VENTURE CAPITAL INDUSTRY – SCOPE IN INDIA

VENTURE CAPITAL INDUSTRY – SCOPE IN INDIA
1. What Is Venture Capital?
Venture capital is money provided by professionals who invest alongside management in young, rapidly growing companies that have the potential to develop into significant economic contributors. Venture capital is an important source of equity for start-up companies.
Venture capitalists generally:
* Finance new and rapidly growing companies
* Purchase equity securities
* Assist in the development of new products or services
* Add value to the company through active participation
* Take higher risks with the expectation of higher rewards
* Have a long-term orientation
2. Investment Philosophy
Early stage funding is avoided by most funds apart from ICICI ventures, Draper, SIDBI and Angels.
Funding growth or mezzanine funding till pre IPO is the segment where most players operate. In this context, most funds in India are private equity investors.
2.1 Size of Investment
The size of investment is generally less than US$ 1mn, US$ 1-5mn, US$ 5-10mn, and greater than US$ 10mn. As most funds are of a private equity kind, size of investments has been increasing. IT companies generally require funds of about Rs30-40mn in an early stage which fall outside funding limits of most funds and that is why the government is promoting schemes to fund start ups in general, and in IT in particular.
2.2 Value Addition
The venture funds can have a totally “hands on” approach towards their investment like Draper or “hands off” like Chase. ICICI Ventures falls in the limited exposure category. In general, venture funds who fund seed or start ups have a closer interaction with the companies and advice on strategy, etc while the private equity funds treat their exposure like any other listed investment. This is partially justified, as they tend to invest in more mature stories.
3. Venture capital in India: A Prognostic View
Technology and knowledge based enterprises properly supported by venture capital can be propelled into a powerful engine of economic growth and wealth creation on a sustainable basis. According to Venture Economics Inc., a leading research organization and industry observer of venture capital industry, much of American innovation and economic development in the past three decades has come from venture capital-backed companies. In fact, many companies, which are now considered as global giants like Microsoft, Intel, and Sun among many others, are venture backed companies. In the global venture capital industry, investor and invitee firms work together closely in an enabling environment that allows entrepreneurs to focus on value creation.
This paper argues that sometimes significant changes are needed to institutionalized venture capital in India. Some of the basic problem faced by industry can be categorized as 1) need of improvement in venture capital practice and 2) improving exit mechanism.
3.1 Improving Practice
Indian venture capital Association (IVCA) was formed as a pressure group to impress upon the government the need for a favorable policy regime. It is molded as the leading public policy advocate for the Venture Capital Industry and is represented by almost all the Venture Capital Companies in India. The members of the association were working with all branches of the government and the media for a better understanding of Venture Capital in Indian economy. The association is largely successful in meeting the objectives it has set out but could not extend the horizon of its operations and could not emerge as an independent knowledge institution.
3.2 High-end Services
In order to meet the new economy’s requirements, where knowledge plays a crucial role, a different kind of institutional set up is required. IVCA should promote research in Venture Activity in India. It should also encourage all knowledge endeavors in related areas such as technology management and innovation. It should be an academic power house which offers training in areas such as setting Venture Capital funds, to name a few. These programs can be aimed at catering to the needs of young Venture Capitalists, entrepreneurs and investors in Venture Funds. It should employ knowledge workers in various technological spheres and form related areas of social science like entrepreneurship, who will be contributing to the cause of educational and professional development of the individual in the industry.
It should offer performance testing services which will provide crucial information about aspect if interests such as how well Venture funded Initial Public Offerings have performed or gains made by Venture funds through Mergers and Acquisition. Also, it should assess the industry in the wider economic sphere, i.e., by providing information about the number of jobs generated each year by funded companies of this industry and contribution to GDP. Some of the benchmarking services may include offering cost of capital benchmark that aid the industry in valuation and develop broad stock market returns information that aids the Venture Capital funds to assess their performance against market returns. In doing so, care should be taken to include only representative listed companies that broadly represent Venture Capitalist’s client companies.
3.3 Widening Exit Route
According to Asian Venture Capital Journal, the number of exits (venture capitalists divesting their stakes) in the year 2000 improved from $ 2.5 bn in 1999 to $ 3.93 bn, largely because of a successful series of IPOs in the US and regional markets and several successful trade sales. In the year 2001, there seemed to be a general slowdown in venture activity all over the world, especially in the US. From given table it is evident that the scale of venture capital exists in India was very small in compared to Japan, Korea, Hong and Australia.
Number of Disinvestment in South Asia
Country 1999 2000 % change
Australia 236 258 9.3
Hong Kong/China 375 755 101.3
India 6 28 366.7
Indonesia 21 29 38.1
Japan 876 1156 32.0
Korea 660 969 46.8
Malaysia 3 6 100.0
Philippines 6 39 550.0
Singapore 147 377 156.5
Sri Lanka 1 1 0
Taiwan 195 148 -24.1
Thailand 14 10 -28.6
Vietnam – 158 –
(Source: ICFAI Journal of Financial Economics. June 2005)
4. Indian Scenario – A Statistical Snapshot
Contributors of Funds
Contributors Rs mn Per cent
Foreign Institutional Investors 13,426.47 52.46%
All India Financial Institutions 6,252.90 24.43%
Multilateral Development Agencies 2,133.64 8.34%
Other Banks 1,541.00 6.02%
Foreign Investors 570 2.23%
Private Sector 412.53 1.61%
Public Sector 324.44 1.27%
Nationalized Banks 278.67 1.09%
Non Resident Indians 235.5 0.92%
State Financial Institutions 215 0.84%
Other Public 115.52 0.45%
Insurance Companies 85 0.33%
Mutual Funds 4.5 0.02%
Total 25,595.17 100.00%
Methods of Financing
Instruments Rs million Per cent
Equity Shares 6,318.12 63.18
Redeemable Preference Shares 2,154.46 21.54
Non Convertible Debt 873.01 8.73
Convertible Instruments 580.02 5.8
Other Instruments 75.85 0.75
Total 10,000.46 100
Financing By Investment Stage
Investment Stages Rs million Number
Start-up 3,813.00 297
Later stage 3,338.99 154
Other early stage 1,825.77 124
Seed stage 963.2 107
Turnaround financing 59.5 9
Total 10,000.46 691
Financing By Industry
Industry Rs million Number
Industrial products, machinery 2,599.32 208
Computer Software 1,832 87
Consumer Related 1,412.74 58
Medical 623.8 44
Food, food processing 500.06 50
Other electronics 436.54 41
Tel & Data Communications 385.09 16
Biotechnology 376.46 30
Energy related 249.56 19
Computer Hardware 203.36 25
Miscellaneous 1,380.85 113
Total 10,000.46 691
Financing By States
Investment Rs million Number
Maharashtra 2,566 161
Tamil Nadu 1531 119
Andhra Pradesh 1372 89
Gujarat 1102 49
Karnataka 1046 93
West Bengal 312 22
Haryana 300 22
Delhi 294 21
Uttar Pradesh 283 29
Madhya Pradesh 231 2
Kerala 135 15
Goa 105 16
Rajasthan 87 11
Punjab 84 6
Orissa 35 5
Dadra & Nagar Haveli 32 1
Himachal Pradesh 28 3
Pondicherry 22 2
Bihar 16 3
Overseas 413 12
Total 9994 691
Source IVCA

5. Problems with VCs in the Indian Context
One can ask why venture funding is so successful in USA and faced a number of problems in India. The biggest problem was a mindset change from “collateral funding” to high risk high return funding. Most of the pioneers in the industry were people with credit background and exposure to manufacturing industries. Exposure to fast growing intellectual property business and services sector was almost zero. All these combined to a slow start to the industry. The other issues that led to such a situation include:
5.1 License Raj and the IPO Boom
Till early 90s, under the license Raj regime, only commodity centric businesses thrived in a deficit situation. To fund a cement plant, venture capital is not needed. What was needed was ability to get a license and then get the project funded by the banks and DFIs. In most cases, the promoters were well-established industrial houses, with no apparent need for funds. Most of these entities were capable of raising funds from conventional sources, including term loans from institutions and equity markets.
5.2 Scalability
The Indian software segment has recorded an impressive growth over the last few years and earns large revenues from its export earnings, yet our share in the global market is less than 1 per cent. Within the software industry, the value chain ranges from body shopping at the bottom to strategic consulting at the top. Higher value addition and profitability as well as significant market presence take place at the higher end of the value chain. If the industry has to grow further and survive the flux it would only be through innovation. For any venture idea to succeed there should be a product that has a growing market with a scalable business model. The IT industry (which is most suited for venture funding because of its “ideas” nature) in India till recently had a service centric business model. Products developed for Indian markets lack scale.
5.3 Mindsets
Venture capital as an activity was virtually non-existent in India. Most venture capital companies want to provide capital on a secured debt basis, to established businesses with profitable operating histories. Most of the venture capital units were offshoots of financial institutions and banks and the lending mindset continued. True venture capital is capital that is used to help launch products and ideas of tomorrow. Abroad, this problem is solved by the presence of ‘angel investors’. They are typically wealthy individuals who not only provide venture finance but also help entrepreneurs to shape their business and make their venture successful.

5.4 Returns, Taxes and Regulations
There is a multiplicity of regulators like SEBI and RBI. Domestic venture funds are set up under the Indian Trusts Act of 1882 as per SEBI guidelines, while offshore funds routed through Mauritius follow RBI guidelines. Abroad, such funds are made under the Limited Partnership Act, which brings advantages in terms of taxation. The government must allow pension funds and insurance companies to invest in venture capitals as in USA where corporate contributions to venture funds are large.
5.5 Exit
The exit routes available to the venture capitalists were restricted to the IPO route. Before deregulation, pricing was dependent on the erstwhile CCI regulations. In general, all issues were under priced. Even now SEBI guidelines make it difficult for pricing issues for an easy exit. Given the failure of the OTCEI and the revised guidelines, small companies could not hope for a BSE/ NSE listing. Given the dull market for mergers and acquisitions, strategic sale was also not available.
5.6 Valuation
The recent phenomenon is valuation mismatches. Thanks to the software boom, most promoters have sky high valuation expectations. Given this, it is difficult for deals to reach financial closure as promoters do not agree to a valuation. This coupled with the fancy for software stocks in the bourses means that most companies are proponing their IPOs. Consequently, the number and quality of deals available to the venture funds gets reduced.