I L'tiiiire ( apiial Manaf^emeni Indian Experience

CHAPTER 1

INTRODUCTION TO VENTURE CAPITAL

Page
S.No.
TITLE No.
1.1 INTRODUCTION 24
1.2 DEFINITION 25
1.3 VENTURE CAPITAL COMPANY 27
1.4 NATURE & SCOPE 28
1.5 FEATURES OF VENTURE CAPITAL 29
1.6 VENTURE CAPITAL-THE HISTORY 31

1.7 BEGNININGOF MODERN VENTURE

CAPITAL 31

1.8 NEED AND RELEVANCE OF

VENTURE CAPITAL IN INDIA 33

1.9 STAGES OF VENTURE CAPITAL

INVESTMENT 33

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 I 'ftiiure ( apiial Management Indian Experience

Chapter I
INTRODUCTION TO VENTURE CAPITAL

1.1 INTRODUCTION

Venture capital is a growing business of recent origin in the area of industrial

financing in India. The various financial institutions set-up in India to promote
industries have done commendable work. However, these institutions do not come
up to the benefit of risky ventures when new or relatively unknown entrepreneurs
undertake them. They contend to give debt finance, mostly in the form of term
loan to the promoters and their functioning has been more akin to that of
commercial banks. The financial institutions have devised schemes such as seed
capital scheme. Risk capital Fund etc.. to help new entrepreneurs. However, to
evaluate the projects and extend financial assistance they follow the criteria such
as safety, security, liquidity and profitability and not the potential to grow. The
capital market with its conventional financial instruments/ schemes does not come
much to the benefit or risky venture. New institutions such as mutual funds,
leasing and hire purchase Company's have been established as another source of
finance to industries. These institutions also do not mitigate the problems of new
entrepreneurs who undertake risky and innovative ventures.

The term Venture Capital comprises of two words that is "Venture" and
"Capital".(Subbulakshmi. 2004: 44-46). Venture is defined as a course of
processing, the outcome of which is uncertain but to which is attended the risk or
danger of LOSS. Capital means resources to start an enterprise. To connote the
risk and adventure of such a fund, the generic name Venture Capital was coined.

Venture capital is long-term risk capital to finance high technology projects,

which involve risk, but at the same time has strong potential for growth. Venture
capitalists pool their resources including managerial abilities to assist new
entrepreneur in the early years of the project. Once the project reaches the stage of
profitability, they sell their equity holdings at high premium.

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 ( cfinire ( apuutManugcitwiu Indian l.xpentfiHt'

Venture capital refers to organize private or institutional financing that can

provide substantial amounts of capital mostly through equity purchases and
occasionally through debts offerings to help growth oriented firms to develop and
succeed.

The term venture capital denotes institutional investors that provide equity
financing to young businesses and play an active role advising their managements.

Broadly the Venture Capital finance includes a variety of investment vehicles. A

much wider range of activities than purely start up situations are undertaken by
Venture capital.

1.2 DEFINITION :
Venture capital is a type of private equity capital typically provided by
professional, outside investors to new, growth businesses. Generally made as cash
in exchange for shares in the investee company, venture capital investments are
usually high risk, but offer the potential for above-average returns.

The term 'Venture Capital" is understood in many ways. In a narrow sense, it

refers to, investment in new and tried enterprises that are lacking a stable record of
growth.

In a broader sense, venture capital refers to the commitment of capital as

shareholding, for the formulation and setting up of small firms specializing in new
ideas or new technologies. It is not merely an injection of funds into a new firm, it
is a simultaneous input of skill needed to set up the firm, design its marketing
strategy and organize and manage it. It is an association with successive stages of
firm's development with distinctive types of financing appropriate to each stage of
development.

It means an investment in those business ventures where uncertainties are yet to

be reduced to the risk that is subject to rational criteria of security analysis.

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 Venture ('apttal Management Indian Experience

Venture capital can also include managerial and technical expertise. Most venture
capital comes from a group 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 limited
operating history, which cannot raise funds through a debt issue. The downside
for entrepreneurs is that venture capitalists usually get a say in company decisions,
in addition to a portion of the equity.

Contrary to popular perception, venture capital plays only a minor role in funding
basic Innovation. Where venture money plays an important role is the next stage
of innovation life cycle-the period in a company's life when it begins to
commercialize its innovation. It is estimated that more than 80% of the money
invested by Venture Capitalist goes into building the infrastructure required to
grow the business in expense investments (manufacturing, sales, and
manufacturing) and the balance sheet (providing fixed asset and working capital).

Venture money is not long term money. The idea is to invest in a company's
balance sheet and infrastructure until it reaches a sufficient size and credibility so
that it can be sold to a corporation or so that an institutional public equity markets
can step in and provide liquidity. In essence Venture Capital buys a stake in an
entrepreneur's idea, nurtures it for a short period of time, and then exits with a
help of Investment Banker.

Venture capitals niche exists because of the structure and rule of capital markets.
Someone with a new idea or technology often has no other institution to turn to.
Usually law, limits the interest banks can charge on loans-and the risk inherent in
start ups justify the higher rates so charged by the banks. This limits a bank to
invest in those projects that secure the debt with hard assets. And in today's
information based economy, many start ups have few hard assets. Public Equity
and Investment Bank are both constrained by regulations and operating practices
to protect the public investor. Venture Capital fills the gap between innovation
and traditional lower cost sources of capital available for ongoing concerns.
Filling that void successfully requires the venture capital industry to provide a
sufficient return on capital to attract private equity funds, attractive returns for its
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 Venture ('apiial Managemcnl Indian lixpertence

own participants, and sufficient upside potential entrepreneurs to attract high

quality ideas that will generate high returns.
The new economy is driven by technological development and the basis of
technological development is new technologies which come from invention.
However having invention by itself is not enough; there also needs to be
successful commercialisation of invention.(Hisrich & peters,1998 :55-60) It is
here the role of successful entrepreneurs come into force because this person is the
one who develop projects, take risk and work to succeed in commercialisation of
new products , servicesand process.

1.3 VENTURE CAPITAL COMPANY

A venture capital company is defined as a financing institution which joins an

entrepreneur as a co-promoter in a project and shares the risks and rewards of the
enterprise.{Subbarao,2002:2-3)

Venture capital general partners (also known in this case as "venture capitalists"
or "Venture Capitalists") are the executives in the firm, in other words the
investment professionals. Typical career backgrounds vary, but many are former
chief executives at firms similar to those which the partnership finances and other
senior executives in technology companies.

Investors in venture capital funds are known as limited partners. This constituency
comprises both high net worth individuals and institutions with large amounts of
available capital, such as state and private pension funds, university financial
endowments, foundations, insurance companies, and pooled investment vehicles,
called fund of funds.

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 Venture ('apital Management Indian Experience

1.4 NATURE AND SCOPE

Venture capital refers to organize private or institutional financing that can

provide substantial amounts of capital mostly through equity purchases and
occasionally through debts offerings to help growth oriented firms to develop and
succeed. The term venture capital denotes institutional investors that provide
equity financing to young businesses and play an active role advising their
managements.

It is also important to understand the financial problems or barriers that prevents

entrepreneurs and inventors from innovating and commercialissing their
inventions.(Carlsson,2002:25-26)

Venture capital thrives best where it is not restrictively defined. Both in the
U.S.A., the cradle of modern venture capital industry and U.K. where it is
relatively advance venture capital as an activity has not been defined. Laying
down parameters relating to size of investment, nature of technology and
promoter's background do not really help in promoting venture proposals.
Venture capital enables entrepreneurs to actualize scientific ideals and enables
inventions. It can contribute as well as benefit from securities market
development. Venture capital is a potential source for augmenting the supply of
good securities with track record of performance to the stock market that faces
shortage of good securities to absorb the savings of the investors. Venture capital
in turn benefits from the rise in market valuation that results from an active
secondary market.A study by NVCA revealed that company originally backed by
Venture Capitalist generated US$ 736 billion in revenue in the year
2000.According to the study Venture Capitalist backed companies represent 3.3%
of US total Jobs.(NVCA 2002)

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 Viniure Capital Management - Indian Experience

1.5 FEATURES OF VENTURE CAPITAL

The key terms found in most definition of Venture capital are: high technology
and high risk, equity investment and capital gains, value addition through
participation in management.

High Risk

By definition the Venture capital financing is highly risky and chances of failure
are high as it provides long term start up capital to high risk-high reward ventures.
Venture capital assumes four types of risks:

^ Management Risk-inability of the management teams to work together.

=> Market Risk- product may fail in the market.
=> Product Risk- product may not be conimercially viable
=> Operation Risk- operations may not be cost effective resulting in increased
cost and decreased gross margins.

High Technology

As opportunities in the low technology area tend to be few and of lower order, and
hi-tech projects generally offer higher returns than projects in more traditional
areas, Venture capital investments are made in high technology areas using new
technology. Not just high technology, any high-risk ventures where the
entrepreneur has conviction but little capital gets venture finance. Venture capital
is available for expansion of existing business or diversification to a high-risk
area. Thus technology financing had never been primary objective but incidental
to Venture capital.

Equity Participation and Capital Gains

Investments are generally in equity and quasi equity participation through direct
purchase of shares, options, convertible debentures where the debt holder has the
option to convert the loan instruments into stock of the borrower or a debt with
warrants to equity investment. The funds in the form of equity help to raise term
loans that are cheaper source of funds. In the early stages of business, because
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 Venture ('opital Management Intlian Kxpenence

dividends can be delayed. Equity investment implies that investors bear tiie risic of
venture and would earn a return commensurate with the success in the form of
capital gains.

Participation in Management

Venture capital provides value addition by managerial support, monitoring and

follow up assistance. It monitors physical and financial progress as well as market
development initiative. It helps by identifying key resource persons. They want to
be on the company's board of directors and involvement, for better or worse, in
the major decisions affecting the direction of the company. This is a unique
philosophy of "hands on management" where Venture capitalist acts as
complementary to the entrepreneurs. Based upon the experience with other
companies, a venture capitalist advises the promoters on project planning,
monitoring, financial management, including working capital and public issue.
Venture capital investor cannot interfere in day today management of the
enterprise but keeps close contact with the promoters or entrepreneurs to protect
his investment.

Length of Investment

Venture capitalists help companies grow, but they eventually seek to exit the
investment in three to seven years. An early stage investment may take seven to
ten years to mature, while most of the later stage investments take only a few
years. (Subba Rao,2002:6-7) The process of having significant returns takes
several years and calls on the capacity and talent of venture capitalist and
entrepreneurs to reach fruition.

Illiquid Investment

Venture capital investments are illiquid that is, not subject to repayment on
demand or following a repayment schedule. Investors seek return ultimately by
means of capital gains when the investment is sold at market place. The
investment is realized only on enlistment of security or it is lost if enterprise is
liquidated for unsuccessful working. It may take several years before the first
investment starts to return proceeds. In some cases the investment may be locked
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 Venture Capital Maiiagemeni Indian Experience

for seven to ten years. Venture Capitalist understands this illiquidity and factors in
his investment decisions.

1.6 VC - THE HISTORY

In the 1920's «&30's the wealthy families of and individuals investors provided the
start up money for companies that would later become famous. Eastern Airlines
and Xerox are the famous ventures they financed. Among the early Venture
Capital Funds set up was the one by Rockefeller Family that started a special
called VENROCK in 1950, to finance new technology companies.(Satyanarayan
Chary,2005:2-10)

USA is the birthplace of Venture Capital Industry, as we know it today. During

most its historical evolution, the market for arranging such financing was fairly
informal, relying primarily on the resource of wealthy families.(Dilek,2008:8-10)

After the Second World War in 1946 the American Research and Development
was formed as first venture organization that financed over 900 companies.
Venture capital had been a major contributor in development of the advanced
countries like UK, Japan and several European countries.

1.7 BEGINNING OF MODERN VENTURE CAPITAL

Although many other similar investment mechanisms have existed in the past,
General Georges Doriot is considered to be the father of the modern venture
capital industry.

In 1946, Doriot founded American Research and Development Corporation

(AR&DC), whose biggest success was Digital Equipment Corporation. When
Digital Equipment went public in 1968 it provided AR&D with 101% annualized
Return on Investment (ROI). ARD's $70,000 USD investment in Digital
Corporation in 1957 grew in value to $355 million.(Subba Rao,2002:5-10) It is
commonly accepted that the first venture-backed startup is Fairchild
Semiconductor, funded in 1959 by Venrock Associates. Venture capital
investments, before World War II, were primarily the sphere of influence of
wealthy individuals and families. One of the first steps toward a professionally
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 I 'enlurc C 'apital Managemeni - huitan Experience

managed venture capital industry was the passage of the Small Business
Investment Act of 1958. The 1958 Act officially allowed the U.S. Small Business
Administration (SBA) to license private "Small Business Investment Companies"
(SBICs) to help the financing and management of the small entrepreneurial
businesses in the United States. Passage of the Act addressed concerns raised in a
Federal Reserve Board report to Congress that concluded that a major gap existed
in the capital markets for long-term funding for growth-oriented small businesses.
Facilitating the flow of capital through the economy up to the pioneering small
concerns in order to stimulate the U.S. economy was and still is the main goal of
the SBIC program today.

Generally, venture capital is closely associated with technologically innovative

ventures and mostly in the United States. Due to structural restrictions imposed on
American banks in the 1930s there was no private merchant banking industry in
the United States, a situation that was quite unique in developed nations.

As late as the 1980s Lester Thurow, a noted economist, decried the inability of the
USA's financial regulation framework to support any merchant bank other than
one that is run by the United States Congress in the form of federally funded
projects. US investment banks were confined to handling large M&A transactions,
the issue of equity and debt securities, and, often, the breakup of industrial
concerns to access their pension fund surplus or sell off infrastructural capital for
big gains.

Not only was the lax regulation of this situation very heavily criticized at the time,
this industrial policy differed from that of other industrialized rivals—notably
Germany and Japan—which at that time were gaining ground in automotive and
consumer electronics markets globally. However, those nations were also
becoming somewhat more dependent on central bank and elite academic
judgment, rather than the more diffuse way that priorities were set by government
and private investors in the United States.

Actually venture capitalist developers venture situations in which to invest. For

his trouble, venture capitalist receive 20 to 25 percent of the ultimate profits of the
partnership know as carried interest. He also collects an annual fee of 2 percent

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 I'eniure Capilal Management Indian Experience

(of capital lent or invested in equity) to cover costs. Apart from individuals,
investors include institutions such as pension funds, life insurance companies and
even universities. The institutional investors invest about 10 percent of their
portfolio in the venture proposals. Specialist venture capital funds in USA have
about $30 billions on an annual basis to seek-out promising start-ups and take in
them. In Japan there are about 55 active venture firms with funds amounting to $
7 billions (1993). Venture capital funds are also extant in U.K., France and Korea.

1.8 NEED AND RELEVANCE OF VENTURE CAPITAL

IN INDIA
In USA given its highly progressive industrial environment and entrepreneurial
culture , it is normal for an entrepreneur or inventor of anew product /process to
set up company to produce and market the product by obtaining finance through
the sale of company shares to Venture Capital Fundss which are readily willing to
share the risk in return for future gains .In India risk financing of this type has yet
to pick up in any significant way. There are large number of financial institutions
which provide conventional finance to business firms .This sort of traditional
financing primarily caters to projects based on proven established processes and
technology with minimum investment risk .it is security oriented and asset based.
It involves fixed and uniform payment of interest and principal and it follows
fixed form of financing e.g. debt equity ratio, promoters contribution security
margin etc. The existing financial institutions are conservative in their approach A
number of people in India feel that financial institutions are not only conservative
but they also have bias for foreign technology and they do not trust the abilities of
entrepreneurs.(Satyanarayan Chary,2005:31 -35)

1.9 STAGES OF VC INVESTMENT

There are 5 Investments stages widely used by the industry to invest. These stages
are defined as under
 cntun: ( apnul Mana^emenl Indian i-^xpent'nce

Seed Stage
Financing provided to new companies for use in product development and initial
marketing constitutes Seed Stage. Eligible companies may be in the process of
being setup or may have been in business for a short time or may not have sold
their product commercially. This is the fmancing provided to companies when the
Initial Concept of the business is being formed

Startup
Financing provided to new companies, for manufacturing and commercializing
the developed products, represent Startup. The companies may be in their initial
stages of development and finance may be extended for creation of new
infrastructure and meeting the Working Capital Margin

Other Early Stage

Financing provided to companies that have completed the commercial scale
implementation and may require further funds to meet initial cash and further
working capital is treated as Other Early Stage. The companies may have
expended their capital and would require additional funds and may not yet be
generating profit

Later Stage Financing

Capital provided for the growth and expansion of established companies. Funds
may be used to finance increase in production capacity, market or product
development and/ or provide additional working capital. This would include
product diversification, forward/backward integration, besides creation of
additional capacity. Capital could be provided for companies that are breaking
even or profitable or in turnaround situations

Turnaround Financing
Capital provided for companies that are in operational or financial difficulties
where the additional funds would help in Turnaround
Situations.(Subbulakshmi,2004:38-40)

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 I ciiltiiv ( apuui Muiia^nimciu Indian I'^.xpt'rwnLV

Earlier VC funds use to invest in Seed and Startup stages and very rarely in
Turnaround Stages, but off late the trend is changing and Venture Capitalist funds
are a part of every stage and are also actively participating in Turnaround Stages
through buyouts and takeovers

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