an introduction to venture capital

8/2/2019 An Introduction to Venture Capital

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An Introduction to Venture Capital

Venture Capital/Private Equity is medium to long-term finance provided in

return for a shareholding in unquoted companies. For the purposes of this guide

Private Equity refers toVenture Capital and Business Angel investments at

stages in a companys development, from the seed to expansion stages, as well

as management buy-outs and buy-ins. The terms

Venture Capital and Private Equity should therefore be regarded as

interchangeable phrases.

The purpose of this booklet is to encourage you to start planning early when

seeking finance to accelerate the growth of your business. It will explain how a

Venture Capitalist approaches the process of investing equity in a business and

what you need to do to improve your chances of raising equity. It gives guidance

on what should be included in your business plan, the most important document

you will produce when searching for a private equity investor. The guide also

demonstrates the positive advantages that venture

capital/private equity will bring to your business.

The main sources of private equity on the island are Venture Capital Funds,

Business Angels (private individuals who provide smaller amounts of finance at


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an earlier stage than many private equity firms are able to invest at),

Government Agencies (depending upon the sector your business operates

in, the presence of other investors and where the business is in its development

cycle) and Corporate Venturers. Corporate Venturers can be product related or

service companies that provide funds and/or a partnering relationship between

mature and early stage companies which may operate

in the same industry sector.

This Guide's principal focus is upon Venture Capital Funds. However, the

investment criteria that both Venture Capital Funds and Business Angels apply

when assessing potential investee companies is often very similar - therefore the

guide will benefit entrepreneurs and their advisers looking

for private equity from both these sources. In short, the aim is to help you

understand what Venture Capital Funds are looking for in a potential business

investment and how to approach them.

What is venture capital/private equity?

Venture Capital/Private Equity; provides long-term, committed share capital, to

help unquoted companies grow and succeed. If you are looking to start up,

expand, buy into a business, buy out a division of your parent company,

turnaround or revitalise a company, Private Equity could help.


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Obtaining private equity is very different from raising debt or a loan from a

lender, such as a bank. Lenders, who usually seek security such as a charge over

the assets of the company, will charge interest on a loan and seek repayment of

the capital. Private equity is invested in exchange for a stake in

your company and, as shareholders, the investors' returns are dependent on the

growth and profitability of your business. The investment is unsecured, fully at

risk and usually does not have defined repayment terms. It is this flexibility

which makes private equity an attractive and appropriate form of finance for

early stage and knowledge-based projects in particular.

Brief History of the Venture Capital Industry

The idea of investing capital in risky ventures with a tremendous upside is not new.

The explorers who sailed the globe in the fifteenth and six-teenth centuries looking

for fabulous treasure in exotic lands had to get their financing from somewhere.

The lucky ones had access to the king or queen and the royal treasurer. Even if you

had a great reputation as a seagoing adventurer, it wasnt easy to get an audience

with the crowns money men, unless you had someone on the inside to make the

contact for you. The more things change . . .

With the Industrial Revolution, funding technology ventures eventually became an

interesting diversion for the very rich. In the late nineteenth century, a prolific


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inventor sought $30,000 in research and development (R&D) funding for a device

he claimed would replace the universally popular gas lamp, although attempts to

commercialize other similar devices had failed for several decadesthey

generated an unsafe amount of heat, and the materials used to manufacture the

alternative devices were too expensive. A syndicate of financiers, including

J. P. Morgan and the Vanderbilts, decided to go ahead and fund the development of

the new technology. Potential financial partners might have been concerned about

the inventors lack of formal scientific training or his weak financial management

skills. But the inventor was Thomas Edison, and he produced the incandescent

electric light bulb. This shows us that if you notice J. P. Morgan is the lead investor

in a deal, go ahead and jump in.

Prior to the Second World War, companies seeking start-up capital often relied on

wealthy individuals or wealthy industrial families as backersangels, as we call

them today. These were old-money type of investors, and deals were often

consummated in the quiet dining rooms of country clubs. These were careful

investors who knew how long it took to accumulate wealth.

The first true venture fund, in that it raised institutional capital and invested in

early-stage ventures, is said to have begun in 1946. The first letter to an

entrepreneur declining investment went out that same year, and the phrase Sorry,

your venture does not fit our investment parameters was coined.


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The first business plan is thought to have been written in 1954, revised throughout

1955, and read by an investor for 12 minutes sometime in early 1956.

The U.S. Government passed the Small Business Investment Act in

1958, which created incentives for the development of Small Business

Investment Companies (SBICs) that would provide financing for small companies

that did not have ready access to the capital markets. The country was founded in

1776. Thus it only took the government 182 years to figure out that the small

business person needs capital.

Silicon Valley emerged in the 1960s, when a company there, south of San

Francisco, became the first to make computer chips completely out of silicon.

Developments related to this technological breakthrough required venture capital,

and a community of engineers and scientists, investors, and managerial talent

sprang up. This pattern would later be repeated in other areas of the United States:

Plant a seed of technology, fertilize with management talent, water with abundant

amounts of venture money, grow companies, and hope for a bountiful harvest three

to seven years later.

Over the next 20 years the number of venture capital companies and investment

groups in the United States swelled to several thousand and the amount of venture

investment grew steadily to the tens of billions of dollars. The investment

concentration of these companies changed with major technological innovation:


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biotech, computer hardware and software, semiconductors, communications, and

the Internet have all had their day in the sun. Entrepreneurs have an innate sense of

what investment area is currently hot because its the area completely unrelated

to whatever company they are seeking capital for at the time.

In the mid- to late 1990s, a tremendous upsurge in stock prices created thousands

of new millionaires in the United States, many of whom began to seek out

investments in entrepreneurial ventures. These new angel investors are quite

different from the angels of old. With nearly unlimited access to information, they

have the ability to make much better informed decisions than their predecessors.

After all, it cant be that hard to be a venture capitalist, can it?

Who Are the Venture Capitalists?

They are commonly called the VCs, as if they are a completely homogenous

group with uniform background, experience, attitudes and business philosophy.

The popular image of the venture capitalist is a middle-age person with a finance

background, probably from one of the nations premier universities. A kind of pin-

stripe suit person. Very focused on rate of return. A bottom-line guy. The truth is

very different. Some VCs are quite young. It is not unusual these days for partners

in venture capital firms to be in their early 30s. Increasing numbers of women are

entering this once very maledominated profession. They are not all finance gurus,

either. If you examine the background of venture capitalists that are posted on their


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web sites, you will see that many have an engineering or technical background,

some are marketing experts, and quite a few have general business experience

related to starting and growing small companies into large ones. In medical-

oriented venture capital funds, a number of the partners are physicians or scientists.

Not all venture capitalists are even from the United States. Because business is

increasingly conducted on a global basis, you will see partners in venture capital

firms from Europe, Asia, and other parts of the world.

How do I make my company attractive to a Venture Capitalist or

an investor in general?

Many small companies on the island do not grow and so do not provide 'upside

potential' for the owners other than to provide a good standard of living and job

satisfaction. These businesses are not generally suitable for private equity

investment, as they are unlikely to provide sufficient financial

returns to make them of interest to an external investor. High potential

businesses can be distinguished from others by their aspirations and potential for

growth, rather than by their current size. Such businesses are aiming to grow

rapidly to a significant size. As a rule of thumb, unless a business can


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offer the prospect of significant turnover growth within three to five years, it is

unlikely to be of interest to a private equity investor. This usually means that the

market for the product and service will not solely be on the island.

Private equity investors are interested in companies with high growth prospects,

enjoy barriers to entry from competitors, are managed by experienced and

ambitious teams and have an exit opportunity for investors which will provide

returns commensurate with the risk taken.

Venture Capital Funds normally agree their investment criteria with those who

have invested in the fund, for example, preferred sectors and stages of

development. Business Angels also usually prefer to invest in projects which

reflect their own skill sets or investment history.

When approaching a Venture Capitalist or a Business Angel, it is important to

understand if their investment criteria or preferences match your project.

Earlier stage projects normally reflect a higher level of risk for equity investors,

so it's important that entrepreneurs explore all possible sources of finance when

fundraising.

Benefits of Venture Capital

In the current economic climate on the island, most fast growth start-ups are

knowledge based. Given that these projects cannot offer tangible security to traditional


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debt financiers or predictable cash flows to service loans, private equity is the obvious

source of finance to fill the financing gap. Investment executives working with

Venture Capital Funds attempt to identify the best projects in order to minimize their

investment risk. Research has shown that Venture Capital backed companies grow

faster than other types of companies, employ more people and are more profitable

when benchmarked against their peers. This is made possible by a combination of

capital, Venture Capitalists identifying and investing in the best

investment opportunities and input from Non-Executive and Executive Directors

introduced by the VC investor (a key differentiator from other forms of finance)

WHY DO VENTURE CAPITALISTS SEEM SO FOCUSED ON CERTAIN

GEOGRAPHICAL AREAS?

A significant number of venture capital firms will consider investing in companies

throughout the United States. Many others, however, limit their interest to certain

regions, or even certain states.

The main reason for this is simply that it is easier to visit companies and attend

meetings with management after funding if the company is within driving distance

or at most a short plane trip away from the venture capitalists office. Another

reason is that the venture capital firms tend to locate their offices in areas that are

particularly fertile regarding the number of good companies to invest in. They


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dont see a need to spend time looking outside this area. The reverse is also true:

Entrepreneurs are attracted to areas with an infrastructure of venture capital firms

and professional service providers that work with start-up or emerging companies.

And then the best managerial talent is attracted to these same areas because there

are many challenging job opportunities with the potential for lucrative stock

options. So you end up with pockets of the country that have all the ingredients

investors, the hottest technologies, the best management talent, a complete service

infrastructure. Its almost as if It takes a village to build a company. Hmmm.

Kind of a catchy phrase. Entrepreneurs puzzle over venture capitalists who say,

We invest primarily in Southern California but are willing to look at excellent

opportunities in other parts of the country. Should I contact that venture capital

firm or not? asks the entrepreneur in the Midwest, who of course believes that his

company represents an excellent opportunity.

Why Is Finding Capital So Difficult for Entrepreneurs?

There are a number of reasons why entrepreneurs have so much trouble finding

capital.

Entrepreneurs dont understand how the process works and do not understand the

thought processes of investors. Investors end up seeming more elusive than they

really are.


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Entrepreneurs dont know where to look for capital, and do not have the contacts

necessary to be introduced to investors.

Different capital sources fit different stages of investment and type of companies.

Raising money takes a certain flair for salesmanship that not everyone has. Some

individuals are better at doing than talking.

Entrepreneurs underestimate how long it will take to find investors.

Raising money is a time-intensive process that takes time away from what the

entrepreneur really wants to do: build a successful enterprise.

And the most important reason: The funding of private enterprises is not an

efficient market. It is getting more efficient, but it has a long way to go. Its

certainly not an efficient market when willing buyers and willing sellers of a

commodity (equity in emerging enterprises) have such an incredibly difficult time

finding each other. You would never say the market is efficient when the pricing

for the commodity is established by guesswork and the opinions of a handful of

potential buyers. And it is not an efficient market when the seller is allowed to

Meet the buyer only if the seller has met the good friend of a good friend of the

buyer at some cocktail party sometime, somewhere. Fortunately, we will see in

later chapters that the Internet is bringing down some of these barriers that keep the

entrepreneurs from having access to the investors. But the market inefficiencies


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show why entrepreneurs should not be too hard on themselves when it takes more

time to find capital than they imagined it would. A free and open marketplace

would be the ideal; its not here yet.

What Entrepreneurs Dont Know About Venture Capitalists

Venture capitalists have to go out and raise money, too. Wealthy individuals, or

angels, may use their own funds to invest, but professionally managed venture

capital firms get the majority of their funds from outside the partners in the firm.

They raise the money from corporate pension funds, corporations, public pension

funds, foundations, endowment funds, wealthy individuals, and insurance

companies. Venture capitalists have people watching them, too. The funds are

often organized as limited partnerships, with the venture capital firm serving as a

general partner. The other institutional investors are the limited partners. They may

talk like financiers, but they are actually employees of a financial institution

much like your local commercial banker. Venture capitalists will tell you they are

much smarter than most commercial bankers, however. Venture capitalists are

under a certain amount of pressure to find good investments for the fund within a

reasonable length of time, just as commercial loan officers in banks are charged

with going out and finding companies that will make good loan prospects. Venture

capitalists have to go out periodically and raise money themselves. This is why

they have a keen understanding of what the entrepreneur goes through trying to


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find money. Venture capitalists will meet with the managers of the large pension

funds and the other funding sources mentioned above and describe what the

investment focus of the new venture fund is planned to be, and why the venture

capitalists believe the partners of their firm are uniquely qualified to find great

investments and build portfolio companies. This is why we see venture funds that

are extremely focused on a narrow range of investmentssome wont do seed

stage ventures, for example; some only invest in telecommunications, or medical

technology. They have secured funding for the venture fund based on the

understanding that they will stick close to these criteria. That is why, as a general

rule, no amount of discussion or sales effort on the part of an entrepreneur, no

matter how persuasive, will get a venture capitalist to deviate very far from the

Established investment focus of the firm. The institutions that place money in

venture capital funds do so because of the historically superior investment returns

venture capital funds have been able to achieve relative to other classes of equity

investment.

Lets say that in the long run you are able to achieve a return of 10 percent by

investing in publicly traded securities. The historical returns venture capital funds

have been able to achieve have been closer to 25 percenta substantially better

performanceand even higher in recent years. Some top-performing funds


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achieve average annual returns of 100 percent or more. Institutional investors

typically allocate only a very small percentage of their total investment capital in

venture capital funds because there is a great deal of risk in this type of investment.

The 25 percent rate of return just mentioned comes about by averaging the widely

varying performance of the individual investments, or companies funded, in the

venture capitalists portfolio. It is often said that venture capitalists seek an annual

return of 30 to 40 percent or higher on each investment. The 25 percent average

return comes about because some companies are complete busts and the

investment has to be written off. Some companies fail and the investment has to be

written off. Others will not reach growth expectations but are still viable

enterprises. There will be solid companies that perform as expected in their

business plans. It is hoped that there will be superstars that become phenomenal

initial public offerings (IPOs) or will be acquired by other companies for large

multiples on revenues or earnings.

LOOKING BEYOND THE FUNDING

Money is only part of the contribution venture capitalists make to growing

businesses. They offer knowledge about how to grow companies, the challenges all

entrepreneurial companies face, how to build a distribution network, and how to

attract top-flight management. They understand the entire life cycle of a company,

from getting started to going public or being acquired. Venture capitalists manage


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a portfolio of investments, much as mutual fund managers do with public

companies. They consider diversification by stage of company and industry. They

hold onto investments longer than mutual fund managers. An entrepreneur may get

turned down by a venture capitalist not because the company does not have

investment merit, but because the company does not fit into the overall strategy of

the fund. Perhaps the fund already has several other investments in similar

companies.

Capital availability is not distributed evenly across the United States. Northern

California and the Northeast states dominate in terms of the number of companies

being funded and the total capital committed to companies there. The pace of

investment is picking up significantly in the Midwest and Southeast, however.

Companies located in places outside the venture capital hotbeds have a more

difficult time finding investors.

Entrepreneurs still think venture capital is available only to high- technology

companies. The majority of companies funded have a technology component, yes,

but its not the whole picture. Many entrepreneurs are surprised to find out there

are venture capital funds that focus solely on retail enterprises, for example.

THE CONFLICT BETWEEN THE ENTREPRENEUR AND THE

INVESTORS


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How would you characterize the relationship between an investor and an

entrepreneuras predator/prey? As father/offspring? As partner/partner? As

boss/employee? Or as benefactor/beggar?

If you ask investors how the relationship is supposed to work, they would

uniformly respond that it should be partner/partner. Does it work that way in real

life? It can, but not necessarily. And its not all the investors fault.

POINTS OF CONFLICT

Many Entrepreneurs Dont Really Want Partners, They Want Money.

At the heart of the entrepreneurial desire is the need to be in control, in command.

Many talk a good game about wanting to have the investor involved, but they dont

really want to. Forming a partnership with an investor inherently creates the

potential conflict over who is in control, but theres no way around doing it that

way. It can be far too expensive for a small company to go public on its own. And

small companies need expertise investors have to offer. The partnership with the

investor results in the entrepreneurs strategies or decisions being questioned, not

an easy thing for some people to take. Entrepreneurs can get excessively stuck

on certain ideas and resent input from investors. They can have a kind of

arrogance regarding the benefits or what they perceive as the true perfection of

their products or services.


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Wow, How Long Does It Take to Grow an Ego That Large? The meeting

between the investor and the entrepreneur amounts to the clash of two (or more)

tremendous egos. Anyone who has met a venture capital-ist at a trade show, a

venture capital conference, or any other event can attest that many of them cant

wait to tell you how much they know about every aspect of every industry and

every enterprise. They always know more than you doeven if you have worked

in the industry for a number of yearsand they will gladly tell you so. The more

successful they are and the more money they have made, the larger the ego grows.

It is an interesting facet of capitalism in general that the people who reach the top

and acquire the most wealth eventually, conveniently, forget the sheer luck, the

being-in-the-right-place-at-the-right-time phenomena, that was greatly responsible

for their success, and recall only the strokes of individual genius that led to their

(inevitable) victory. When dealing with venture capitalists, theres no getting

around this ego factor. It is a state of nature with them. Ah, but the entrepreneur is

not so innocent in this regard, either. Several years ago we arranged a meeting for

an entrepreneur with a venture capital group that specializes in expansion capital

for industry consolidation deals, putting several companies together to create a

larger, more competitive entity. The partner of this group is a very pleasant, fair,

easygoing individual, whose firm has done extremely well; and his family had

done well for generations. The entrepreneur was, at best, a guy with a spotty track


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record and a tiny company with big dreams. The entrepreneur shook hands with

the venture capitalist, sat down in the mans office, and the first thing out of his

mouth was Im here to see if youre good enough to be my venture capital

partner. You probably already can guess this meeting only lasted about two

minutes longer.

Back in the 1960s there was a wonderful episode of a science fiction TV series

about an older, vastly wealthy businessman who grew tired of not having any

challenges any more and longed to go back to the beginning of his career and do it

all again. He visited a rather sinister travel agency that accommodated his dream of

going back in time. He returned to the small town where he started, a young man

again. But this time he missed some of the key connections, the seemingly small

incidents of good fortune, that actually caused him to succeed in such a big way.

This time things went sour for him, and he learned an important lesson: Business is

a team sport.

Questions to ask before approaching a Venture Capitalist

Does my company have high growth prospects and is my team ambitious to grow the

company rapidly?


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Does my company have a product or service with a competitive edge or unique selling

point?

Can it be protected by Intellectual Property Rights?

Can I demonstrate relevant industry sector experience?

Does my team have the relevant skills to deliver the business plan fully?

Am I willing to sell some of the company's shares to a private equity investor?

Is there a realistic exit opportunity for all shareholders in order to realise their

investment?

Am I prepared to accept that my exiting this business may be in the best interest of all

shareholders?

If your answers are 'yes', external equity is worth considering. If 'no', it may be that

your proposal is not suitable for venture capitalists and it may take additional work on

your behalf to make the proposal 'investor ready'. When seeking to raise capital to

accelerate the development of a business idea, promoters must explore all possible

sources of funds. It is likely that an equity investor will usually help the promoters

secure other sources of funds.

This usually includes debt finance from banks to finance working capital and asset

purchases, grant aid from development agencies and, indeed, an equity investment

from the promoters. Such an investment from the promoters/management team can

help demonstrate commitment to a project and may attract fiscal incentives in the


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form of the Business Expansion Scheme, Enterprise Investment Scheme or Enterprise

Management Incentives, depending upon the jurisdiction the company is based in and

other criteria. Professional help should be sought to confirm eligibility and benefits of

these schemes at an early opportunity. The end result is likely to be a funding package

which includes a cocktail of funders secured with the assistance of the Venture

Capitalist. It is this flexibility and value-added input

From a private equity investor which differentiates them from other funders.

Venture Capitalists look for capital gains from their investments. They adopt a

portfolio approach to their investments which reflects their strategy to mitigate the risk

of investing unsecured funds in early stage companies. Before they invest, VC

executives will consider the likelihood of realising their investment.

After all, they are responsible for returning the cash invested in their fund with interest

to their investors. The promoters ability to implement their business plan in

full is the obvious question, but just as importantly, can the company in question be

sold to another trade player or find another way to redeem the venture capitalist's

investment within a reasonable time frame (usually between three and

Seven years)?ITAL

The Business Plan

The business plan is the most important document for a company seeking to raise

finance from private equity investors. It should demonstrate what the business


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opportunity is, the amount of funds required to deliver the business plan and a

management team capable of implementing it. Venture Capitalists read numerous

business plans from a wide range of sources and they must invest in the best projects.

Their first impression of your business plan will determine whether they take their

interest any further. It is absolutely essential that your business plan demonstrates an

'investor ready' project. The following section is intended to give you a summary of

what the business plan should include:

Executive Summary

This is the key part of the document which must immediately and clearly articulate the

investment opportunity for the reader. The Executive Summary should make a

potential investor believe that your unique proposition has the potential to make

a good return on their investment and that you and your team have the ability to

deliver what the plan says. If this part of the Business Plan is not presented with

conviction and in clear language, you may miss the opportunity of ensuring that a

potential investor takes the time to read your entire plan.

The detailed plan should give full details under the following headings:

1. The Product / Service

2. The Market

3. Management Team

4. Business Process / Operations


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5. Financial Projections

6. Proposed Investment Opportunity

1. The Product / Service

In simple language, this should explain what exactly the product / service offering is.

This will clearly demonstrate the unique selling point of your offering, differentiation

from other products, barriers to entry etc and how your product /

Service will add value to the purchaser.

2. The Market

A common mistake that entrepreneurs make is to express their market in terms of a

global figure representing all activity within their sector. The private investor requires

comfort that there is a commercial opportunity for your product/service

and that the management team has the ability to exploit this opportunity.

The marketing section should demonstrate who the customer base is likely to be, how

the product / service will be priced, how it will be distributed to customers, an analysis

of competitors and how you will deal with competing goods and services.

It is unlikely that there will be no rivals in your market sector and you should avoid

comments like 'there is no competition' or, 'our product is totally new'. If no one has

thought of offering a similar or competing product, is it conceivable that there is no

demand for your product or that customers do not realise that they need it?

3. Management Team


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Most venture capitalists will tell you that they invest in people not ideas. The

management team must sell their experience to investors as well as their

understanding of the market which they are targeting. This section must convey the

message that the team has the full complement of skills required to deliver the plan.

Indeed, it is prudent to identify skill gaps which must be addressed in order to deliver

the plan as new investors in a business can utilise their networks to fill the gaps. Non-

Executive Directors (NEDs) are an obvious source of expertise for early stage

companies to address this issue and and Venture Capital Fund managers usually

appoint a NED to investor companies to help them avoid the pitfalls of growing a

business. Further details on NEDs can be found in the next section of the guide.

4. Business Processes / Operations

This section explains how the business operates, be that manufacturing products,

delivering a service, or both. It should demonstrate that any necessary R&D can be

fully undertaken and that an appropriately skilled workforce is available. The location

of the business and the physical infrastructure will also be detailed. Care should be

taken to demonstrate that there is sufficient flexibility within systems, facilities and

human resources to expand the business in line with its projected growth. Whilst there

may be a market for the product/service being offered, you must ensure that the

proposed location, process and utilisation of resources (human and physical) are the

best available to exploit this opportunity.


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5. Financial Projections

An investor will always wish to review a detailed set of integrated financial

projections which encompasses profit and loss accounts, balance sheets and cashflow

statements. These figures will be supported by detailed assumptions

Which reflect the content of the business plan The projections must be realistically

achieveable, but they must also be sufficiently ambitious to demonstrate that there

is an attractive investment opportunity. These projections will form the basis of any

term sheet which an equity investor may issue. Negotiation with the Venture

Capitalist over valuation, future milestones and ultimate exit opportunities will be

influenced by the delivery of the financial projections. Much consideration should be

given to this section to produce realistic projections and indicate an openness to work

with the investor in the future to deliver a common goalthe maximising of value.

6. Proposed Investment Opportunity / Exit

This is the opportunity to identify the level of funds required, how and when they will

be spent, and an outline showing how investors will receive a return on their

investment.

As with the financial projections the exit opportunity should be realistic and take

account of current market conditions. It cannot be stressed too much that the Business

Plan is the single most important document that you will provide for


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potential private equity investors. It must be coherent, well presented and of a length

which maintains the interest of the reader. It is essential that you strike a balance

between providing the investor with sufficient information to evaluate

the investment opportunity while not overloading them with technical information.

The Role of theNon-Executive Director

The considerable amount of media attention on the issue of corporate governance has

highlighted the role of Non-Executive Directors. It is well documented that

Non-Executive Directors can make a significant contribution to company performance

regardless of size. The use of Non-Executive Directors is one way of accelerating the

development and growth of SMEs and whether it is a longstanding traditional

business or a start-up seeking equity finance, non-executives can bring added value

with objectivity drawn from their own experience and skills.

It is normal for Venture Capital investors to place a Non-Executive Director on the

Board of the investee company to represent their interests. This can either be one of its

own fund managers or an individual who has sectoral, market, or management

expertise which will help delivery of the corporate plan.

Most Venture Capitalists, however, recognise that the chemistry and teamwork

between the non-executive and the existing management team is crucial. As a result,


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the VC's Non-Executive Director is there to play an integral role in the development

of the company rather than act as a watchdog for their investment.

This availability of outside expertise to the management team represents a valuable

asset for most companies, particularly start-ups, and is one reason why Venture

Capital is regarded as a value-added source of finance for SMEs.

Glossary of Terms

ACQUISITION The act of one company taking over a controlling interest in

another company. Investors often look for companies that are likely acquisition

candidates, because the acquiring firms are usually willing to pay a premium on

the market price for the shares. This may be the most likely exit route for a VC

investor.

ANGEL FINANCIERSThe first individuals to invest money in your company. For

example, friends, family. They do not belong to a professional venture capital firm

and do not have similar monitoring processes. They often believe in the Entrepreneur

more than the actual product. This capital is generally used as seed financing.

ANTI-DILUTION PROTECTION In the event a company sells shares in the

future at a price lower than what the VC paid, an adjustment will be made to the % of

shares held by the VCs.


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BOOTSTRAPPING A means of finding creative ways to support a start-up

business until it turns profitable. This method may include negotiating delayed

payment to suppliers and advances from potential partners and customers.

BRIDGING FINANCEType of financing used to fill an anticipated gap between

more permanent rounds of capital investments. Usually structured to enable them to

become part of future rounds if successfully raised.

BURN RATE The rate at which your company is consuming cash, usually

expressed on a monthly basis.

CAPITAL GAINS The difference between an assets purchase price and selling

price when the selling price is greater. Capital gains are usually subject to tax which

may be mitigated by careful tax planning.

CARRIED INTEREST The portion of any gains realised by a Venture Capital

Fund to which the fund managers are entitled, generally without having to contribute

capital to the fund. Carried interest payments are customary in the

venture capital industry to create a significant economic incentive for venture capital

fund managers to achieve capital gains.

CONVERTIBLE SECURITYA financial security (usually preference shares) that

is exchangeable for another type of security (usually ordinary shares) at a pre-stated

price. Convertibles are appropriate for investors who want higher income, or


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liquidation preference protection, than is available from ordinary shares, together with

greater appreciation potential than regular bonds offer.

DILUTIONThe process by which an investor's ownership percentage in a company

is reduced by the issue of new shares.

DUE DILIGENCE The process by which VCs conduct research on the market

potential, competition, reference interviews, financial analysis, and technology

assessment. Usually divided into commercial, financial, legal and commercial due

diligence.

EARLY STAGEA fund investment strategy involving investments in companies to

enable product development and initial marketing, manufacturing and sales activities.

Early stage investors can be influential in building a companys management team and

direction. While early stage venture capital investing involves more risk at the

individual deal level than later stage venture investing, investors are able to buy

company stock at very low prices and these investments may have the ability to

produce high returns.

EXIT STRATEGY A funds intended method for liquidating its holdings while

achieving the maximum possible return. These strategies depend on the exit climates

including market conditions and industry trends. Exit strategies can include selling or

distributing the portfolio companys shares after an initial public offering (IPO), a sale


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of the portfolio company or a recapitalisation. (See Acquisition, Initial Public

Offering)

FUND FOCUS (OR INVESTMENT STAGE)The indicated area of specialization

of a venture capital fund usually expressed as Balanced, Seed and Early Stage, Later

Stage, Mezzanine or Leveraged Buyout (LBO). (See all of the stated fund types for

further information)

FUND SIZE The total amount of capital committed by the investors of a venture

capital fund.

HOCKEY STICK Refers to a financial projection which starts modestly for a

number of months and rapidly accelerates. How much of a hockey stick is in the

plan?

INVESTMENT PHILOSOPHYThe stated investment approach or focus of a fund

manager.

INITIAL PUBLIC OFFERING (IPO) The sale or distribution of a stock of a

portfolio company to the public for the first time. IPOs are often an opportunity for the

existing investors (often venture capitalists) to receive significant returns on their

original investment. During periods of market downturns or corrections the opposite is

true.

LATER STAGEA fund investment strategy involving financing for the expansion

of a company that is producing, shipping and increasing its sales volume. Later stage


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funds often provide the financing to help a company achieve critical mass in order to

position itself for an IPO. Later stage investing can have less risk than early stage

financing because these companies have already established themselves in their

market and generally have a management team in place. Later stage and Mezzanine

level financing are often used interchangeably.

LEAD INVESTOR Each round of Venture Capital has a lead investor who

negotiates the terms of the deal and usually commits to at least 50% of the round.

LEVERAGED BUYOUT (LBO)A takeover of a company using a combination of

equity and borrowed funds (or loans). Generally, the target companys assets act as

the collateral for the loans taken out by the acquiring group. The acquiring group then

repays the loan from the cash flow of the acquired company. For example, a group of

investors may borrow funds using the assets of the company as collateral in order to

take over a company. Or the management of the company may use this vehicle as a

means to regain control of the company by converting a company from public to

private. In most LBOs, public shareholders receive a premium to the market price of

the shares.

LIMITED PARTNERSHIPSAn organization comprised of a general partner, who

manages a fund, and limited partners, who invest money but have limited liability and

are not involved with the day-to-day management of the fund. In the typical venture

capital fund, the general partner receives a management fee and a percentage of the


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profits or carried interest). The limited partners may receive both income and capital

gains as a return on their investment.

MANAGEMENT FEE Compensation for the management of a venture funds

activities, paid from the fund to the general partner or investment advisor. This

compensation generally includes an annual management fee.

MANAGEMENT TEAM The persons who oversee the activities of a venture

capital fund.

MEZZANINE FINANCING Refers to the stage of venture financing for a

company immediately prior to its IPO. Investors entering in this round have lower risk

of loss than those investors who have invested in an earlier round. Mezzanine level

financing can take the structure of preference shares, convertible bonds or

subordinated debt (the level of financing senior to equity and below senior debt).

NEW ISSUE A stock or bond offered to the public for the first time. New issues

may be initial public offerings by previously private companies or additional stock or

bond issues by companies already public. New public offerings are registered with the

Securities and Exchange Commission. (See Securities and Exchange Commission and

Registration)

OPTION POOLThe number of shares set aside for future issuance to employees of

a private company.


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PORTFOLIO COMPANIESPortfolio companies are companies in which a given

fund has invested.

POST-MONEY VALUATIONThe valuation of a company immediately after the

most recent round of financing. This value is calculated by multiplying the companys

total number of shares by the share price of the latest financing.

PREFERENCE SHARES Form of equity which has rights superior to ordinary

shares. Most VC deals use preference shares which may convert to ordinary shares

upon an IPO or Acquisition.

PRE-MONEY VALUATION The value of the company before VCs cash goes

into the business. VCs use the Pre-Money Valuation to determine what % ownership

they will have in your company.

PRIVATE EQUITY Private equities are equity securities of companies that have

not gone public (in other words, companies that have not listed their stock on a

public exchange). Private equities are generally illiquid and thought of as a long-term

investment. As they are not listed on an exchange, any investor wishing to sell

securities in private companies must find a buyer in the absence of a marketplace.

PROPRIETARY INFORMATION Any information uniquely possessed by a

company which is not generally available to the public.

PROSPECTUS A formal written offer to sell securities that provides an investor

with the necessary information to make an informed decision. A prospectus explains a


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proposed or existing business enterprise and must disclose any material risks and

information according to the securities laws. A prospectus must be filed with the SEC

and be given to all potential investors. Companies offering securities, mutual

funds, and offerings of other investment companies (including Business Development

Companies) are required to issue prospectuses describing their history, investment

philosophy or objectives, risk factors and financial statements. Investors should

carefully read them prior to investing.

SECONDARY SALE The sale of private or restricted holdings in a portfolio

company to other investors.

SEED MONEY The first round of capital for a start-up business. Seed money

usually takes the structure of a loan or an investment in preferred stock or convertible

bonds, although sometimes it is common stock. Seed money provides start-up

companies with the capital required for their initial development and growth. Business

Angels and early-stage venture capital funds often provide seed money.

STOCK OPTIONS There are two definitions of stock options. The right to

purchase or sell a stock at a specified price within a stated period. Options are a

popular investment medium, offering an opportunity to hedge positions in other

securities, to speculate on stocks with relatively little investment, and to capitalize on

changes in the market value of options contracts themselves through a variety of

options strategies. A widely used form of employee incentive and compensation.


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The employee is given an option to purchase its shares at a certain price (at or below

the market price at the time the option is granted) for a specified period of years.

TERM SHEET Typically a 3-5 page document which outlines the fundamental

business terms of a Venture Investment. This document serves to drive at the final

business agreement of closing the deal. If you receive a term sheet from a VC there is

a high probability of closing and funding the deal.

VENTURE CAPITAL Money provided by investors to privately held companies

with perceived long-term growth potential. Professionally managed venture capital

firms generally are limited partnerships funded by private and public pension funds,

endowment funds, foundations, corporations, wealthy individuals, foreign investors,

and the venture capitalists themselves.

WRITE-OFFThe act of changing the value of an asset to an expense or a loss. A

write-off is used to reduce or eliminate the value an asset and reduce profits.

WRITE-UP/WRITE-DOWN An upward or downward adjustment of the value of

an asset. Usually based on events affecting the investee company or its securities

beneficially or detrimentally.

Venture Capital Regulations in India

"There is a tide in the affairs of men, which taken at the flood, leads on to

fortune...And we must take the current when it serves, or lose our ventures."

- William Shakespeare


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Growth is the process that only happens when the untread is tried and the undone is

materialized. For any new venture we undertake there is always apprehension of

missesthan hitting the bulls eye and this apprehension for years has curbed the

entrepreneurs from innovating and growing. Venture Capital is the conduit for giving

the entrepreneurs wings to fly when they are willing to jump of the cliff.

Simply put, Venture Capital is a term coined for the capital required by an

entrepreneur to venture into something new, promising and unconventional.

Investing in a budding company has always been a risky proportion for any financier.

The risk of the business failure and the apprehensions of an all together new project

clicking weighed down the small entrepreneurs to get the start-up fund. The Venture

Capitalists or the angel investors then came to the forefront with an appetite for risk

and willingness to fund the ventures.

How does it work? Venture Capital financing is a process whereby funds are pooled

in for a period of around 10 years and investing it in venture capital undertakings for a

period of 3 to 5 years with an expectation of high returns. To protect the funds of the

investors against the risk of losses, venture capital fund provides its expertise,

undertake advisory function and invest in the patient capital of the undertaking

equities. Venture Capital financing had been a popular source of funding in many

countries and served as a lucrative bait to create a similar industry in India as well.

Regulations of Venture Capital:


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VCF are regulated by the SEBI (Venture Capital Fund) Regulations, 1996. The

regulation clearly states that any company or trust proposing to carry on activity of a

VCF shall get a grant of certificate from SEBI. Section 12 (1B) of the SEBI Act also

makes it mandatory for every domestic VCF to obtain certificate of registration from

SEBI in accordance with the regulations. Hence there is no way that an Indian

Venture Capital Fund can exist outside SEBI Regulations. However registration of

Foreign Venture Capital Investors (FVCI) is not mandatory under the FVCI

regulations.

A VCF and registered FVCI enjoy several benefits:

No prior approval required from the Foreign Investment Promotion Board (FIPB)

for making investments into Indian Venture Capital Undertakings (VCUs).

As per the Reserve Bank of India Notification No. FEMA 32 /2000-RB dated

December 26, 2000, an FVCI can purchase/ sell securities/ investments at a price

that is mutually acceptable to the parties and there is no ceiling or floor restriction

applicable to them.

A registered FVCI has been granted the status of Qualified Institutional Buyer

(QIB), so they can subscribe to the share capital of a VCU at the time of intial

public offer. A lock-in of one year is applicable to the shares subscribed in an IPO.

The lock-in period applicable for the pre-issue share capital from the date of

allotment, under the SEBI (Disclosure and Investor Protection) Guidelines, 2000


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is not applicable in case of a registered FVCI and VCF.

Under the SEBI (Substantial Acquisition of Shares and Takeover) Regulations,

1997 if the promoters want to buy back the shares from FVCIs, it would not come

under the public offer requirements.

Structure of a VCF:

The regulations in India have been carefully drafted but then have left ambiguity in

understanding to many. Though the laws relating are not complex but then they do not

lay down clear cut laws; susceptible to interpretations and discussions.

Section 2(m) defines a VCF is a corpus of funds created by raising funds in a specific

manner to be invested in a manner as specified in the regulations. This means any

activity beyond the periphery of what is laid in the charter is prohibited. A VCF can

be created in a form of a 1) trust, 2) company including 3) a body corporate. This

means that no matter what the form of a VCF is the core substance shall remain the

same. The VCF is segregated into schemes in which the funds are invested. The

scheme relates to investing the money into venture capital undertakings as defined

under sec 2 (n) of the regulations. A VCF raises money from the investors in the form

of units (discussed below) to be invested in these schemes. Chapter III and IV lay

down the restrictions and prohibitions on raising and investment of funds by a VCF.

From the above laid structure the following few key features of a VCF have emerged:

A VCF raises funds in the form of units. Section 2(l) defines units as


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beneficial interest of the investors in the scheme or funds floated by a trust or issued

by a company including a body corporate. Chapter III says that these funds can be

raised from Indian, foreign or non-resident investors by the way of issuance of units.

Chapter VI prohibits public offers for inviting subscription or purchase of units from

the public. The above elucidated two things 1) the units are the beneficial interest of

the investors and that the VCF holds only legal interest and 2) that the VCF is a

channel of investing the investors money in various schemes.

The regulations have crisply laid down the core substance of the VCF. The

regulations lay down that the VCF can be constituted in form of a trust or company

including a body corporate but have rested in the beneficial interest in the hands of the

investors and legal interest in the hands of the managers of the fund. In case of a trust

form of VCF, it is evident that the funds pooled are held by the trustees and that they

have only legal interest in the raised funds, so this raises no confusions. However, in

case of a company/ body corporate also the company holds only legal interest in the

fund. Unlike a company, fund is raised scheme specific and cannot be used by the

company in any other manner or for any other purpose and that the unit holders are the

beneficiaries, reducing the status of the company to having only fiduciary interest in

the fund. Thus, no matter what form a VCF is constituted in the essence would be that

of a trust. This further raises question as to what is the interest of the trust or company

(including body corporate) in managing the schemes. Section 2 (hh) of the regulation


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defines investible funds ascorpus of the fund net of expenditure for administration

and management of fund. So the managers of the fund receive fees for the

management of the VCF business. The regulations expressly do not specify the

permissible or prohibited quantum of the fees. This clears the sham, surfacing the

clear cut view that the VCF may be dressed in any form raising doubts on

interpretations, the conclusion is that the core substance prevails.

Accessing Venture Capital in India

The Human Capital Supply:

Quality, Quantity, Mobility, and Risk-Taking Attitudes

In the 1970s, IT exports from India began with body-shopping, also known as

contract programming. In such contracts, the amount of code was specified in the

contract and there was relatively little risk. Until 1991, this was the main form of

IT exports, and it was performed exclusively by Indian firms. Foreign firms were

deliberately excluded as a matter of government policy. It was a difficult business

environment. Indian firms that were exporting bodies, as well as firms that

operated only in the domestic market, found themselves operating in a closed

economy, featuring high tariffs on hardware imports and non-tariff barriers on

software imports. Quite by accident, this situation led to a growth of skills that

would be of great value to India a few years later. Indias UNIX talents, now


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globally in demand due to the growth of the Internet, developed because the

countrys closed economy forced Indian computer makers to develop their own

hardware and software design skills. Sridhar Mitta noted that, in 1983, the United

States used an Intel 386 microprocessor as the base for a simple personal

computer, whereas India employed the same microprocessor with the UNIX

operating system to power mainframes that controlled large en terprises. Indias

closed environment also spurred the countrys IT industry to develop advanced

skills in system design, architecture, protocol stacks, compilers, device drivers, and

boards. When India began to export its IT labor in the 1970s, most workers came

from one city: Bangalore. The emergence of Bangalore as a suitable site for high

technology work rests on two key factors. The first is the presence of several

academic institutions and government sponsored high technology enterprises, such

as the Indian Institute of Sciences and Hindustan Aeronautics Limited. The

ongoing strength of the four southern statesTamil Nadu, Andhra Pradesh (AP),

Karnataka (which includes Bangalore), and Keralain supplying labor is helped

by the fact that four hundred of Indias six hundred technical colleges are located

within them. In a recent presentation at Stanford University, the director of the

Indian Institute of Technology (IIT) at Kanpur (one of Indias five prestigious

IITs) noted that Bangalores Indian Institute of Science, as a research center for IT,

has in fact overtaken the IITs as a center of technology research.2 The second


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group of factors contributing to Bangalores current IT dominance springs from its

lower real estate costs, good weather, and the development of an international

airport. Together, these attributes led an important high technology firm, Wipro,

as well as several multinationals, to relocate from Mumbai to Bangalore in the

1980s. Bangalore offers many advantages, but even these may not be eternal.

Recent visits to its IT Park, a private venture funded by the Tatas, Indias largest

industrial group, and the Government of Singapore, suggest that Bangalore is

losing out to Hyderabad. To be sure, Bangalore possesses a much stronger labor

pool, but its severe power and water shortages, along with incentives from APs

state government to firms setting up in Hyderabad, are conspiring to make it a less

popular choice than previously. A recent, prominent example of this phenomenon

occurred when General Electrics finance division, after rejecting an initial

decision to go with Bangalore, chose to take advantage of the AP Government

incentives. From 1991 onwards, the Indian economy was opened to foreign

investment. Almost immediately, U.S. high technology firms began outsourcing

software development in India, leveraging local knowledge of English and lower

labor costs, and adding value without risk. Indian firms which had until then

focused on hardware and software design, and on products and services for the

local market, were unable to compete with U.S. firms for labor. They shifted their

focus to the export market. Meanwhile, those Indian firms which had become


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leaders in on-site body-shopping shifted into off-site work in India. Since then,

several Indian exporters have successfully entered the software support business.

In some cases, their current revenues exceed those of many mid-tier, U.S.-based,

public IT service companies. These companies continue to lead the Indian industry

today. Interestingly, the domestic market for IT products and services has grown

very slowly (less than 10 percent per year through the past decade), while the

export market, by contrast, has done very well. In addition, though low value-

added services still dominate the export market, the balance has shifted in the past

two years from on-shore services to off-site services. According to the Pune-based

Maratha Chamber of Commerces IT group, about 50 percent of Indias exports

come from on-site body-shopping and 30 percent from off-site contract work.

High value-added next-stage businesses, such as turnkey projects, consultancy,

and transformational outsourcing, remain small, and branded product development

for the export market is negligible. Nor is India yet a player in technology

development or hardware products. Though generally thought to be very high, the

quality of labor is still a matter of debate within India. The head of training at

Satyam Computers, a large IT firm with Level training facilities (a European

designation awarded to fewer than a dozen firms worldwide), stated that his firm

found the quality of graduates from the software training institutes to be

inadequate. He noted that the best students of the IITs (the top 10-15 percent)


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possessed outstanding ability, but most of them went abroad (primarily to the

United States) after graduating. The remainder, in his view, were of poorer quality

and needed substantial additional study to improve their skill-sets. At the middle

levels of the IITs, similar perceived quality problems, combined with the inability

to recruit top level candidates, have dented IIT enrollment numbers. The

proportion of IIT students at the Indian Institute of Management, Ahmedabad, the

premier management institute in India, has decreased from 70 percent in 1990 to

less than 30 percent today. Holding aside for the moment the question of whether

India has the talent and overall quality of labor for product development, it clearly

possesses the quantity. Each year, 61,000 computer engineering graduates come

out of Indian universities, as compared with the 30,000 graduates who complete

the same degree in the United States. An even larger number of Indian students

215,000 per yeargraduate in other engineering fields. Many of these graduates

promptly shift to computer engineering because of the earning differential, or join

the 200,000 people who annually enroll in private software training institutes. Still

other Indian IT workers are trained in post-recruitment, in-house institutes, at firms

such as Wipro and Satyam. This generally youthful population is also mobile,

willing to move anywhere in India or abroad to pursue their jobs. Indeed, 50

percent of the H1-B visas issued by the United States in 1998 went to Indians.


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The Indian IT industry now boasts a much more open environment, yet its

production of high value-added business capabilities lags behind that of Israel and

Taiwan. In his conference presentation, Mitta argued that software work remains

limited to low-level programming jobs. He attributed this to an inability to

understand market and technology trends from a distance, which in turn leads to

problems in arriving at the desired product and engineering specifications. Gaps

exist in user interfaces that prevent ease of use or quality of back-up

documentation and technical support, and ultimately lower Indian software

companies ability to address investor demand and changing market scenarios. In

contrast, while discussing the Israeli IT industry, David Blumberg noted that Israeli

companies tend to pay particular attention to user interface. They recognize that,

for companies based outside the United States, customer care and technical support

procedures must maintain a quality as high or higher than that available in the

American market. The problems noted above relate more to smaller-scale structure

and interface adjustments than to large-scale, innate problems of the Indian labor

force. Nevertheless, in many quarters there exist concerns about software

specialists willingness to risk starting or joining a new company. Multinationals

and large Indian firms remain the employments of choice. This may reflect the

financially insecure background from which Indians come, or the countrys long-

standing culture of bureaucratic control. Either way, it has led to what Som Das


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and Sudhir Sethi called in their remarks the 51 percent ownership syndrome.

Indian entrepreneurs are reluctant to allow a venture firm to supply capital that will

reduce their personal ownership to below 51 percent at any stage of the financing

process. This reluctance leads to the peculiar problem of project investments often

being too small at the start-up stage to justify venture capitalists attention. This

may be why financing focuses on later-stage projects, which in turn accounts for

the general shortage of seed capital for start-ups in India.

These concerns about risk aversion are transitional issues likely to disappear soon.

As Blumberg noted, Israel went through the same experience in its venture capital

industry. Once the low hanging fruit of late-stage firms is plucked and venture

capitalists have shored up a reservoir of talent to advise start-ups, the situation

changes quickly. This has been borne out by Indian entrepreneurs in Silicon

Valley. Having started as shopped-bodies, these workers rapidly became risk-

takers. In her conference remarks, Anna Lee Saxenian noted that between 1980

and 1997, Indian entrepreneurs started 565 firms in Silicon Valley, or 6 percent of

the total number of firms established in that time frame. The figure has likely

risen since then. By 1997, Indian start-ups in Silicon Valley were generating

annual sales of $3.25 billion and employment for 13,664 people. Das and Sethi

noted that in India, the typical risk-averse mindset shows signs of positive change.

Recently, they observed, the supply of young, technically qualified entrepreneurs


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has been increasing. At the same time, increasing numbers of internationally

savvy, senior management have been leaving established multinationals and large

Indian firms to start new companies. In addition to risk aversion, K. Ramachandran

pointed out another kind of human capital deficiencyone that operates within its

domestic venture capital firmswith which Indian IT must contend. For reasons

that will be covered more fully later in this summary, most Indian venture capital

firms are staffed by personnel seconded or transferred from public sector banks, or

recruited fresh from management institutes. Their income is unrelated to

performance, and they bring with them the baggage of undeveloped management

skills and high risk aversion. Firms employing such personnel typically do not

possess the industry knowledge that can help a start-up, particularly in the high

tech field. While this, too, may be a transitional problem, it has led to inefficient

outcomes. Ramachandran reported a typical example of inefficient board strategy.

The CEO of one of the largest venture capital firms in India sits on the board of six

companies belonging to six different industries, including firms from the

pharmaceutical, textile, and IT industries. Similarly, Indias largest venture capital

firm, ICICI Ventures, has a portfolio of two hundred and fifty companies, in a wide

range of industries located in different parts of the country, managed by fourteen

managers. Many of the ICICI Ventures-financed firms are not in the high

technology field, and a risks they often carry is that of finding a market in a


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competitive industry. Examples include Gum India, a manufacturer of bubble and

chewing gum, and Asian Peroxides, a manufacturer of hydrogen peroxide.

In summary, the conference concluded that change in human resources for IT,

though underway, is too slow. Indias software and services exports are unlikely to

meet the governments expectations for a ten-year annual growth rate of 33 percent

in the absence of an environment more conducive to skill development.

The Financial Capital Supply:

Quality, Quantity, Mobility, and Risk-Taking Attitudes

The private venture capital industry in India started in 1990, on the

recommendation of the World Bank (WB), when four funds, all promoted by

public sector undertakings, were begun. Overseas and truly private domestic funds

only began investing in India in 1996, after the venture capital regulator, the

Securities and Exchange Board of India (SEBI), announced the first guidelines for

registration and investment by venture capital firms.

The venture capital supplied to India remains small and dominated by foreign

investors. Domestic pension funds, insurance firms, and mutual funds are not

permitted to invest in venture capital firms. International Finance Corporation

(IFC) data supplied at the conference show that of the twenty private equity funds

in India classified as very active, three are subsidiaries of development financial

institutions (DFIs), or long-term debt suppliers. Seventeen are foreign funds. There


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are no domestic funds in this category. Of the seventeen funds classified as

moderately active, four come from the DFI group, four from domestic private

funds, and nine from off-shore funds. Data presented by L.K. Singhvi for SEBI,

and corroborated by IFC data show that about $1 billion has been committed from

off-shore funds, of which less than half has been invested to date. The fourteen

registered domestic funds have committed 3.8 billion rupees, of which 1 billion

rupees (U.S. $23 million) have been invested across 108 projects. While these

figures are very low, Singhvi estimated that the total pool will grow very quickly to

200 billion rupees (U.S. $4.6 billion). Data from the Indian Venture Capital

Association (IVCA) for 1998 show that, among the domestic funds, 64.3 percent

was invested in equity shares, 19.8 percent in convertible debt and 7.6 percent in

preference shares. Of the 719 start-ups financed, only 166 were late-stage

financings; the rest were start-ups, seed stage, and other early-stage financings.

Interestingly, the software industry took 19.9 percent of the money disbursed,

second only to industrial products machinery at 23.5 percent.


Legal and Regulatory Issues

Indian law does not allow for the formation of limited partnerships, which are the

common international method of organizing venture capital firms. Since the

limited partnership law does not exist in India, SEBI has laid down special


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guidelines permitting the tax department to provide incentives, for venture capital

firms registered with SEBI, that mimic the tax passthrough available to U.S.

limited partnerships. For this to be possible, venture capital firms must be

organized as limited companies or trusts, and may create, if they desire, separate

asset management companies. All long-term capital gains earned (defined as

capital gains on investments held for more than one year) are exempted from tax.

Since dividend receipts in India are tax-exempt in the hands of all recipients, the

combination of the two rules effectively means almost complete tax exemption for

venture capital firms and their investors.

Venture firms have to pay tax only on two occasions: if their gains are short-term

or in the form of interest receipts (38.5 percent for companies and 33 percent for

trusts), or if they organized as companies rather than trusts, thus requiring them to

pay dividends (10 percent withholding tax). This structure for venture capital firms

has the following advantages and disadvantages:

1) The trust form of the venture capital firm is more tax-advantageous than the

company form. In fact, in the typical case, it allows for complete tax exemption in

the hands of both trust and investor. However, Nishith Desai noted in his

conference remarks that the kinds of securities a venture capital trust firm may

acquire are limited mainly to equity securities under the Indian Trusts Act. This

means that investing in equity-linked securities, such as convertible preference


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shares, would cause the trust to lose its tax-exempt status. Further, an important

aspect of equity-linked securities their voting rights, the essential mechanism

through which a venture capitalist controls an investee firms managementis not

available.

2) While the tax status of dividend payouts in India is more advantageous than in

most other countries, including the United States, the Indian tax code does not

recognize marking-to-market of either unrealized capital gains or losses as taxable

income or loss. Likewise, capital distributions to investors are not allowed, except

in the event of the venture capital firms termination. This is particularly important

for new funds that may lose money in the initial years. Such losses cannot be

passed on to investors to realize potentially advantageous personal tax losses.

3) When the tax rules were first announced, their chief featurea tax pass-

through, not available in any other corporate formmeant that investors had a

strong incentive to abuse them. For example, a finance company that specialized in

providing finance to textile retailers could reorganize itself as a venture capital

trust, thus avoiding income taxes completely. The venture capital guidelines stated

that the funds were to be used for new or untried technology, but the words

untried technology lent themselves to wide interpretation. In an effort to limit the

tax pass-through benefit to socially desirable activities only, the tax department

restated the law in 1999, making tax pass-through available only for funds


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investing in software, information technology, production of basic drugs, bio-

technology and agriculture, or the production of patented items from government-

approved research laboratories. Obviously, this list of industries is meant to be a

dynamic one, but it creates a new (and as yet untested) bureaucratic filter,

discussed later in this summary. Other restrictions on Indian tax pass-through

include:

At least 80 percent of the funds must be invested in equity shares or

equityrelatedsecurities of unlisted or financially weak companies.

A venture capital firm may not own more than 40 percent of an investee company

and may not invest more than 5 percent of its externally raised funds or 20 percent

of its total paid-up capital in a single company.

To protect small investors, a high net-worth restriction requires a minimum

investment of half a million rupees per investor.

All permitted listed investments are subject to tax at normal corporate rates

for venture capital companies, and at normal trust rates for venture capital trusts.

4) Conflicts between the edicts of SEBI, the Ministry of Finance, and the Income

Tax Department (ITD) remain unresolved. In order to claim tax exemption, the

Income Tax Department only requires investment in unlisted equity shares,

whereas SEBI permits limited investment (up to 20 percent) in listed equity, and in

the listed equity of financially weak or sick companies. Another point of


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disagreement arises over quasi-equity securities within a trust: the ITD does not

recognize them and will disqualify a firm that invests through convertible

preference and other quasi-equity securities from tax pass-through. But SEBI will

continue to recognize such firms as registered venture capital firms.

5) Since most venture capital funds call up capital as needed from investors, they

initially have high proportions invested in the first few investee firms, making the

20 percent restriction untenable. Further, in the event of foreign shareholdings in

divested firms, the central bank must approve the price of divestment. The Reserve

Bank of Indias (RBI) guidelines are the same as for listed equity and could be

restrictive. They require a price that is the higher of 60 percent of the Bombay

Stock Exchange P/E multiple or 60 percent of the firms Net Asset Value (NAV).

For companies developing intellectual property that have yet to make profits,

neither guideline makes much sense.

6) For the on-shore investor, the above restrictions have led to the peculiar

situation of not a single registered venture capital firm claiming the tax pass-

through. For offshore investors permitted to invest in domestic firms, these

restrictions have led to a preference for direct investment in investee companies via

tax havens such as Mauritius. This requires a simple bureaucratic filter in that each

investment must be approved by the Foreign Investment Promotion Board, but

there are no other significant restrictions.


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The tax haven treaty also guarantees complete tax exemption from Indian taxes,

thus allowing foreign investors to create exactly the kind of capital structure they

want off-shore. The result is an uneven playing field favoring off-shore venture

capital firms over domestic ones.

Policy Options

Allowing Limited Partnerships. In his conference remarks, Ravindra Gupta

stated that permitting limited partnerships is a major goal of the Department of

Electronics, and that the government has approved a limited partnership law in

principle. S. Vardachary also noted that legislation to provide for limited

partnership is one of the Centre for Technology Developments key policy

objectives.

Amending Trusts. An alternative argument put forward by Desai proposed that

trusts be given tax exemptions as above; that the tax department recognize

marking- to-market, capital, and interest distributions; and that restrictions on

venture capital portfolios and the kinds of securities they may hold be lifted.

Using General Partnerships. India currently allows partnerships only as general

partnerships, where partnership income is taxed once at the level of the partnership

(the current rate is 38.5 percent), and the income distributed to the partners is

tax-free. Losses can be carried forward only by the partnership and are not

distributed to the partners. Clearly, a general partnership with unlimited liability


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would not work for venture capital firm structuring. The primary tax advantage of

the limited partnership structure is that income and losses are taxed in the partners

hands (as capital gains/losses, interest payments, or dividends) and not in the

partnership. The partners liability, excluding that of the general partner, is limited

to the amount subscribed, and the partnership can have a limited tenure. Non-tax

distributions of stock and other securities are also permissible. The primary non-

tax advantage of limited partnerships is that the liability of general partners

is unlimited, thus allowing active risk managers to assume more risk than passive

investors. Nevertheless, though such a risk-sharing arrangement may be desirable

for passive investors, it is not an important factor for the success of venture capital

firms. This is borne out by the fact that most venture capital firms general partners

are themselves structured as firms with limited liability, thus rendering the

unlimited liability clause ineffective. From the venture capital firms perspective,

the corporate form in which it operates should permit control of investee firms

through an adequate number of seats on the board, regardless of the proportion of

the investee company it holds. This arrangement can be negotiated independently

of the venture capital firms corporate structure, and does not require a limited

partnership structure. From the investee firms perspective, its financial structure

should allow venture capital firms to invest at a higher price than the founders and

employees, in recognition of their socalled sweat equity (the typical ratio is


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10:1). This scenario requires that the venture capital firm hold quasi-equity, such

as voting, and preference shares convertible at prices different from shares issued

to employees, without losing its tax pass-through status. In summary, the key

elements for venture capital are tax pass-through, capital distributions, recognition

of marking-to-market, the ability to invest in an unrestricted variety of financial

instruments, and the ability to disinvest without special approvals. According to

Desai, allowing different risk-sharing arrangements between general and limited

partners is not important for venture capital firms since the trust structure, duly

amended as discussed, will do the job.


Governance and Exit Issues

As discussed earlier in this summary, the only active domestic venture capital

funds in India are subsidiaries of government-related, long-term lending

institutions. As the experience of the United States, Japan, and several other

countries has demonstrated, such firms make poor venture capitalists. Problems

arise from the risk aversion parameters they set and the quality of the human

capital, described earlier in these proceedings, working within them.

In examining governance and exit issues in Indian venture capital, Ramachandran

pointed out what he calls a god to dog phenomenon. After being treated like

gods during the borrowing process, the venture capital firm is thereafter treated as


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a pariah dog, and tends to have no ongoing relationship with the investee firm once

it has handed out the money. In most cases, Indian entrepreneurs, as in the United

States, would prefer bank loans to venture capital, but do not have the collateral to

secure them. They must, therefore, accept the venture capitalists onerous terms.

Since they receive no other support from the venture capitalist, they tend to view

the cost

an introduction to venture capital

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