VENTURE CAPITAL FUNDING

Financial Services

AAKANKSHA BHATIA 75001ASHAYA JAIN 75014KARAN ARYA 75029

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Venture Capital Financing

Starting and growing a business always require capital. There are a number of alternative methods to fund growth. These include the owner or proprietor’s own capital, arranging debt finance, or seeking an equity partner, as is the case with private equity and venture capital.

Private Equity is a broad term that refers to any type of non-public ownership equity securities that are not listed on a public exchange. Private equity encompasses both early stage (venture capital) and later stage (buy-out, expansion) investing. In the broadest sense, it can also include mezzanine, fund of funds and secondary investing.

Venture capital is a means of equity financing for rapidly-growing private companies. Finance may be required for the start-up, development/expansion or purchase of a company. Venture Capital firms invest funds on a professional basis, often focusing on a limited sector of specialization (e.g. Information Technology, infrastructure, healthcare or life sciences, clean technology etc.). The goal of Venture Capital financing is to build companies so that the shares become liquid (through IPO or acquisition) and provide a rate of return to the investors (in the form of cash or shares) that is consistent with the level of risk taken.

With venture capital financing, the venture capitalist acquires an agreed proportion of the equity of the company in return for the funding. Equity finance offers the significant advantage of having no interest charges. It is "patient" capital that seeks a return through long-term capital gain rather than immediate and regular interest payments, as in the case of debt financing. Given the nature of equity financing, venture capital investors are therefore exposed to the risk of the company failing. As a result the venture capitalist must look to invest in companies which have the ability to grow very successfully and provide higher than average returns to compensate for the risk.

When venture capitalists invest in a business they typically require a seat on the company's board of directors. They tend to take a minority share in the company and usually do not take day-to-day control. Rather, professional venture capitalists act as mentors and aim to provide support and advice on a range of management, sales and technical issues to assist the company to develop its full potential.

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Characteristics of Venture Capital Funding

Under venture capital finance the lender provides financial support to a company which is in early stage of development, though it involves risk but at the same time is has the potential for generating abnormal returns for venture capitalist. Given below are some of the features of venture capital:

Venture capital involves not only investing money but also active participation in the management of the company by the person who has made investments in the company.

Venture capitalist divests his or her holding once the investments has generated returns in accordance with the venture capitalist desired return.

Venture Capital Financing is in the form of equity participation rather than giving it as loan or debt.

Venture Capital Financing is usually done for companies which are small level or medium level and also relatively newly formed companies are the preferred choice of venture capitalist.

Venture capitalist does Venture Capital Financing in order to make a capital gain on equity investment at the time of exit.

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Features unique to VC firms

Investment in high-risk, high-returns ventures: As VCs invest in untested, innovative ideas the investments entail high risks. In return, they expect a much higher return than usual. (Internal Rate of return expected is generally in the range of 25 per cent to 40 per cent).

Participation in management: Besides providing finance, venture capitalists may also provide technical, marketing and strategic support. To safeguard their investment, they may also at times expect participation in management.

Expertise in managing funds: VCs generally invest in particular type of industries or some of them invest in particular type of businesses and hence have a prior experience and contacts in the specific industry which gives them an expertise in better management of the funds deployed.

Raises funds from several sources: A misconception among people is that venture capitalists are rich individuals who come together in a partnership. In fact, VCs are not necessarily rich and almost always deal with funds raised mainly from others. The various sources of funds are rich individuals, other investment funds, pension funds, endowment funds, et cetera, in addition to their own funds, if any.

Diversification of the portfolio: VCs reduce the risk of venture investing by developing a portfolio of companies and the norm followed by them is same as the portfolio managers, that is, not to put all the eggs in the same basket.

Exit after specified time: VCs are generally interested in exiting from a business after a pre-specified period. This period may usually range from 3 to 7 years.

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Stages of Venture Capital Funding

Venture capital is a source of financing for new businesses. Venture capital funds pool investors' cash and loan it to startup firms and small businesses with perceived, long-term growth potential. This is a very important source of funding startups that do not have access to other capital and it typically entails high risk (and potentially high returns) for the investor.

Most venture capital comes from groups of wealthy investors, investment banks and other financial institutions that pool such investments or partnerships. This form of raising capital is popular among new companies, or ventures, with a limited operating history that cannot raise capital though a debt issue or equity offering. Often, venture firms will also provide start-ups with managerial or technical expertise. For entrepreneurs, venture capitalists are a vital source of financing, but the cash infusion often comes at a high price. Venture firms often take large equity positions in exchange for funding and may also require representation on the start-up's board.

Angel investors are most often individuals (friends, relations or entrepreneurs) who want to help other entrepreneurs get their businesses off the ground - and earn a high return on their investment. The term "angel" comes from the practice in the early 1900s of wealthy businessmen investing in Broadway productions. Usually they are the bridge from the self-funded stage of the business to the point that the business needs true venture capital. Angel funding usually ranges from $150,000 to $1.5 million. They typically offer expertise, experience and contacts in addition to money.

Seed: The first stage of venture capital financing. Seed-stage financings are often comparatively modest amounts of capital provided to inventors or entrepreneurs to finance the early development of a new product or service. These early financings may be directed toward product development, market research, building a management team and developing a business plan. A genuine seed-stage company has usually not yet established commercial operations - a cash infusion to fund continued research and product development is essential. These early companies are typically quite difficult business opportunities to finance, often requiring capital for pre-startup R&D, product development and testing, or designing specialized equipment. An initial seed investment round made by a professional VC firm typically ranges from $250,000 to $1 million. Seed-stage VC funds will typically participate in later investment rounds with other equity players to finance business expansion costs such as sales and distribution, parts and inventory, hiring, training and marketing

Early Stage: For companies that are able to begin operations but are not yet at the stage of commercial manufacturing and sales, early stage financing supports a step-up in capabilities. At this point, new business can consume vast amounts of cash; while VC firms with a large number of early-stage companies in their portfolios can see costs quickly escalate.

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Start-up: Supports product development and initial marketing. Start-up financing provides funds to companies for product development and initial marketing. This type of financing is usually provided to companies just organized or to those that have been in business just a short time but have not yet sold their product in the marketplace. Generally, such firms have already assembled key management, prepared a business plan and made market studies. At this stage, the business is seeing its first revenues but has yet to show a profit. This is often where the enterprise brings in its first "outside" investors.

First Stage: Capital is provided to initiate commercial manufacturing and sales. Most first-stage companies have been in business less than three years and have a product or service in testing or pilot production. In some cases, the product may be commercially available.

Formative Stage: Financing includes seed stage and early stage.

Later Stage: Capital provided after commercial manufacturing and sales but before any initial public offering. The product or service is in production and is commercially available. The company demonstrates significant revenue growth, but may or may not be showing a profit. It has usually been in business for more than three years.

Third Stage: Capital provided for major expansion such as physical plant expansion, product improvement and marketing.

Expansion Stage: Financing refers to the second and third stages.

Mezzanine (bridge financing): Finances the step of going public and represents the bridge between expanding the company and the IPO. Also, Balanced-stage: financing refers to all the stages, seed through mezzanine.

Buyouts and second-stage financing are the most popular stages of venture capital financing. Globally, according to a report by PricewaterhouseCoopers, around 80 per cent of the total private equity investment is done at these stages.

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Venture Capital funding: better than the rest!

Venture capital funding as a long term source of finance is more advantageous than other sources of financing institutional requirements because:

It injects long term equity finance which provides a solid capital base for future growth.

The venture capitalist is a business partner, sharing both the risks and rewards. Venture capitalists are rewarded by business success and the capital gain.

The venture capitalist is able to provide practical advice and assistance to the company based on past experience with other companies which were in similar situations.

The venture capitalist also has a network of contacts in many areas that can add value to the company, such as in recruiting key personnel, providing contacts in international markets, introductions to strategic partners, and if needed co-investments with other venture capital firms when additional rounds of financing are required.

The venture capitalist may be capable of providing additional rounds of funding should it be required to finance growth.

How VCI’s really function?

It is popularly believed that venture capitalists fund only established players and proven products. There is a lot of cynicism amongst many about all the hype that private equity and venture capital is getting in India of late.

However, the truth is that, in recent times in India, the VCs have actually provided capital to relatively new, start-up companies that have a reasonable, though not certain, prospects to develop into highly profitable ventures. Travelguru.com is a case in point, funded by Sequoia Capital and Battery Ventures.

The advent of firms like Helion Ventures with a $140 million corpus is helping the VC scenario to improve in the country. The three key people behind Helion Ventures, Ashish Gupta, Sanjeev Aggarwal and Kanwaljit Singh, all carry with them a successful track record across various companies in the international arena.

What is interesting is that for first time in India, venture capital will be backed by successful entrepreneurs who themselves have a hands-on experience in handling and developing businesses.

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The National Venture Capital Association defines venture capital as: "Money provided by professionals who invest alongside management in young, rapidly growing companies that have the potential to develop into significant economic contributors."

Innovation is the key driver of competitiveness within organizations as well as within countries. It has been well said: "Nothing is more powerful than an idea whose time has come." However, innovative ideas need more than research and knowledge to succeed.

They need not only financial, but also, managerial (technical, marketing and HR), support to achieve success. This support is lent in many forms by private funding and incubation organizations such as venture capitalists.Akhil Gupta, JMD & CFO of Bharti Airtel, once remarked, "While we could have raised funding from other sources, Warburg Pincus' involvement helped us in scaling up significantly." Almost identical has been the findings of a research conducted recently by Venture Intelligence (founded by Arun Natarajan, a leading provider of information and networking services to the private equity and venture capital ecosystem in India) with the guidance of Prof. Amit Bubna of Indian School of Business, Hyderabad, to study the economic impact of PE and VCs on the Indian businesses.

In the process venture capitalists have created some of the best known companies in the world. Without VCs we might not have seen companies such as Apple, Compaq, Sun Microsystems, and Intel to name a few.

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SEBI Foreign Venture Capital Investors (FVCIs) Regulations 2000

The investments by a foreign investor in Indian Venture Capital Undertakings (VCU) and Venture Capital Funds (VCF) are governed by Foreign Exchange Management (Transfer or Issue of Security by a person Resident Outside India) Regulations, 2000 and SEBI (Foreign Venture Capital Investor) Regulations 2000.

A foreign investor who wants to make investment in a venture capital company in India has to ensure that it has been registered as a Foreign Venture Capital Investor in India with SEBI under SEBI (Foreign Venture Capital Investor) Regulations 2000.

According to the definition given in Regulation 2(iiia) of Foreign Exchange Management (Transfer or Issue of Security by a person Resident Outside India) Regulations, 2000, FVCI means an investor incorporated and established outside India and which proposes to invest money in Venture Capital Funds or Venture Capital Undertaking in India and is registered with SEBI. SEBI (Foreign Venture Capital Investor) Regulations 2000 also defines FVCI as an investor incorporated and established outside India and is registered under the said regulations and proposes to make investments in accordance with the se regulations. Therefore it is mandatory for a foreign investor that it should have got itself registered with SEBI before it proceeds to make investment in Venture Capital Company of India.

Thus there are three requirements to be satisfied by a foreign investor before it can make investments in venture capital companies in India:

It should have been incorporated and established in any country outside India It should be willing to make investment in VCFs or VCUs in India in accordance

with SEBI regulations; and It should have got itself registered with SEBI as a FVCI.

Such an FVCI can be in form of a company including a body corporate or a trust. Before a Foreign Investor can obtain certificate of recognition as FVCI from SEBI it has to satisfy certain eligibility criteria as are provided in Reg. 4 of SEBI (Foreign Venture Capital Investor) Regulations 2000. Some of these criterions which are to be considered by SEBI are the applicants track record, professional competence, fairness and integrity of applicant, financial soundness of applicant, prior experience, whether applicant is fit and proper person in accordance with SEBI (Criteria for Fit and Proper Person) Regulations, 2004, etc. Further it has to be seen that whether the applicant has got necessary approvals from RBI for making investments in India or not.

Once the SEBI is assured that applicant satisfies all conditions under Reg. 4 it can proceed to grant registration to the applicant as FVCI allowing him to make investment in Indian VCUs and VCFs in accordance with applicable rules and regulations. This

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depends upon the discretion of SEBI which can impose suitable terms and conditions upon the applicant before it is recognized as FVCI.

After an investor has been recognized and registered as FVCI by SEBI it has to seek further approval of RBI under FEMA Regulations before making investment in India. Such an FVCI can apply to RBI for general permission through SEBI to invest in IVCU or VCF or in a scheme floated by such VCF [Reg. 5(5) and Sch. 6 of FEM (Transfer or Issue of Security by a person Resident Outside India) Regulations, 2000].

The definitions of VCFs and VCU are given both in FEM (Transfer or Issue of Security by a person Resident Outside India) Regulations, 2000[Reg. 2(xi) and Reg. 2(va) respectively] and SEBI (Foreign Venture Capital Investor) Regulations 2000[Reg. 2(1)(l) and Reg. 2(1)(m) respectively]. The definitions are almost similar in nature except the fact that SEBI Regulation uses the term VCU whereas FEM regulations use the term IVCU. Joint reading of both these regulations explains the terms VCFs and VCU in following manner. 

Indian Venture Capital Undertaking (IVCU): IVCU means a company incorporated in India whose shares are not listed on a recognized stock exchange in India and which is not engaged in an activity specified under the negative list specified by the SEBI. IVCU is generally a new born private company which is yet to establish itself and is in need of funds and experienced advice and support.

Venture Capital Fund (VCF): It is a fund established in the form of a trust or a company including a body corporate and registered with SEBI under SEBI (Venture Capital Fund) Regulations 1996 and which has a dedicated pool of capital raised in manner specified in regulations and which invests in VCU in accordance with said regulations. A VCF is also allowed to make investments in VCU subject to provisions in SEBI (Venture Capital Fund) Regulations.

Therefore a FVCI that has got registered with SEBI as such and has been permitted by RBI to make investments in India can make investment in either IVCU or VCF or both. FVCI that has been permitted by RBI to make investment in IVCU or VCF can make investment by purchasing equity or equity linked instruments or debt instruments or debentures of an IVCU or of a VCF. Equity linked instruments means and includes instruments that are later convertible into equity shares or share warrants, preference shares or debenture convertible into equity. These investments can be through Initial Public Offer or Private Placement or in units of schemes/funds set up by VCF [Schedule 6 of Foreign Exchange Management (Transfer or Issue of Security by a person Resident Outside India) Regulations, 2000]. But an FVCI registered with SEBI and permitted by RBI can make investment only in those IVCU and VCF that are also registered with SEBI under respective SEBI regulations [Master Circular on Foreign Investment in India No. 6/2004-05 Dated 1-7-2004].

According to Reg. 11 of SEBI (Foreign Venture Capital Investors) Regulations, 2000 a FVCI registered with SEBI is permitted to make investment in following manner:

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An FVCI can invest all of its funds in a domestic VCF- a registered FVCI is allowed to invest 100% of its funds in a VCF registered under SEBI (Venture Capital Fund) Regulations.

It has to invest at least 66.67% of its investible funds in unlisted equity shares or equity linked instruments of Venture Capital Undertakings.

It can invest only 33.33% of its funds (and not more), by Subscribing to initial public offer of adventure capital undertaking whose shares

are proposed to be listed; Investing in debt or debt instrument of the VCU provided it has already invested

by way of equity in such a VCU Preferential allotment of equity shares of a listed company subject to lock in

period of one year. Investment by subscription or purchase in the equity shares or equity-linked

securities of a financially weak listed company or industrial listed company.

Investment by way of subscription or purchase in  Special Purpose Vehicles created for the purpose of facilitating or promoting investment in accordance with these regulations.FVCI have a fixed life cycle. Every FVCI making investments in IVCU or VCF has to mandatorily disclose life cycle of its fund before making any investments. It has to further disclose all its investment strategies to the SEBI before it makes any investment in India.

RBI allows foreign VC firms to invest in secondary transactions

The Reserve Bank of India (RBI) has relaxed regulations for overseas private equity and venture capital funds, and will now allow those to directly invest into secondary transactions. The circular from India’s banking regulator states that these foreign investors can buy the stake held by other VC/PE funds in both private and public companies, and also invest in secondary transactions on stock exchanges.

PE/VC funds are registered as venture capital funds (VCFs) or Foreign Venture Capital Investment (FVCI) with the market regulator Securities & Exchange Board of India (SEBI).

“It has now been decided to allow FVCIs to invest in the eligible securities (equity, equity-linked instruments, debt, debt instruments, debentures of an IVCU or VCF, units of schemes/funds set up by a VCF) by way of private arrangement/purchase from a third party,” states the RBI circular issued last week. “It is also being clarified that SEBI-registered FVCIs would also be allowed to invest in securities on a recognized stock exchange.”

Existing rules say that FVCIs (read foreign VC/PE funds) cannot buy shares in a secondary transaction from another venture capital fund, either domestic or foreign. Transactions till date only allowed FVCIs to buy primary shares, either in listed or

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unlisted firms. Earlier, secondary deals were structured around these regulations and required FIPB approval for each and every transaction. But now, RBI’s new rule will ensure hassle-free investments for VC/PE funds in these sectors, as provided in FVCI guidelines.

According to experts, there will be other advantages as well, as FIIs investing through FDI cannot buy more than 10 per cent in a company while FVCIs can buy over 10 per cent. FVCIs are also exempt from entry and exit pricing restrictions and don’t have a lock-in on the shares of their portfolio companies going for initial public offerings.

This will make FVCI the more favored route rather than FIIs, which is being used by several private equity and venture capital funds at this point of time.However, the RBI ruling also states that investments through market transactions will have to comply with provisions of the SEBI (FVCI) Regulations, 2000, which will need further clarification. Also, as investment by FVCIs is restricted in nine sectors, it remains to be seen how this percolates into actual benefit for the foreign PE/VC firms.

If implemented in its full form, the move is likely to have a significant positive impact on investments from FVCIs. According to VCCEdge, the financial research platform of VCCircle, there was 16 exits through secondary deals valued at $718 million in the entire CY2011. Till March 27, 2012, there have been eight secondary deals worth $545 million.

Secondary deals, in terms of stake transfer from one private equity firm to another, are expected to be a large market over the next three years as investors seek exit from 2006-2008 vintage deals while others are sitting on significant dry powder.

Private investments in public equities (PIPEs), either through public issues or direct purchases from the market, have also been on the rise after falling in 2009 post-Lehman crisis. Public market deals increased from 70 to 93 in volume from 2010 to 2011, while rising from $2.37 billion to $3.5 billion over the same period. Till March 27, 2012, there have been 23 PIPE deals worth $670 million.

Over the last 6-8 months, global private equity majors like the Carlyle Group, General Atlantic, Providence Equity Partners and the Blackstone Group have also picked up shares in listed company from the markets. In fact, most mid-market private equity firms in India have started investing in public markets opportunistically, but there are also some dedicated players like Nalanda Capital and WestBridge Capital.

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Proposed Budget 2012: Venture Capitalists fear setback, to meet officials shortly

The India Venture Capital Association, the industry body for private equity firms and venture capital companies, is planning to meet finance ministry officials shortly to discuss the impact some of the Budget proposals would have on their investments.

"Often PE firms scale up their portfolio companies through inorganic growth (acquisitions). Share premium paid in such acquisitions becomes taxable, thereby impacting the PE operations," said Raja Kumar, founder & CEO, Ascent Capital

The proposal to introduce certain rules to curb money laundering, including the move to tax any premium on issue of shares over fair market value, as income in the hands of the investee company, will impact unregistered venture capital funds and angel investors, fear industry officials.

Private equity fund officials say the cost of initial acquisition may not rise in the first instance, but the cost would go up when its portfolio companies acquire another company. Venture capital funds say emerging businesses like e-commerce, which has attracted significant investments in the past, could be affected as premium is paid considering factors such as future projections and cash flows.

According to industry estimates, in the past three years the e-commerce sector has attracted close to $450 million from venture capital funds.

Mahendra Swarup, president, IVCA, said the move to tax share premium will also impact downstream investment in infrastructure firms, where they use a holding company structure to acquire aspecial purpose vehicle. Budget 2012 has also made it mandatory for private equity funds coming from some taxfriendly jurisdictions like Cayman Islands and Bahamas to obtain the certificate of residence.

"The Tax Residency Certificate (TRC) needs to be in the prescribed form; else the tax authority can overlook the TRC and deny the treaty benefits. It may not be possible for every country to issue a TRC in the prescribed form due to internal reasons," Swarup said. The government has also proposed a General Anti-Avoidance Rule (GAAR) in the Budget, which vests unlimited power with the revenue authorities, tax experts said.

Prominent Venture Capital deals

Kinnser Software, an Austin, Texas-based provider of online software solutions for the home health industry, has raised $40 million in Series A funding from Insight Venture Partners.

ThreatMetrix, a San Jose, Calif.-based provider of cybercrime prevention solutions, has raised $18 million in Series D funding. August Capital led the

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round, and was joined by return backers Tenaya Capital, U.S. Venture Partners and CM Capital. The company has now raised over $36 million.

CiRBA Inc., a Toronto-based provider of infrastructure control software, has raised C$15 million in third-round funding. Tandem Expansion Fund led the round, and was joined by return backers Sigma Partners and Edgestone Capital Partners. 

BiO2 Medical Inc., a San Antonio-based developer of catheters to prevent pulmonary embolism-related mortality and morbidity, has raised $13.7 million in Series B funding. San Antonio's Targeted Technology Fund and Pasadera Capital led the round, which includes the conversion of a $1 million State of Texas Emerging Technology Fund (ETF) award. 

UnboundID, an Austin, Texas-based provider of a platform for identity services, has raised $12.5 million in Series B funding from OpenView Venture Partners. 

ImaginAb Inc., a Los Angeles-based developer of in vivo imaging agents for positron emission tomography, has raised $12.5 million in Series A funding. Novartis Venture Funds led the round, and was joined by Merieux Developpement, Nextech Invest, Cycad Group and return backer Momentum Biosciences. 

Tracelytics, a Providence, R.I.-based provider of application performance management SaaS, has raised $5.2 million in Series A funding. Bain Capital Ventures led the round, and was joined by seed backers Google Ventures, Battery Ventures and Flybridge Capital Partners.

CloudLock, a Waltham, Mass.-based maker of software for securing enterprise cloud data, has raised $8.7 million in Series B funding. Ascent Venture Partners was joined by return backer Cedar Fund.

Sojern, a San Francisco-based travel data and media company, has raised $7.5 million in new VC funding. Industry Ventures led the round, and was joined by return backers Norwest Venture Partners, Trident Capital and Focus Ventures. 

Vigilent, an El Cerito, Calif.-based provider of energy management systems for data centers, has raised $6.7 million in new funding led by Accel Partners.