to the UK economy. 2005 data shows that: Private equity-related activities generated estimated fee revenue for financial and professional services firms of over 3.3 billion, representing around 7% of the total annual turnover of the UK financial services industry. There are more than 5,500 individuals (3,500 of which are investment professionals) employed in some 260 private equity, venture capital, funds-of-funds and secondaries investment firms in the UK. The UK has a network of around 750 financial, professional and business services firms providing advisory and financial support to private equity and venture capital firms. They employ a full time equivalent pool of close to 6,700 executives engaged in private equity-related activities. Taken together, there are over 10,000 highly skilled professionals employed across over 1,000 firms engaged either directly or indirectly in private equity-related activities. For every private equity executive investing directly in UK companies, there are 2.3 full time equivalent advisors or finance executives providing specialist advice and services. Financial, professional and other business services executives working on private equity-related mandates in 2005 generated an average of 500,000 per head in fees.

Private equity-backed transactions account for a significant proportion of total M&A activity in the UK with almost 30% of all UK investment banking fees from M&A and loan financing being derived from private equity backed transactions in 2005. The UK private equity industry has long attracted capital investment from outside its own shores, with almost 50 billion of foreign investment into UK private equity funds over the past six years. Furthermore, two-thirds of the total capital invested by UK firms over the same period was committed to companies within the UK, demonstrating a positive net inflow of capital into the UK economy. Investment activity BVCA are an industry that invests across all sectors, from start-ups to buy-outs, all around the UK, across continental Europe and around the world. In 2005, UK private equity activity increased to its highest ever levels, in terms of funds raised, private equity investments made and also divestments. Here are a few key figures that illustrate the scale of what we do: Funds raised from investors reached 27.3 billion. 1,535 companies were financed. Worldwide investment by UK private equity firms increased by 21% in 2005 to 11.7 billion from 9.7 billion in 2004. Companies financed at start-up stage increased by 9% to 208. By any measure, the UK private equity and venture capital industry is a UK success story. And yet it is disappointing that despite the fact that the benefits of private equity as an asset class are so clear that last year 80% of BVCA investors came from overseas, with 45% coming from the US.

The primary objective of the private equity industry is to drive returns to its investors and while it is a good thing that we can attract inward investment, it is a pity that the beneficiaries of the capital gains created by this industry predominantly accrue to overseas investors.

UK private equity and venture capital industry is a good strong British success story. Major investment attract into the UK from overseas, BVCA make major investment around the UK investing in companies, creating jobs and building businesses, and they invest across continental Europe and around the world bringing returns home for the benefit of their investors. This industry has benefited from a strong cross Party consensus that understands the important role BVCA play in keeping the UK economy competitive and dynamic. This support is much appreciated. Private equity investment should not be regarded as an end in itself, but rather as part of a life cycle of a business. The private equity model brings together absolute alignment of interest between investor and management. This enables absolute focus on agreed purpose, the ability to achieve change swiftly and efficiently and a complete concentration on the direction of the business.

6.2 Case Study- 2: Silicon Valley's success. Venture capitalists supply the funds to budding entrepreneurs who want to start their own companies - and 40% of such deals in the US take place in Silicon Valley. Venture capitalists also help nurture those companies to success, supplying introductions to potential customers or partners, assistance with raising more funds, and even management support. And venture capital has been one of the extraordinary growth industries in the Valley, with the amount of money invested in venture capital funds rising in the decade from $1bn in 1990 to $20bn in 1999 - and nearly doubling again to $35bn in 2000. fall-out Ann Winblad, founder of venture capital firm Hummer Winblad, with $1bn in funds under management, was one of the victims of the fall-out. Her company had backed one of the biggest and most well-known internet companies selling to consumers,, which stopped trading despite millions of dollars in private investment and an enthusiastic stock market flotation. In her sleek, wooden-beamed offices in San Francisco's newly fashionable SoMo district, which has become a beacon for companies, she explained what went wrong. In her view, the increasing frenzy in the stock market for internet companies whatever their business plan or chances of profitability - had meant that too many companies had been funded and brought to the stock market too quickly. Too many inexperienced people came into the venture capital marketplace, with financiers, bankers, and big companies all prepared - even desperate - to back internet ventures.

Fund raising difficulties At one point, she says, $1bn a week was being offered to entrepreneurs - attracting too many people who were "mercenaries not missionaries" to the world of enterprise. But when the market woke up, and and tech stocks crashed in April, it became impossible for even well-managed internet companies to raise additional money. and other e-tailers needed more capital to grow - and that was no longer available at any price. Now, she says, it is unlikely that anyone would fund any internet company for at least the next two years, and e-tailers, or companies selling to consumers, are the "mad cow disease" of the venture capital world - no one will touch them at all. And in future, the pace of investment will be slower and more measured, taking 3-5 years to bring companies to the stage at which they can be floated on the stock market - and that venture capitalists will resume their role of "company coach" rather than pure deal-makers. Profit hopes dimmed And now, one of the factors limiting the further expansion of venture capital firms is their need to spend more time managing their existing portfolio - "tending to the sick and needy" in the words of the chief of one that has survived, Obongo's John Hunt. Mr Knoblauch says that in the height of the euphoria one year ago, venture capitalists began to believe that they could make a profit on nearly any company they backed. But now, they expect only about one in five of the companies they back to become a major success - but those successes, with returns of 10-20 times investment, will still make the whole fund profitable. Vital role Venture capitalists will still play a vital role as catalysts for Silicon Valley's future.

It was the presence of the world's most sophisticated venture capital industry that attracted John Hunt of Obongo from the UK to San Francisco. Venture capitalists have played a crucial part in launching his company, which provides the software for electronic wallets used for shopping on the internet. Obongo was created in the offices of venture capital firm Sequoia, who introduced the UK based company, then called Smartport, to its Silicon Valley rival, Chabi - and they agreed to merge with each other 30 minutes into the meeting. Sunny outlook And Obongo's other venture capital partner, Atlas, played a central role in helping them secure their first customer, the large US bank Citibank. It is networks like these which will secure the future of the Valley, according to historian and city planner Anna Lee Saxenian. Nowhere else have venture capitalists such a close connection with their industry, she argues, with most moving from being entrepreneurs themselves. Their understanding of the technology, the markets, and the competition means that entrepreneurial knowledge is shared and is transferred more quickly here than anywhere else. It is that culture that will ensure that, despite the sharp change in market sentiment, Silicon Valley will remain the world's high-tech incubator.

Case Study-3: Failure of Analog Devices Enterprises

In 1980, Analog Devices established a corporate venture program, Analog Devices Enterprises (ADE), to generate both attractive financial returns and strategic benefits in the form of licensing agreements and acquisitions. Funding was provided by Amoco, and ADE had invested $26 million in 11 firms by 1985. That very year Amoco ceased contributing capital, and the ADE program was suspended. Around this time, Analog Devices took a $7 million charge against earnings; in 1990, with most of the portfolio liquidated, it took another $12 million charge. Of the 11 firms in ADEs portfolio, 10 were terminated, acquired by other companies at unattractive valuations, or relegated to the "living dead." Only one firm ultimately went public. In this case, ADEs stake was so diluted by a merger that it was worth only about $2 million at the time of the offering. What went wrong? Clearly, the ADE program exhibits all three of the classic structural failings: 1. Program managers were hampered by the lack of a clear objective. Instead, they had a threefold mission: to invest in firms pursuing technologies relevant to the ongoing business of Analog Devices and Amoco, to obtain options to acquire firms of interest to Analogs management, and to generate high financial returns. 2. Analog Devices researchers, seeing scarce resources being devoted to ADE, resented the program. Also, Amoco only committed to fund the program for five years, considerably less time than was needed to grow the early-stage companies. 3. Incentives of the various parties appear to have been improperly aligned. The management of Analog Ventures believed that they were insufficiently rewarded, and Amoco did not share in the profits generated.


For getting about practical knowledge of working of VCFs, survey was conducted in 3 firms namely SIDBI (Small Industrial Development Bank of India), JM Equity Fund, IDFC Equity Fund. Following questions were asked and some of the answers given were: 1) What do VCF looks for in evaluating a new company? Most critical element VCF looks for. A- Business potential, Company background, core plan, Promoter details. B- Growth, management, value, Business model, valuation expectation, return expected. C- Promoter very careful, understanding, profile and background. Interpretation- VCF looks for good profile and background of promoter, business potential and management for evaluating in a new company. 2) How is business plan presented? A - Presentation, calling, executive, e-mail, advisors. B Presentation, Financial model, mgmt meeting, matter of convenience to both Promoter and VCF. C Based on business plan and industry in relation to its growth, potential, growth, returns. Presentation is done in front of Investment banker (middleman between VCF and Promoter). Interpretation- Business plan is presented through various ways like presentation, financial model, etc. whichever is more convenient for both parties. 3) How do VCFs define their contribution? A- By providing facilities through schemes like Started Investment and Smart Money. B- Best practices, Advice for approaching to financial market, etc.

C- Appointment, issues, tie ups with government, tie up with portfolio company, equipments, training, venturing in new areas, broader view and thinking. Interpretation- VCFs defines their contributions by showing the Promoters correct way for taking appropriate steps. 4) What are the milestones in achieving whether the company will achieve their goal? A Milestones are laid down during agreement in top line and bottom line revenue. Term sheet documentation is signed by promoter. B Through companies profit numbers and total sales. C All the milestones are noted down in shareholders agreement. Interpretation- The landmarks are decided by the VCFs and Promoter during signing of agreement between them. 5) What are the major trends in VCF industry? A Latest trend is interest in Bio-tech sector. B Upcoming sectors like Logistics, BPO, Financial Services, Real Estate. C All upcoming sectors especially Transport and Logistics. Interpretation- The trends in VCFs industry depends upon type of firms, as all of them have interests in different sectors for financing. 6) What companies in VCF might make interesting investments. A - Depends upon the sector which is booming at that time. B Same as above said sectors. C The best sector in todays scenario is IT sector which will be backbone for economy. Interpretation- The companies themselves shows as interested investing sectors to VCFs by their performance. 7) How long does it take to make investment or participation decision? A Taken after a long procedure of investigation gets over from 6-8 weeks. B It takes 10 days sometimes and also get extent up to 3-4 months. C Lengthy process as investigation about promoter is done. Then too it takes 3-5 months.

Interpretation- Time taken by VCFs for investment decision is from 10 days till 34 months. It also sometime extents till 6 months. 8) Critical features of an agreement between VCF and Promoter. A Exit options, Right to appoint a BOD, Internal Auditor, Projects. Even main steps taken by promoter should be consulted by VCF. B Liquidity event, seat in BOD, Minority protection rights, big decisions to be consulted. C Rights and Obligations of Promoter, Board seat, Rights to see committee, Veto Right. Interpretation- The most critical features are selecting exit options, rights and obligations of venture capitalists, and major decisions should be consulted with VCF. 9) Exit policies followed by VCFs. A- IPO, Selling stake to 3rd party, Promoters buyback from VCF, Drag-along & Tag-along. B- Selling to strategic, Block deal, IPO. C- IPO, Promoters buyback, Selling stake, Combination of promoters buyback and selling stake. Interpretation- There are 3 basic exit options been followed by VCFs all over the world. 10) Risk analysis. A Risk depends upon type of company, market, exit risk, proper investment done or not, cultural risk, competition. B If valuation does not grow as per expectation then business plan fails. C Scenario building. Risk in terms of promoter, revenue, cost (as operating expenses). Even on potential of promoter. Interpretation- The risk analysis varies as per depending on the situation.

Note: As per the answers given for the following questions, A presents SIDBI, B presents JM Equity Fund and C IDFC Equity Funds. Interpretation is short conclusion of all answers.

Earlier patterns of growth or failure in venture capital industries in other countries and regions indicate that the evolution of venture capital seems to be either entry into a self reinforcing spiral, such as occurred in Silicon Valley and Israel, or growth and stagnation, as occurred in Minnesota in the 1980s or the United Kingdom until recently. Given Indias wish to develop a high-technology industry funded by venture capital, it is necessary to keep improving the environment by simplifying the policy and regulatory structure (including eliminating regulations that do not perform necessary functions such as consumer protection). The World Bank, with its agenda of decreasing government regulation, funded the creation of the first venture capital funds. Though these funds experienced little success, they were the beginnings of a process of legitimitizing venture investing and they were a training ground for venture capitalists who later established private venture capital funds. It is unlikely that the venture capital industry could have been successful without the development of the software industry and a general liberalization of the economy. Of course, this is not entirely surprising, because an institution as complicated as venture capital could not emerge without a minimally supportive environment. This environment both permitted the evolution of the venture capital industry and simultaneously allowed it to begin changing that environment and initiating a co-evolutionary dynamic with other institutions. India still remains a difficult environment for venture capital. Even in 2006 the Indian government remains bureaucratic and highly regulated. To encourage the growth of venture capital will require further action, and it is likely that the government will continue and even accelerate its efforts to encourage venture capital investing. The role of the government cannot be avoided: it must address tax, regulatory, legal, and currency exchange policies, since many of these affect both venture capital firms and

the companies that they finance. More mechanisms need to be developed to reduce risk if funds for venture capital must come from publicly held financial institutions managed by highly risk-averse managers. In short, VCF is next engine for economical growth for all countries in the World.

Suggestions for growth of VCF:

Venture capital industry is at the take off stage in India. It can play a catalytic role in the development of entrepreneurship skill that remains unexploited among the young and energetic technocrats and other professionally qualified talents. It can help promote new technology and hi-tech industries, which involve high risk but promises attractive rate of return. In order to ensure success of venture capital in India, the following suggestions are offered:

(i) Exemption/Concession for Capital Gains: Capital gains law represents a hurdle to the success of venture capital financing. The earnings of the funds depend primarily on the appreciation in stock values. Further, the capital gains may arise only after 3 to 4 years, of investment and that the projects, being in new risky areas, may not even succeed. Capital gains by corporate bodies in India are taxed at a much investment risk and long gestation period this is a deterrent to the development of VCFs.

The benefit of the capital gains, under section 48 of the Act is not significant. Hence, it would be advisable that all long term capital gains earned by VCCs should be exempted from tax or subject to concessional flat rate. Further, capital gains reinvested in new venture should also be exempted from tax. Section 52(E) of the Act should be amended to give effect to this. (ii) Development of Stock Markets: Guidelines issued by finance ministry provides for the sale of investment by way of public issue at the price to be decided on the basis of book value and earning capacity. However, this method may not give the best available prices to venture fund as it will not be able to consider future growth potential of the invested company. One of the major factors which contributed to the success of venture funds in the West is development of secondary and tertiary stock markets. These markets do not have listing

requirements and are spread over all important cities and towns in the country. These stock markets provide excellent disinvestments mechanism for venture funds. In India, however, stock market is not developed beyond a few important cities. Success of venture capital fund depends very much upon profitable disinvestments of the capital contributed by it. In US and UK secondary and tertiary markets helped in accomplishing the above. However, in India, promotion of such maker is not feasible in the prevailing circumstances as such laissez faire policy may attack persons with ulterior motives in the business to the determent of general public. However, stock market operation may be started at man by more big cities where, say, the number of stock exchanges can be increased to 50. Further, permission to transact in unlisted securities with suitable regulation will ensure firsthand contact between venture fund and investors. (iii) Fiscal Incentives: Fiscal incentives may be given in the form of lowering the rate of income tax. It can be accomplished by: (i) Application of provisions applicable to non-corporate entities for taxing long term capital gains. (ii) An allowance to funds similar to section 80-CC of Income Tax Act, say 20 percent of the investment in new venture which can be allowed as deduction from the income. (iv) Private Sector Participation In US and UK where the economy is dominated by private sector, development of venture fund market was possible due to very significant role played by private sector which is often willing to put money in high risk business provided higher returns are expected. The guidelines by finance ministry provide that non- institutional promoters share in the capital of venture fund cannot exceed 20 percent of total capital; further they cannot be the single largest equity holders. The private sector, because of this provision, may not like to promote venture fund business. Promotion of venture funds by private sector, in addition to public financial institution and banks, is recommended as:

Private sector is in advantageous position as compared to financial institutions and banks to provide managerial support to new ventures as leading industrial house have a pool of experienced professional managers in all fields of management viz. marketing, production and finance. The leading business houses will be able to raise funds from the investing public with relative ease. (v) Review the Existing Laws Todays need is to review the constrains under various laws of the country and resolve the issue that could come in the way of growth of the innovative mode of financing. Suitable exemption should be given from Section 43 A of the companies Act to venture capital finance companies so that they are not required to comply with several provisions of the Act applicable to public limited companies. Amendment of Section 77 of the Companies Act is required to enable the new venture capital companies to buy back their shares at the time of disinvestments by VC Finance Companies.

Ceiling on interoperate loans and investment as specified in Section 370 and 372 of the companies Act should be relaxed in case of VC Finance Companies and Venture Capital Companies to enable them to invest suitable in newly promoted companies. The only investment available to the VC Finance company for investment is equity shares. This restriction should be relaxed so that VC Finance Company can finance through preferential issues and conditional loans. The scope of VC should not only be confirmed to start up finance but also be broadened to development finance, expansion and growth, buyouts, mergers and amalgamation. The restriction on investment of 80% of the entire funds within a period of 3 years should be removed. (vi) Limited Partnership The Practice of the limited partnership as in vogue in UK should be permitted in order to promote integration of object between the managers and contributors for the success of venture capital projects.

Chapter 8

Annexure 8.1 SEBI Guidelines and Regulations 8.2 Certificate of Registration 8.3 Tax Aspects 8.4 Investment conditions and restrictions

8.1 SEBI Guidelines and Regulations: In the absence of an organised Venture Capital industry till almost 1998, individual investors and development financial institutions played the role of venture capitalists in India. Entrepreneurs have largely depended upon private placements, public offerings and lending by the financial institutions. In 1973 a committee on Development of Small and Medium Enterprises highlighted the need to foster venture capital as a source of funding new entrepreneurs and technology. Thereafter some public sector funds were set up but the activity of venture capital did not gather momentum as the thrust was on high-technology projects funded on a purely financial rather than a holistic basis. Later, a study was undertaken by the World Bank to examine the possibility of developing Venture Capital in the private sector, based on which the Government of India took a policy initiative and announced guidelines for Venture Capital Funds (VCFs) in India in 1988. However, these guidelines restricted setting up of VCFs by the banks or the financial institutions only. Thereafter, the Government of India issued guidelines in September 1995 for overseas investment in Venture Capital in India. For tax-exemption purposes, guidelines were also issued by the Central Board of Direct Taxes (CBDT) and the investments and flow of foreign currency into and out of India have been governed by the Reserve Bank of India's (RBI) requirements. Further, as a part of its mandate to regulate and to develop the Indian capital markets, the Securities and Exchange Board of India (SEBI) framed the SEBI (Venture Capital Funds) Regulations, 1996. These guidelines were further amended in Apr 2000 with the objective of fuelling the growth of Venture Capital activities in India.

In the late 1990s, the Indian government became aware of the potential benefits of a healthy venture capital sector. Thus in 1999 a number of new regulations were

promulgated. Some of the most significant of these related to liberalizing the regulations regarding the ability of various financial institutions to invest in venture capital. Perhaps the most important of these went into effect in April 1999 and allowed banks to invest up to 5 percent of their new funds annually in venture capital. The main statutes governing venture capital in India included the SEBIs 1996 Venture Capital Regulations, the 1995 Guidelines for Overseas Venture Capital Investments issued by the Department of Economic Affairs in the Ministry of Finance, and the Central Board of Direct Taxes (CBDT) 1995 Guidelines for Venture Capital Companies (later modified in 1999). In early 2000, domestic venture capitalists were regulated by three government bodies: the Securities and Exchange Board of India (SEBI), the Ministry of Finance, and the CBDT. For foreign venture capital firms there was even greater regulation in the form of the Foreign Investment Promotion Board (FIPB), which approves every investment, and the Reserve Bank of India (RBI), which approves every disinvestment. Since SEBI is responsible for overall regulation and registration of VCF, multiple regulatory requirements should be harmonized and consolidated within the framework of SEBI Regulations to facilitate uniform, hassle-free, single window clearance. Registration of a venture capital fund Applicant should follow the procedure given below so as to expedite the registration process. However, SEBI will also guide the applicant step by step after getting application for registration as a venture capital fund. Normally, all replies are sent within 21 working days from the date of getting each communication from the applicant during the process of registration. Thus, the total time period for registration depends on how fast the requirements are compiled with by the applicant. Main requirements under SEBI (Venture Capital Funds) Regulations, 1996: The following are the eligibility criteria for grant of a certificate of registration as per regulation 4 of SEBI (Venture Capital Funds) Regulations 1996. For the purpose of grant of a certificate of registration, the applicant has to fulfil the following, namely:-

(a) If the application is made by a company, (i) Memorandum of association has as its main objective, the carrying on of the activity of a venture capital fund; (ii) It is prohibited by its memorandum and articles of association from making an invitation to the public to subscribe to its securities; (iii) Its director or principal officer or employee is not involved in any litigation connected with the securities market which may have an adverse bearing on the business of the applicant; (iv) Its director, principal officer or employee has not at any time been convicted of any offence involving moral turpitude or any economic offence. (v) It is a fit and proper person.

(b) If the application is made by a trust (i) The instrument of trust is in the form of a deed and has been duly registered under the provisions of the Indian Registration Act, 1908 (16 of 1908); (ii) The main object of the trust is to carry on the activity of a venture capital fund; (iii) The directors of its trustee company, if any, or any trustee is not involved in any litigation connected with the securities market which may have an adverse bearing on the business of the applicant; (iv) The directors of its trustee company, if any, or a trustee has not at any time, been convicted of any offence involving moral turpitude or of any economic offence; (v) The applicant is a fit and proper person.

(c) If the application is made by a body corporate (i) It is set up or established under the laws of the Central or State Legislature. (ii) The applicant is permitted to carry on the activities of a venture capital fund. (iii) (iv) The applicant is a fit and proper person. The directors or the trustees, as the case may be, of such body corporate have not been convicted of any offence involving moral turpitude or of any economic offence. (v) The directors or the trustees, as the case may be, of such body corporate, if any, is not involved in any litigation connected with the securities market which may have an adverse bearing on the business of the applicant. (d) The applicant has not been refused a certificate by the Board or its certificate has not been suspended under regulation 30 or cancelled under regulation 31.

Application for Registration: An applicant should apply for registration in form a prescribed under First Schedule of SEBI (Venture Capital Funds) Regulations 1996 along with requisite fees. All documents should be enclosed as specified in the form. Additional information: 1. A complete list of your associate companies registered with SEBI, and also indicate the capacity in which they are registered along with the SEBI Registration number; 2. State whether the applicant is registered with SEBI in any capacity.

3. A complete list of your group companies registered with SEBI, and also indicate the capacity in which they are registered with SEBI along with their SEBI Registration number. 4. Whether the applicant or the intermediary, as the case may be or its whole time director or managing partner has been convicted by a Court for any offence involving moral turpitude, economic offence, securities laws or fraud 5. Whether any winding up orders have been passed against the applicant or the intermediary. 6. Whether any orders under the Insolvency Act have been passed against the applicant or any of its directors, or person in management and have not been discharged. 7. Whether any order restraining prohibiting or debarring the applicant or its whole time director from dealing in securities in the capital market has been passed by SEBI or any other regulatory authority and a period of three years from the date of the expiry of the period specified in the order has not elapsed; 8. Whether any order canceling the certificate of registration of the applicant on the ground of its indulging in insider trading, fraudulent and unfair trade practices or

market manipulation has been passed by SEBI and a period of three years from the date of the order has not elapsed ; 9. Whether any order, withdrawing or refusing to grant any license/ approval to the applicant or its whole time director which has a bearing on the capital market, has been passed by SEBI or any other regulatory authority and a period of three years from the date of the order has not elapsed. 10. (a) Details of registration of your company/associate/group companies (to be given separately), which are registered/ required to be registered with Reserve Bank of India

(RBI) as a Banking company or Non Banking Finance Company or in any other capacity and address(es) of concerned branch office(s) of RBI. (b) Details of disciplinary action taken by RBI against you or any of your group/associate companies. Please also inform us in case there is any default in repayment of deposits by you or any of your group / associate companies. Applicant can submit no objection certificate from RBI for getting registered with SEBI, to expedite the registration process. Other Documents to be submitted to SEBI 1) Memorandum and Articles of Association of applicant company, executed copy of trust deed if the fund is being set up as a trust and main objective of constitution in case of body corporate. 2) Executed copy of Investment Management Agreement, if applicable. 3) Disclose in detail the investment strategy as required under regulation 12(a) of the SEBI (Venture Capital Funds) Regulations, 1996. Also state the target size of the fund along with the profile of the investors of the fund. 4) An undertaking to the effect that the fund will not enter into any venture capital activity if it fails to raise a commitment of at least Rs. five crore as

required under Regulation 11(3) of SEBI (Venture Capital Funds) Regulations, 1996. 5) Copies of letters of commitment from investors in support of the target amount proposed to be raised by the fund. 6) Undertaking that the venture capital fund will not make investment in any area listed under Third Schedule to SEBI (Venture Capital Funds) Regulations, 1996. 7) Venture Capital Fund shall disclose the duration/ life cycle of the fund.

Grant of Certificate of Registration Once all above requirements have been complied with and requisite fees as per Second Schedule to Regulations have been paid, SEBI will grant certification of registration as a venture capital fund.

8.2 Certificate of Registration 2006 Certificate of registration as venture capital fund I. In exercise of the powers conferred by sub-section (1) of section 12 of the securities And exchange Board of India Act, 1992, (15 of 1992) read with the regulation made There under, the board hereby grants a certificate of registration to ------------------------------------------------------------------------as a venture capital fund subject to the conditions specified in the Act and in the regulations made there under. II. The Registration Number of the venture capital fund is IN/VC/ / Date: Place: MUMBAI By order Sd/For and on behalf of Securities and Exchange Board of India Income Tax benefits In order to encourage the development of venture capital funds, the income Tax Act, 1961 exempts the income of a venture capital fund from Income Tax. Income of a venture capital fund [section 10(23FB)] (on and from Financial Year 1999-2000) Any income of a venture capital fund (VCF) or a venture capital company (VCC) set up to raise funds for investment in a venture capital undertaking (VCU) is exempt.

VCC means a company which has been granted a certificate of registration by SEBI and which fulfils the conditions laid down by SEBI with the approval of the Central Government.

VCU means a domestic company whose share are not listed in a recognized stock exchange in India and which is engaged in the business for producing services, production or manufacture of an article or thing but does not include activities or sectors which are specified by SEBI with a approval of the Central Government.

8.3. Tax Aspects:

VCFs have been provided complete income tax relaxation (July 1995) and exemption from long-term capital gains tax after they are listed on stock exchanges. Shares have to be held for at least 12 months to enjoy tax exemption. A lock-in period of three years is however applicable for unlisted shares. The Finance Act, 1995 provided [Section 10 (23 F) of the IT Act] income tax exemption on any income by way of dividends or long-term capital gains of a venture capital fund or a venture capital company from investments made by way of equity shares in a venture proposal. To enjoy tax exemption the venture capital company has to obtain approval and satisfy prescribed conditions. The Central Board of Direct Taxes (CBDT) issued guidelines, on 18-7-1995 specifying that the prescribed authority for approval for exemption under Section 10 (23F) of Income Tax Act is Director of Income Tax (Exemption). The conditions for approval are: it is registered with the SEBI (guidelines of 13.2.1996 discussed below); it invests 80 percent of its total monies by acquiring equity shares of venture capital undertakings; it invest 80 percent of its total paid-up capital in acquiring equity share of the it shall not invest more than 20 percent (Budget for 1997-8 raised it from 5 to venture capital undertakings; 20 percent.)it shall not invest more than 40 percent in the equity capital of one venture undertakings

it shall maintain books of account, and submit audited accounts to the

Director, Income Tax (Exemption).

8.4. Investment conditions and restrictions

A venture capital fund may raise money from any source, whether Indian, foreign or non resident Indian by way of issue of units. No venture capital fund shall accept any investment from any investor less than Rs5,00,000. However this condition is not applicable to:8.2.1 8.2.2 employees or the principal officer or directors of the venture capital fund has been established as a trust employees of the fund manager or asset management company for the purpose of the se regulations, fund raised means actual money raised from investors for subscribing to the securities of the venture capital fund and includes money that is raised from the author of the trust (in case the venture capital fund has been established as a trust) but does not include the paid up capital of the trustee company, if any. 8.2.3 Each scheme launched or fund set up by a venture capital fund shall have firm commitment from the investors for contribution by the venture capital fund.

All investment made or to be made by a venture capital fund shall be subject to the following conditions, namely:a. venture capital fund shall disclose the investment strategy at the time of application for registration; b. venture capital fund shall not invest more than 25% corpus of the fund in one venture capital undertaking ; shall not invest in the associated companies; and

d. venture capital fund shall make investment in the venture capital undertaking as enumerated below (i). at least 75% of the investible funds shall be invested in unlisted equity shares or equity linked instruments. However, if the venture capital und seeks avail of benefits under the relevant provisions of the Income Tax Act applicable to a venture capital fund, it shall be required to disinvest from such investments within a period of one year from the Date on which the shares of the venture capital undertaking are listed. In a recognized stock Exchange. (ii). Not more than 25% of the investible fund may be invested by way of: a. subscription to initial public offer of a venture capital undertaking whose shares are proposed o be listed subject to lock-in period of one year; b. debt or debt instrument of a venture capital undertaking in which the venture capital fund has already made an investment by way of equity.

List of Venture Capital Companies in India :1. 20th Century Finance Corporation Limited Centre Point Dr.Ambedkar Road Parel Mumbai - 400012 AIG Investment Corporation (Asia) Limited India - Representative Office 2634 Oberoi Towers Nariman Point Mumbai - 400021 Acuity Strategic Financials Private Limited 14 Santosh, 2nd floor 242 Lady Jamshedji Road Mumbai - 400028 AIA Capital India Private Limited 9B Hansalaya Barakhamba Road New Delhi - 110001 Alliance DLJ Private Equity Fund 404 / 405 Prestige Centre Point 7 Edward Road Bangalore - 560052 Alliance Venture Capital Advisors Limited 607 Raheja Chambers Free Press Journal Road, Nariman Point Mumbai - 400021 APIDC Venture Capital Limited 1102 Block A, 11th floor Babukhan Estate, Basheerbagh Hyderabad - 500001 Canbank Venture Capital Fund Limited 2/F Kareem Towers, 11th floor 19/5 -19/6 Cunningham Road Bangalore - 560052 Draper International (India) Private Limited V203 Prestige Meridian -1 M.G. Road Bangalore - 560001









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eVentures India (Consultair Investments Private Limited) Khetan Bhavan 8 Jameshedji Tata Road Churchgate Mumbai - 400020 GE Capital Services India Limited AIFACS Building 1 Rafi Marg New Delhi - 110001 Gujarat Venture Finance Limited Premchand House Annexe, 1st floor Behind Popular House Ashram Road Ahmedabad - 380009 HSBC Private Equity Management Mauritius Limited Ashoka Estate, 3rd floor 24 Barakhamba Road New Delhi - 110001 ICICI Securities and Finance Company Limited 41/44 Strand Palace M.Desai Marg Colaba Mumbai - 400005 ICICI Venture Funds Management Company Limited (formerly TDICI) Raheja Plaza, 4th floor 17 Commissariat Road D'Souza Circle Bangalore - 560025 IFB Venture Capital Finance Limited 8/1 Middletown Row Calcutta - 700071 Industrial Development Bank of India IDBI Tower Cuffe Parade Mumbai - 400005

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Small Industries Development Bank of India (SIDBI) SIDBI Venture Capital Limited

Nariman Bhavan 227 Vinay K. Shah Marg Nariman Point Mumbai - 400021 1 9. Tata Investment Corporation Limited Ewart House, 3rd floor Homi Modi Street Fort Mumbai - 400001 Templeton India Private Equity Fund 125 Free Press House Nariman Point Mumbai - 400021 Vista Ventures DBS Corporate Club 26 Cunningham Road Bangalore - 560052 Walden-Nikko India Management Company Limited One Silverstone 294 Linking Road Khar (West) Mumbai - 400052

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Books Indian venture capital market, - Evalueserve Indian Venture Capital Association - IVCA Venture Activity


Newspapers . Economic Times Times of India