CHAPTER II

VENTURE CAPITAL: CONCEPT AND APPLICATION

2.0.0 Introduction
Venture capital emerged as a financial inteimediary for giving financial assistance to start
ups that have uncertain fixture. First generation entrepreneurs with new innovative ideas
find it difficult to get fiinding from conventional sources of finance. Venture capitalists
provide financial assistance to new and risky ventures. Venture capital therefore can be
defined as risk capital. This form of financing has helped in creating new industries.
Google, Sun Microsystems, Compaq, etc. were fimded by venture capitalists at the initial
stages of their development. IT and ITES have been the favourite sectors for venture
capitalists across the globe. The focus of the venture capital industry has been the high-
tech sector as a result many define venture capital as a vehicle for fiinding new high-tech
ventures. However, venture capitalists in reality do provide funding to non-tech ventures
also. For instance FedEx the world's first courier company was fimded by venture
capitalists, which is a service firm and Sun Pharmaceuticals was also financed by venture
capitalists.
Venture capital as a financial mechanism supports innovative entrepreneurship. When
banks and other financial institutions lend money to enterprises, they have certain
stipulations with respect to the current financial position and profitability of the company,
collateral to secure the finance provided by them etc. Obviously, they are not suitable for
providing financial assistance to new ventures. Venture capital therefore is a very
important financial intermediary that promotes innovations and entrepreneurship in an
economy. Venture capitalists invest by way of equity and equity related instruments and
offer value added and need based services in the areas of market research, strategic
management etc. to the ventures funded by them. After the venture grows and becomes
profitable and is in a position to raise finance from conventional sources or the stock
market, venture capitalists make an exit. With a view to promoting entrepreneurship,

17
innovations and developing technology, in many countries the government has taken
initiatives to start and develop the venture capital industry. More than a regulator, the
government's role should be that of a facilitator.

2.0.1 Objectives
The major objectives of this chapter are to
• Understand the concept of venture capital and how it is different from other
financial mechanisms.
• Trace the history and evolution of venture capital.
• Understand the venture funding process.
• Understand the typical provisions in the agreement between the venture capital
firm and its investee companies and between the venture capital firm and its
investors.

2.1.0 Venture capital Defined

"Venture capital represents financial investment in a highly risky proposition in the hope
of earning a high rate of return". (Chandra Prasanna, 1994)'

"Venture capital is an investment, in the form of equity, quasi-equity and sometimes

debt-straight or conditional (i.e. interest and principal payable when the venture starts
generating sales), made in new untried technology, or high-risk venture, promoted by a
technically or professionally qualified entrepreneur, where the venture capitalist
• Expects the enterprise to have a high growth rate,
• Provides management and business skills to the enterprise,
• Expects medium to long-term capital gains, and does not expect any collateral to
cover the capital provided." (Pandey, 1996)

18
"Venture capital involves medium term equity participation in an unquoted enterprise
where returns are mainly generated in the form of capital gains realized at the end of the
venture." (Paxson and Wood, 1997)^

"The term Venture Capital refers to capital investments made in a business or industrial
enterprise which carries elements of risk and insecurity and the probability of business
hazards. Capital investment may assume the form of either equity or debt, or both, or a
derivative instrument". (Verma, 1997/

"Venture capital is a specialist form of equity finance provided to new, young, small or
risky unquoted firms by institutional investors". (Moles and Terry, 1999)^

"Venture capital is funds used to invest in small companies that are considered to be in
their first phase of growth. Funding is provided by private and institutional investors. "
(Reuters Financial Glossary, 2000).

"Venture capital is defined as an equity by which an investor supports an entrepreneurial

talent with finance and business skills to exploit market opportimities and thus obtain
long term market gains." (Gupta S.L., Taneja Satish, 2002)'

"Venture capital financing refers to financing and running of the start-ups and funding
o

risky and unproven sophisticated technologies." (Rustagi, 2003)

"Venture Capital is finance provided by a specialized institution to an entrepreneur, start

up or developing business, where a fairly high degree of risk is involved." (Barmock G.,
Davis Evan., Trott Paul, Uncles Mark, 2004)^

"Venture Capital is the long-term financial assistance to projects being set up to introduce

19
new products, inventions/innovations or to employ or commercialise new technologies.
Thus, venture capital entails high risk but has the promise of attractive returns."
(Surendra Sundararajan, 2004)"'

"Venture capital also known as risk capital, is capital invested in a venture (usually a
young company, often in high-technology areas) that presents a risk." (Hammett, 2006)''

"Venture capital is a term used for investment made in those lines where risk element is
very high, especially in new lines of production, new markets or new processes."
(Dictionary of Banking and Finance, 2008)'^

The researcher defines venture capital as dedicated pools of fund floated for the purpose
of investing in new ventures which are characterised by a high degree of risks and
uncertainties and having potential for growing into highly successful and profitable
businesses.

2.2.0 Salient features

Venture capital has certain unique features that set it apart from other sources of finance.

20
D 2.1 Salient Features Of Venture Capital
•>

Venture capital

1 1 1
Equity/Quasi equity
1 Investment in new and
Long term
investment investment risky ventures

1 1
Investmenls in unlisted
1 "
High returns Early stage
companies investments

1 /•

*> /
L^ Value added s ;rvices
1^ Temporary
investment 1^ Objectives

L Self liquidating

Source: Researcher's own contribution

Following are some of the important features of venture capital:

Equity or quasi equity investment: Venture capitalists usually invest in equity or equity
related instruments. They usually acquire stake in the invcstcc company through equity or
preference or convertible debentures or convertible preference shares.

Long term investment: Venture capital represents fairly long term investment. Venture
capitalists remain invested for 3 to 7 years. This can get extended if the market conditions
are not favourable for making an exit. After the recent economic downturn, valuations
have come down and therefore venture capitalists may have to remain invested for a
longer period and wait for valuations to improve.

Investment in new and risky ventures: Venture capital is risk capital invested in new
ventures with high risks. Startups offering products or services that are relatively new and
untried are not funded by the conventional financial intermediaries. Venture capitalists
provide finance to such enterprises.

21
Early stage investments: Venture capitalists invest at very early stages of the life cycle
of an enterprise. They fund startups and remain invested till the company starts earning
profits and is in a position to get finance from other sources.

Investment in unlisted companies: Venture capital represents investments in unlisted

companies. Therefore it is a relatively illiquid investment as investors caimot sell their
stake easily.

High returns: Venture capitalists undertake high risks. To compensate for the risks they
expect high returns.

Value added service: Venture capital represents investments made at very early stages of
the lifecycle of an enterprise. Entrepreneurs having great ideas usually lack business
skills. Venture capitalist therefore offer value added services to their portfolio firms.
Apart from funding they are actively involved in the management of the investee
companies. They help in strategic management, finding additional rounds of finance etc.

Objectives: The objective of traditional independent venture capitalists is to get high

financial returns. They undertake high risks and therefore expect very high returns in the
range of 5 to 10 times the investment. They are financial investors. The venture capital
arms of large organizations, which are referred as corporate venture capital fijnds have
strategic objectives. Through their venture capital arms large organizations invest in
startups that add strategic value to the company. They invest in startups that offer
products/services that stimulate the demand for their existing products or those that use
their existing products or those that are developing technologies that the company can
use. Some venture capital fimds pursue developmental objectives. In India at the initial
stages of the development of the venture capital industry only development financial
institutions such as IDBI, ICICI, made venture capital investments. Now Small Industries

22
Development bank of India's venture capital arm SIDBI Venture Capital Limited is one
of the development financial institutions that provides early stage funding with
developmental objectives. Such venture capital funds invest in enterprises that have the
potential to promote the development of the country. There is a new^ trend among
corporate venture capital fimds. Some of them have launched funds vvith the objective of
getting financial gains and for strengthening entrepreneurship and promoting innovations
in India. In India Reliance Technology Ventures Limited, the venture capital arm of
Reliance ADAG, was launched in 2006. They invest in IT, ITES, hardware,
semiconductors, media and entertainment and telecom sectors. Their objectives are
financial and they also want to promote entrepreneurial forces. '^ VCCs may piirsue other
than purely financial goals, depending on the goals and preferences of their backers.
Although Salman (1990) notes that the most common structure of VCCs in the US is the
limited partnership, not all VCCs are constituted m this way, especially in Europe. Public
sector VCCs, for example, may emphasize employment creation in a certain area or
environmental-friendly investments, rather than purely financial concerns (Lovejoy,
1988; DTI, 1999). For bank affiliates, VC investment activity can be seen as an extension
of the services provided to a potentially profitable market segment and as a mechanism
for binding clients into the financial investor (Bruno, 1986). Captive VCCs, as a strategic
arm of an industrial company, may exist primarily as a means to get a window on
technology, to obtain technology licenses or product marketing rights, or to secure
international business opportunities (Siegel et al., 1988; Manigart and Struyf, 1997).
Independent VCCs, however, invest money from investors whose major objective can be
assumed to be return on investment (Robbie,Wright and Chiplin, 1997). ''*

Temporary investment: The venture capital process requires that investments be

liquidated either through bankruptcy, merger, or an initial public stock offering. For this
reason, the venture capitalist is a temporary investor and usually a member of the firm's
board of directors only until the investment is liquidated. There are a few exceptions.

23
Arthur Rock, the lead venture capitalist in funding Intel, remained on the Board of
Directors for two decades. Donald Valentine, the lead venture capitalist in funding Cisco,
continues on the board fully a decade after it went public.'^ Venture capitalists in India
typically remain invested in an undertaking for about 3 to 7 years on an average.

Self liquidating: Usually venture capital funds are self liquidating. This means that
investors invest in a fund which is invested in undertakings by the fund managers i.e. the
venture capitalists. Investments are made for a period ranging from 3-7 years, at the end
of which, the venture capitalists make an exit through an IPO or a buy back by promoters
or a strategic sale or through redemption. The proceeds are then distributed among the
investors. For further investments, a new fund may be launched. Usually a venture capital
firm manages more than one fund at a time. SIDBI venture capital is currently managing
two funds and is in the process of raising the third fimd.'^

2.3.0 Origin
When Christopher Columbus wanted to sail towards the west from Europe so that he
could reach the eastern countries of Japan, India, China etc., many royal courts of
Europe refused to finance the voyage as it was considered to be too risky. Finally Queen
Isabella of Spain financed the voyage, which turned out to be successful. This is the
earliest example of venture capital, but it was not formally known as venture capital those
days. In 1920s and 30s, new risky ventures were financed by wealthy individuals and
families. The origin of organised form of venture capital can be traced back to the US.
In 1946, General Doroit, a professor at Harvard Business School, Karl Compton,
President-MIT and a few local business leaders founded American Research and
Development (ARD). They wanted to commercialise the technologies that were
developed for World War 2, particularly those that were developed at MIT. ARD was
structured as a publicly traded closed-end fund and marketed mostly to individuals.
(Gompers and Lemer, 2006). Georges F. Doriot is considered to be "the father of venture

24
capital". J.H.Whitney, The Rockfeller family etc are pioneers in the field of venture
capital.

A few other funds that were similarly structured were formed in USA after ARD. Draper,
Gaither and Anderson formed the first Limited Liability Venture Capital fund. However,
there were very few other venture fiinds that adopted the Limited Liability form of
organization those days. Most of the other fimds were either closed-end fimds or Small
Business Investment Companies (SBICs).'^ The flow of venture capital in the US
increased considerably in the late 1970s and early 80s. The 90s saw phenomenal growth
in venture investments not only in US but also in many other countries due to the growth
in IT sector. The IT and dotcom bust of 2000 adversely affected venture capital
investments across the globe.
US was the birth place of organized venture capital industry. Another country in which
VC originated relatively early is Israel. The evolutionary process of the industry in Israel
is quite similar to that of the US. There was a high-technology sector in Israel requiring
fijnds for commercialisation. The formation of Athena in 1985, the first formal venture
capital firm, marked the origin of the industry in Israel.'*

In China the venture capital industry started in the mid 1980s when the government felt
the need for developing high technology industries. The initial efforts were not successfiil
because of the imfavorable regulatory environment in China. In early 1990s, majority of
the venture capital backed firms were State Owned Enterprises (SOEs). Most of the
venture capital funds were organised as joint venture funds with SOEs initially. In China
also the industry grew in 1999-2000 in tandem with the growth in the IT sector.

The venture capital system in Korea was introduced in the year 1987. The government
provides significant support to the industry with a view to promoting venture capital
investments, new businesses and entrepreneurship.

25
Taiwan is one of the most active spots in Asia for venture investing. The initiatives for
developing venture capital industry were made in early 1980s by the Finance Minister
Mr. K.T.Li. Acer Ventures was the first to make venture investments in Taiwan in! 985.
The government has constantly supported the industry after that.

In India also initiatives were taken by the govenmient for the development of the venture
capital industry in mid 1980s. The introduction of a cess of up to 5% on all technology
imports in the fiscal budget of 1987-88 to create a pool of fiinds was probably the first
concrete measure by the government for the development of the industry.

2.4.0 Background
The backgroimd conditions under which the venture capital industry emerged are
different in different countries. As the industry in its formal form originated in the US,
the background conditions in the US will be discussed first. During the Great depression
there were some significant changes in the political scene in the US. There was pressure
for creating new institutional framework and policies for the support of small businesses.
A number of policy measures including the enactment of Securities Act, 1934 and the
creation of Securities and Exchange Commission resulted in tightening of regulations on
issue of stocks. This resulted in major problems for small businesses for getting fimds.
Funding small businesses became a major concern. During the World War II the US
defense realized the need for technology. The military spending on technology increased.
Many new technologies were developed in US universities and large organisations. The
government and prime contractors were willing to buy superior technology from small
businesses at high prices. This encouraged the establishment of high-tech ventures. At the
end of World War II first few venture capital firms were established in the US.

Israel had considerable innovative capabilities and a high-tech sector even before the

26
origin of venture capital industry in the country. The Six Day War and the French
embargo led to the decision to develop a domestic military R&D facility. The Office of
the Chief Scientist (OCS) was established in 1969 to develop applied science capabilities.
The OCS gave R&D grants to individuals. This contributed to the development of
innovative capabilities in the business sector and the high-tech sector in Israel. Many
multinationals such as Motorola, IBM, Intel started investing in semiconductor and
electronics manufacturing in Israel in the 1960s and 70s.

In China in 1980s there were major restrictions on fund raising. State Owned Enterprises
were dominating the economy. Private firms were not favoured by the government.
State Owned Enterprises enjoyed access to resources in China including human
resources, raw material etc Any fund raising in China had to be approved by the People's
Bank of China and the bank rarely approved public fund raising. Later, after the
government initiated market oriented reforms private enterprises had more room to grow.
Right from 1978 the Chinese government paid attention to the development of science
and technology. In 1985 the Central Commission of the Chinese Communist Party and
The State Council proposed a development guideline in the "Decision of Science and
Technology Reform" that science and technology must contribute to economic
development. In 1984, the Center of Science and Technology Development of The State
Science & Technology Commission, now known as Ministry of Science and Technology,
cooperated with experts from Britain to study how to develop technology in China. The
British experts proposed that venture capital should be developed in China for the
development of technology. However, the stock markets in China were initially
developed for the purpose of raising capital for large enterprises with mature technology.
They were not suitable for listing of small companies. There was also a lack of talented
human resources for driving a venture capital firm and supporting high-tech ventures.

Taiwan is an island situated around 50km away from china. China and Taiwan share the

27
same culture, language and history. Taiwan had the strongest entrepreneurial forces
among the countries in that region. There was an early emphasis on electronics as a key
industry. Technology sector in Taiwan emerged in 1970s as a source of low cost skills for
labour-intensive calculator and electronic component manufacturing.

Chinese engineers settled overseas played a very important role in convincing the
government to promote the venture capital industry. Policy makers realized that the
conservatism of existing financial institutions was a major hindrance for the
establishment of high tech ventures.
At that time Taiwanese businesses had the following characteristic:
95% were small or medium sized units.
Most were family run. They lacked incentives to adopt modem management techniques.
Taiwan lacked the relevant institutional know-how to start a venture capital industry.
Therefore the government organized collaborations with large financial institutions in
the US to facilitate transfer of relevant financial and managerial expertise. They sent
individuals to the US to be trained in managing a venture capital business and introduced
a series of initiatives to encourage domestic firms to enter the venture capital industry.

The Korean economy was dominated by traditional family owned businesses. There
were large business conglomerates referred to as "Chaebols". They made significant
contribution to the economy but nevertheless were a hindrance to small and medium
enterprises. The venture capital system was introduced in Korea in 1987. The
government imdertook major initiatives from 1998. The goverrmient made direct
infusion of equity capital. Some small businesses were identified as eligible for venture
capital investments from venture capital firms and limited partnership funds, both funded
largely by the government and Chaebols. Generous tax incentives are provided to
investors in venture capital firms and limited liability partnerships. Thus the Korean
goverrmient played a major role in fostering the growth of venture capital in Korea.

28
Korea now ranks among the leading OECD countries (Organisation for Economic
Cooperation and Development) in venture capital investments as a share of GDP and in
the share of venture capital channeled into startup enterprises.

In India in 1973, the government appointed a committee under the chairmanship of

Shri.R.S.Bhatt, called the Bhatt committee to examine strategies for funding small and
medium enterprises. It was foimd that new entrepreneurs and technologists faced a
number of problems in setting up enterprises in India. In 1975 IFCI launched Risk
Capital Foundation and in 1976 IDBI launched Seed Capital Scheme to supplement
promoter's equity and capital support to new enterprises. However, these schemes
provided only finance and unlike typical venture capitalists did not provide any other
value added services in the areas of strategic management and advisory services.
India had certain competitive advantages as a nation. It had a vast pool of English
speaking technically qualified manpower. Many Indian engineers migrated to the US and
became entrepreneurs there. Inadequate infrastructure was and continues to be a problem
in India. Indian economy also was to a great extent dominated by family owned large
business houses. These were the backgroimd conditions in India when the government
undertook the first initiatives for the development of the venture capital industry in the
country

2.5.0 Reasons For The Emergence Of The Venture Capital Industry

A detailed study of the origin and background conditions of the venture capital industry
naturally leads to the reasons for the emergence of the industry in different countries
across the globe. In US, which is the birth place of the formal venture capital industry,
fiinding of small and medium enterprises was a matter of concern for the government and
among academic and business circles before and after World War II. During the World
War II, US defense realized that technology would be the key for fiiture survival of the
country. There was a need for funds for the commercialization of war technology. The

29
defense created demand for high technology products and price was not a limiting factor.
The American space programme resuhed as a response to the Russian's launch of
Sputnik in 1958. R&D expenditure in electronics increased considerably. Silicon Valley
became the hot bed for software and semiconductor industry in late 1950s. In this part of
the US venture capitalists found a number of investment opportunities.
Technology has been the major driving force for the development of the venture capital
industry in every country. Development of new economy is dependent on development of
technology. Long cycles, high risks, high returns etc are the unique characteristics of
high-tech ventures. This makes it difficult for such ventures to get funding from banks,
stock markets and other traditionalfinancialintermediaries. Venture capital fills this gap.
Venture capital as a source offinanceemerged mainly due the need for funding small and
mediimi businesses and commercialization of technology. The inability of traditional
financial institutions to finance small, medium and high tech ventures that are
characterized by high risks and imcertainties added to the necessity for developing an
alternative source of finance.

30
2.6.0 Importance Of Venture Capital
Venture capital is a very important financial mechanism. Following points bring out the
importance of venture capital.
D 2.2 Importance Of Venture Capital

Source Researchers own contribution

Encourages innovations: Venture capital is a critical resource for supporting
innovations, knowledge based ideas and technology and human capital intensive
enterprises. (Rastogi, 2007)''^ Technical institutes and large organizations are constantly
engaged in research and development. When funds are made available for development

31
of new products and commercialization of the same, it encourages innovations. The
experience of US, Taiwan and Israel show that technological innovations and the growth
of venture capital markets are closely related. (Premus 1985) Paul Gompers and Josh
Lemer studied the impact of venture capital on technological innovations. They studied
the patenting across industries over three decades and found that venture capital
accounted for 8% of industrial innovations in the decade ending 1992. Venture Capital is
becoming a major mechanism for stimulating innovation and entrepreneurial growth, hi
India this is catalyzed by the rapid growth of information technology. Venture capitalists
bring a balance between business and technology so that innovation becomes a
commercial success. (Bowonder and Mani)^' This suggests that venture capital certainly
has a positive impact on innovations.

Strengthens entrepreneurial forces: Entrepreneurs have new commercially viable

ideas. However most of them do not have the required funds and managerial skills to
make their ideas commercially successful. They struggle to get funds as the conventional
financial mechanism usually does not fund new ventures with a high degree of
uncertainty and risk. By funding such entrepreneurs, venture capital strengthens
entrepreneurial forces. Venture capital supports first generation entrepreneurs by
providing the equity capital needed for idea based enterprises generally not available
from banks and institutions.(Rastogi, 2007)^^ As an important component of financial
institutions and a specialised financial intermediary, the development of the venture
capital industry has been inherently interwoven with the wave of entrepreneurship during
the last few decades. (Hasan Iftekhar and Wang Haizhi)^'' For instance in 2007, 79% of
the venture capital investments in India were made at seed and first round stages.(Dow
Jones Report, 2008)^"* Investments made at early stages promote entrepreneurship. This is
because when first generation entrepreneurs get funding, it encourages more people with
ideas to set up businesses.

32
Promotes risk taking: Venture capitalists fund risky projects, which in their opinion
have good potential. Even though the failure rate among venture-funded units is high,
venture capitalists earn such high returns from the successful ventures funded by them
that it compensates for the failures.

Fosters closer investor-investee relationships: Venture capitalists provide value added

services to the funded undertakings. Venture capitalists usually insist on a seat on the
board of all the ventures funded by them. They provide finance and assist in strategic
plaiming, marketing research, marketing, finding the right management team; getting
additional finance etc. Venture capitalists' oversight of new firms involves substantial
costs. (Gompers and Lemer) The venture funded undertakings and the venture
capitalists funding them operate like partners. This role of a venture capitalist promotes
closer and healthy relationships between the investors and the investees.

Supports development of new technology: Originally venture capital was conceived as

a mechanism for supporting ventures that wanted to commercialize a new untried
technology or a new technology based undertaking. Therefore at the initial stages of the
evolution of this industry, venture capitalists focused mainly on technology projects.
Thus venture capital not only supports development of new technology, it also helps in
the transfer and adaptation of technology from developed countries to developing
countries. For instance in US, the venture capital industry has played a pivotal role in the
development of the country's high technology industries. Apple, Compaq, Sun
Microsystems etc. were funded by venture capitalists.

Helps in creation of new industries: Venture capital has also helped in the creation of
new industries such as IT, Biotechnology, Courier services etc.

Funding small scale unlisted companies: Small unlisted companies find it very difficult

33
to get finance fi-om conventional sources. Venture capital plays an important role in
funding such units.

2.7.0 Parties Involved In A Typical Venture Capital Financing Process

The fund raising and investing process of a venture capital finn is very complicated. It is
therefore important to understand the parties that are usually involved in the process and
the following diagram gives an idea about this:

D 2.3 Parties Involved In The Venture Funding Process

Investors
Returns " Fund-raising

1'

Venture capitalists

t 1
Equity T I Cash

Firm
Source: Venture capital cycle. Paul Gompers and Josh Lemer
The investors, venture capitalists and the venture funded firm are the three main
categories of participants in a venture funding process.
Investors are the sources from whom the venture capitalists get their fimds. Investors
include wealthy private individuals who want to invest in venture capital and also
organizations such as pension funds, insurance companies, large business enterprises,
government agencies, banks, development financial institutions, academic institutions
etc. By venture capitalists, in this diagram, the authors mean the managers of the venture
capital firm who manage the fund. They identify ventures for investment, formalize the
deal structure and pricing, monitor the fiinded venture, assist in the management of the
firm, distribute the returns earned among investors and liquidate the investment at an
opportune time. For this they charge a fee and also participate in the profits.

34
The firm refers to the venture funded unit or the investee company. Venture capitalists
usually have at least one nominee in the board of all units funded by them. Venture
capitalists include Venture Capital funds or companies formed by a few individuals,
venture funds created by companies, venture capital arms of banks and other financial
institutions, venture capital funds created by government bodies, venture capital arms of
academic institutions etc.

2.8.0 Stages In The Life Cycle Of An Entrepreneurial Venture

A firm requires funding at different stages of its life cycle. In fact venture capitalists often
specialize by focusing on a certain stage of funding. In other words some venture
capitalists give funding only at a particular stage of the life cycle of investee firms.
Different types of financial intermediaries support a firm at different stages of its life
cycle as shown in the following diagram:
D 2.4 Types Of Financial Intermediaries That Fund A Firm At Different Stages Of
Its Life Cycle
R&D and Product development stage •Incubators

1
Start upstage- -• Angels and Venture Capitalists

i
Growth stagCL. _• Venture capitalists

i
Further growth and expansion —• Private Equity

I
Maturity -• IPO/Fimding by banks etc.
Source: Researcher's own contribution

35
The following table shows the typical stages in the development of a technology based
firm.
T 2.1 Typical Stages In The Development Of A Technology Based Firm
Sr. Stage of Activities Type of financing
No development
1 R&D Feasibility studies: Seed financing:
Technical Venture capital funds
Commercial (rarely)
Technical development Own funds etc
Market research
2 Start-up Further development, setting up Venture capital
production and sales, reaching
break-even
3 Risky growth Further growth and development Fledgling finance (Joint
of second generation of product involvement of several
venture capital
organizations)
4 Regular Achieving economies of scale in Bridging finance
growth production and sales Development,
investment banks,
venture capital, takeover
by larger firms
5 Maturity Broadening technological base Stock market (IPO) or
and management capabilities other exit route

An interesting fact that emerges from this table is that venture capital is the sources of
funds at most of the early stages and conventional sources of finance enter the scene only
fi-om the fourth stage onwards. It is obvious that venture capital plays a pivotal role in the

36
west in the development of new technology firms.
At the R&D stage, the promoter usually invests his personal money and may borrow
from friends and relatives. The fiind requirements usually at this stage would be small.
Angels may offer support. For e.g. Andy Bechtolsheim is a famous angel investor in
Silicon Valley. He invested in Google at a very early stage. (Vise, 2005)^^ Many
educational institutions and large organizations offer incubation facilities to
entrepreneurs. The facilities may include office space, telephone and internet connection,
some secretarial help and if required a small amount of financial assistance for the
development of the concept. In India a number of educational institutions including
Indian School of Business, Hyderabad, Indian Institute of Technology, Mumbai etc offer
incubation facilities to entrepreneurs. Venture capitalists very rarely fimd enterprises at
this stage. Gujarat Venture Fund Limited (GVFL) was foimded in 1990 and the first
investment made by the fund was in a start up called Permionics, which was at the seed
stage. The company was developing an ultra filtration membrane that filtered water by
mechanical filtration and removed all bacteria and viruses. This is one of the rare cases
where venture capitalists fimd an enterprise at a very early stage.
Venture capitalists usually enter the scene at the start up stage when the venture requires
fimds for fiirther development of the concept, for setting up production facilities and
starting initial sales. Shanta Biotechnics is a company engaged in the development,
production and marketing of biotechnology based human health care products. Initially,
the company was fimded by the Foreign Minister of Oman, H E Yusuf Bin Alwai, an
angel investor. Later, after the project took off, it got fimding from Technology
Development Board and SBI Mutual Funds.
At the risky growth stage also venture capitalists play an important role. At this stage of
development of an enterprise a few venture capitalists may join hands and co-invest.
When Google was at this stage venture capitalists Kleiner Perkins and Sequoia capital
invested $12.5 million each.
When an enterprise achieves regular growth apart from venture capitalists other

37
financiers such as investment banks, private equity funds etc. may invest in it. The
company requires bridge finance at this stage, which refers to finance required bctbre a
company arranges for the next round of financing or before the IPO. Venture capitalists
usually make an exit at the maturity stage of an enterprise. The exit could be through an
IPO, or a buy back by promoters or a merger with a large organization or an acquisition
by an organisation.

2.9.0 Role Of Venture Capitalists

Venture capital is different from other sources of finance. While conventional financial
intermediaries fund established and proven businesses, venture capitalists fund new risky
ventures. Apart from funding they provide value added services to their portfolio firms.
They play a key role right from setting up of the start up till it becomes profitable and
eligible for getting funds from conventional sources.
D 2.5 Role Of Venture Capitalists

Funding

IPO Mentoring

Portfolio 1 /
Raising
Firm / oy' Finding
subsequent
rounds of human
finance resources

Access to \ / Strategic
networks I 1 management

Source: Researcher's own contribution

38
The relationship between venture capitalists and their portfolio firms are crucial for the
success of the enterprises. There has to be complete transparency in terms of information
and views. The worst thing for a venture capitalist is to hear of a particular development
or bad news about the venture from a third source. (Editorial team of businessgyan)

Mentoring: Most of the people who approach venture capitalists for funding have great
innovative ideas but do not possess the necessary skills to convert them into viable
businesses. Ventwe capitalists mentor such people. There is a new trend in India where
venture capitalists are mentoring entrepreneurs who approach them even before they fund
them. This has been happening in Silicon Valley for a long time. (Jagadeesh N and
Vallikappen S.)^° To make it easier for entrepreneurs in India's smaller towns HeadStart
Foundation, which organizes the HeadStart showcase event for start-ups is coming up
with an online portal listing mentors who will give 20 hours of free advice. Founders of
Lakshya, a coaching school in Patiala for training students for Indian Institutes of
Technology's entrance examination, are being mentored by the Managing Director of
Helion Venture Partners and professors of Indian Institutes of Management. They are
mentoring on business plans including scaling up in a sustainable manner. (Choudhary
Deepti)^'

Finding human resources for portfolio firms: Talented human resources is crucial for
the success of any organization, more so for start ups. The promoters of startups may not
have adequate managerial capabilities and may not have the contacts to get people from
outside. Venture capitalists through their networks help start ups in getting talent.
Venture capitalists add value to portfolio firms by obtaining and transferring information
about senior managers across firms overtime. Venture capitalists hire managers for their
portfolio firms based on suggestions from other venture capitalists and they suggest
managers to each other. (Gledson de Carvalho, W.C.Charles, Amaro de Matos Joao)
Strategic management: venture capitalists participate in the management process of

39
their portfolio firms. They provide need based support and strategic inputs. They give
valuable advice and help in formulating marketing strategy, growth strategy, financing
strategy etc. All this help the portfolio firms in scaling up of business faster. There are
thus many areas in which venture capitalists provide active support to portfolio firms.

Access to networks: An entrepreneur of a start up rarely has access to suppliers,

distributors etc. It usually takes a long time for entrepreneurs to build contacts in the
industry. Venture capitalists who fund such organisations usually provide access to
various networks. Entrepreneurs expect venture capitalists to introduce them to the
networks of customers, financial institutions, consultants, policy makers etc. They want
venture capitalists to make them known to those who matter for the growth of their
enterprises. (Pandey I.M)^^

Raising subsequent rounds of finance: Entrepreneurs require finance for setting up the
business unit, for expansion, for acquiring another firm etc. Venture capitalists help their
portfolio firms in raising additional finance as and when the need arises. Either they may
invest or help the firm in getting fimds from other venture capitalists.

Initial Public offers: Venture capitalists make an exitfi-omthe portfolio firm. IPO is the
mot preferred route of exit among venture capitalists. An IPO is made when valuations
are good and the venture capitalists are fairly confident that the shares of the venture
fimded undertaking will fetch good price in the stock market. However, it is to be noted
that though IPO is the most preferred exit route, it is not the most common. This is
because venture capitalists usually make investments at very early stages of development
of an undertaking. They make an exit in five to seven years. Most of the undertakings are
not ready for going public so early. Therefore, trade sales, buyback by promoters or
merger are the most common exit routes. For instance, SIDBI venture fimd, which is one
of the earliest public venture capital funds in India, was established in 2000. But the fund

40
has so far made only one exit via an IPO. (Survey data) However, venture capitalists
prepare an enterprise for making an IPO.

2.10.0 Sources Of Funds For Venture Capitalists:

As explained earlier, Venture capitalists get their funds from different sources and use
this to create a dedicated pool of fund to be invested in certain specific areas or
industries.
The sources of funds for venture capital funds or investors who invest in venture capital
funds are shown in the diagram:
D 2.6 Sources Of Funds For Venture Capitalists

Source: Researcher's own contribution

Pension funds: Pension funds are the largest investors in venture capital in
USA and UK. Public and private pension funds contributed to 45% of the total

41
venture capital investments in the United States in 2002. They have fairly certain
and long term liabilities and this makes venture capital an ideal instrument
for investments for them. However, in India the concept of pension funds is still at an
infancy stage.

Insurance companies: In many countries insurance companies invest in

venture capital funds. In fact they are major contributors to venture capital. In the
United States in 2002,16% of the investments in venture capital funds were from
insurance companies and banks.
In certain other countries such as India, there are restrictions on investments in
venture capital funds by insiirance companies.

Banks and Development Financial Institutions (DFIs):

In India banks and development financial institutions such as Industrial
Development Bank of India, Small Industries Development bank of India etc. invest
in venture capital funds. For e.g. Rajasthan Venture Capital Fund receives
fiinding from Small Industries Development Bank of India.

High net worth individuals: In America, wealthy individuals invest in

venture capital funds. In the year 1988, 8% of the total investments made in
venture capital funds came from individuals. (Gompers and Lemer)^'' However,
in India very few individuals have so far invested in venture capital fiinds.

Government: In US, Israel and to some extent in India Government invests in

venture capital funds. Under the Yozma Programme, the Israeli government set up a
fund of funds. A part of the fund was invested in private venture capital funds. In
India a part of the funding for the SIDBI Venture Capital Fund comes from the
Ministry of Information Technology, Government of India.^^ However in India

42
 unlike Israel, the government does not invest in private venture capital funds.
It is important to note that corporate venture capital arms are funded by the parent
company.

T 2.2 Sources Of Venture Capital In A Few Asian Countries In 1993

Countries Corporation Private Government Banks Pension Insurance Others
individuals agencies funds companies
India 13 11.5 13.2 38.3 2 3.7 18.9
China 45.8 8.3 6.3 18.4 4.3 12.1 4.9
Korea 26.3 4.6 14 21.2 3.1 0.8 30
Taiwan 64 15.8 4.7 8.9 1 5.6
Source: Adapted from Pandey , Venture Capital-The Indian Experience, 1996, p.22
It is apparent from the table that the sources of venture capital are different in
different countries. Corporations contribute to 45.8% of the total venture capital
investments in China, 26.3% in Korea and 64% in Taiwan, while in India banks
contributed the maximum at 38.3%. These differences arise mainly due to differences
in regulations.

43
2.11.0 Factors Affecting Venture Capital Investments
A set of factors affect the venture capital industry. The ecosystem consists of certain
interdependent variables and any change in one can affect the other factors. For
instance a cut in capital gains tax will result in more investors investing in venture
capital funds.
The following diagram shows the factors that affect the venture capital industry.
D 2.7 Factors Affecting The Venture Capital Industry

Source: Adapted from Golis 2007,38 , Enterprise and Venture Capital, p.42
Exits: Venture capitalists look for exit routes when they make investments. A strong
primary market encourages venture capital investments as IPOs are the most
preferred exit route among venture capitalists. This is because IPOs yield highest
returns to investors. The venture capital investments in India started increasing with
the growth in the stock market.

44
Economic factors: The state of the economy, the growth rate, stage of development,
availabiHty of infrastructure etc are key economic factors that affect venture capital
investments. A growing economy indicates strong fundamentals and would encourage
any type of investment. Good infrastructure is a prerequisite for venture capital
investment because, it will help in establishing new enterprises.

Innovations: Innovations are a prerequisite for a strong venture capital industry. In

the United States, Silicon Valley is a hot bed for innovations. This encouraged the
setting up of a number of venture capital funds. Irmovations offer profitable
investment opportunities to venture capitalists. It is also true that a robust venture
capital industry encourages innovations. In India, technology innovations are few.
However, in recent times, academic institutions such as the IITs, ISC etc. have set up
incubation centers to support innovatioins. Even today, intellectual property led
startups are very rare in India. There are business model innovations and startups that
transfer and adapt technology.

Culture: The existence of strong entrepreneurial culture encourages venture capital

investments. For the industry to flourish there is a need for people with ideas and the
willingness to take risks. In India, people are risk averse. There is stigma attached to
failure. The society does not support risk taking.

Market: Venture capitalists look for investment opportunities in startups that have
the potential to serve large markets or create large markets for their offerings. In
India, the domestic market is small even though the population is huge. This could be
due to low market penetration, less scope for growth due to low purchasing power.
This is a serious deterrent for venture capital investments in the country.

45
 Regulations: In most of the countries venture capital investments are not regulated.
Venture capital is viewed as a mechanism that promotes innovations, risk taking and
entrepreneurship. Reduction in capital gains tax has a favorable effect on venture
capital investments.

2.12.0 The Venture Capital Funding Process

The process of raising capital and structuring funds is complex. (Gompers and
Lemer) . The stages in the venture capital funding process is more or less the same
in all countries and irrespective of the type of venture capitalists. However, the time
taken for negotiating a deal may vary from country to country due to the differences
in the legal and regulatory framework.
The following chart shows the stages involved in the venture funding process:
D 2.8 Stages Involved In The Venture Funding Process
Deal origination

i
Screening

Due diligence

Deal structuring

Post-investment activities

i
Exits
Source Researchers own contribution

46
Deal origination: A continuous flow of deals is very important for venture capitalists.
Almost all the venture capitalists in India have websites that give information about the
sectors and stages of focus, fvmds under management, contact details and e-mail ids to
which entrepreneurs can mail their business plans. Entrepreneurs looking for venture
capitalists get everything from the internet. Apart from this venture capitalists have
strong networks. They suggest good investment opportunities to each other. (Survey
data). Referral system is an important source of deals. Deals may be referred to venture
capital firms by their parent organizations, trade partners, industry associations, friends,
etc. In the United States, the referral system contributes as much as 65% of deals.
(Pandey,1996)'*°

Screening: Venture capitalists get a number of proposals for funding. Before undertaking
a detailed study they screen the proposals and select only a few. The sector, technology,
the market served, the stage of financing, geographic location etc. are the criteria used by
venture capitalists for screening proposals. When a frmd is raised, the venture capitalists
first decide on the number of deals that they would like to make given the size of the
available fund. The venture capitalists may not distribute the fund among too many deals
as it would affect the returns. At the same time, it may not be worthwhile to focus on too
few investments as it may increase the risk and may affect the diversification of the funds
portfolio. The amount required by the firm seeking funds therefore will be considered
while screening proposals. Apart from this, the technology, market sector, stage of
development and geographic location of the venture are considered. (Sagari & Guidotti)"*'

Due diligence: For the venture capital investment process, due diligence means a
rigorous investigation and evaluation of an investment opportimity before committing
fimds. It is an in depth investigation of those proposals that survive the initial screening
process. It includes the review of the management team, business conditions, projections,
philosophy and investment terms and conditions. Usually only 10-15% of proposals make

47
it past the initial screening stage to the due diligence stage and out of those only 10%
receive funding. The accuracy of business plan and accounting statements are verified.
Other areas such as patents, technical issues, unpublished accounting information if any
are investigated. Track record of the management team, size and growth potential of the
market, demand for the product among target customers, ability to deliver the product on
time and at the agreed price, competitive advantage of the product, competitors,
marketing and distribution plans, soundness of financial projections, assessment of
assumptions used, assessment of intellectual property rights if any, existing or possible
legal contingencies and valuation of the venture are the factors studied during due
diligence. (Kotelnikov)''^ Due diligence basically establishes the level of risk inherent in
an investment. There are seven types of risks that venture capitalists need to analyse.
Development, manufacturing, market, management, financing, valuation and exit are the
areas of risks that venture capitalists consider while evaluating an investment proposal.
Due diligence is probably one of the longest stages in the venture capital fimding process.
Venture capitalists have to tap a variety of sources to understand these risks. Many times
entrepreneurs may not have a good grasp on these risks.

48
D 2.9 Risks That Venture Capitalists Have To Analyse During Due Diligence:

Source: Researcher's own contriburtion

• Development risk: Venture capitalists usually do not invest at the product
development stage. Incubators and angel investors support at this stage. Investors
should check whether the product is fully developed or is in the final stages of
development. Sometimes venture capitalists may invest at the product
development stage if they consider the product to have great potential and market.
Obviously, investing at the product development stage is more risky as compared
to making investments in an enterprise that offers an innovative product that is
ready for the market.
• Manufacturing risk: In case of an enterprise that has a ready prototype, the
investors have to ascertain if large scale manufacturing of the product would be

49
 possible and viable. Sometimes, availability and supply of raw material can create
problems. The company has to have a cost advantage.
• Market Risk: The size of the market, growth potential and expected market share
of the company have to be established. Development risk and manufacturing risk
are usually avoided by venture capitalists as they invest at a later stage. Market
risk is borne by them. Often, manufacturers overestimate the market potential of
their offerings. Investors have to therefore study this aspect in detail and
undertake market analysis.
• Management risk: The investors have to establish the quality of the entrepreneur
and his management team. For this purpose, venture capitalists may ask for
references.
• Financing risk. A startup typically requires staged funding. Factors such as, the
ability to raise fimds in fiitiire, the rate of cash bum, which essentially means the
rate at which cash is used up by the enterprise, estimation of fixed and variable
costs, sales happening at the expected time etc. are studied.
• Valuation risk: Mismatch between the entrepreneur's valuation of the enterprise
and the investor's valuation is very common. Entrepreneurs usually have high
expectations. There is a risk of over valuation and the investor overpaying for the
investment. Valuations can be based on networth of the enterprise, or the price-
earnings ratio or industry standards etc.
• Exit risk: This refers to the risk of the investor not being able to make an exit at
the end of the agreed time. This can happen when there is a slowdown and the
valuations are low. This may lead to a situation where the venture capitalists are
stuck with dead investments. (Golis)'*^
Thus venture capitalists have to establish the seven risks mentioned above at the time of
due diligence.

50
Deal structuring: After due diligence if the venture capitalist is convinced that the
proposal is viable, the venture capitalist and the entrepreneur negotiate the terms and
conditions of financing. This is called deal structuring. Bell, Davis et.al undertook an
exploratory study to examine the deal structuring stage of the venture capitalist decision-
making process. The primary issues of concern are investor confidence and potential
control of a venture in relation to the level of financing the investor provides and the
structure with which the funding is delivered.
The two parties may hire the services of legal experts at this stage. Legal experts add
value as they have understanding of the venture capital industry and the industry in which
the company seeking fimds operates. They are well versed with legal terms and will be in
a position to design an appropriate negotiation strategy. Legal firms usually have a
through xmderstanding of the regulatory framework. (Desai)"*^ At this stage the venture
capitalists decide how much funding to deliver, in how many stages to deliver the funds
and how much involvement and control are warranted in the venture capitalists-enterprise
relationship. The venture capitalists ensure that the deal structure provides for a return
commensurate with the risk, influence over the firm through board membership,
minimising taxes, assuring investment liquidity and the right to replace management in
case of consistent poor managerial performance.
The entrepreneurs on the other hand will look at issues such as retention of control and
being able to lead the business, receiving sufficient returns for the initiative, having
adequate flow of funds etc.

Post investment activities: The venture capitalists monitor the ventures fimded by them.
Venture capitalists and entrepreneurs work together like partners. As the stakes and risks
are high, venture capitalists take keen interest in the operations of their portfolio firms
and they nurture the undertakings. There is usually a formal representation of the venture
capitalist on the board of directors of the portfolio firms. The extent of involvement of
venture capitalists in the funded undertakings depends on the objectives of the venture

51 G062
capitalist. They rarely get involved in the day to day operations, while at the same time
keeping a close watch on the enterprises funded by them. For this reason many venture
capitalists prefer to invest in undertakings that are located reasonably close to their
offices. However, it was found that venture caphal in India is not a really localised
business as they invest in undertakings anywhere in India if they see good potential.

Exit: Venture capital is a medium to long term investment and they look for liquidation
of investments in 5 to 10 years time. IPO, redemption, buy-back by promoters,
mergers/acquisitions, strategic sale are the exit routes for venture capitalists. While IPO is
the most preferred exit option, strategic sale is the most common exit route. This is
because, venture capitalists invest at early stages of the life cycle of an undertaking and
they may not be in a position to wait till the company is ready for IPO.

2.13.0 The Term Sheet

When the venture capitalist decides to finance a venture, a term sheet is drafted. It is a
document that states the terms and conditions of the investment. While a number of
clauses in the term sheet are usually standard, in the sense that they will be applicable
universally to all venture capital deals, there are many provisions that are negotiable.
Legal experts are hired to draft the term sheet.
Following are the contents of a typical term sheet

Valuation of the enterprise: In the venture capital funding process, the valuation of the
investee company is an important issue. The entrepreneur expects a higher valuation,
while the venture capitalists prefer to take a conservative view. In the term sheet the
valuation of the investee firm by the venture capitalist is stated. This is negotiable and
before signing the deal a mutually acceptable valuation is arrived at.

The amount and timing of investment: Very often, the venture capitalists make staged

52
investments in enterprises. The next round of funding will be provided when the investee
company meets a mile stone. The number and timing of investments are stated in the term
sheet.

The instruments to be used: Venture capitalists usually use equity or equity linked
instruments for financing. In India, a registered venture capital fund has to use 66.67% of
its corpus for investing in equity of unlisted companies. The balance can be used to
provide debt or for investment in the shares of listed companies. In the term sheet, the
instruments that the venture capitalists will use for financing is mentioned.

No solicitation clause: There is a time gap between the signing of the term sheet and the
actual fimding. During this time period the enterprise cannot accept any fiinding from
other sources or a proposal for acquisition from another party. Provision for this purpose
is made in the term sheet.

Protective provisions: A term sheet contains provisions with respect certain decisions or
actions that the investee company cannot take without prior approval from the venture
capitalist. These may pertain to certain important investment decisions such as purchase
of assets, soliciting finance from other sources etc.

Appointment of directors: The venture capitalists may ask for the right to select a
certain number of directors for the investee companies.

Board representation: Usually venture capitalists demand a seat on the board of

directors of the investee firms. One of the fiand managers represents the venture
capitalists in the board of directors of the enterprise. They at least insist on an observer's
seat.

53
Vesting of founders' stock: The venture capitalists may insist that the stock to be
allotted to the founders and the management team of the investee company vest over a
period of time of employment in the company. This means that the founders are allotted
their shares in stages.

Rights to purchase shares in future: The venture capitalist may ask for the right to
purchase shares that are issued in future to ensure that their ovmership in the company is
not diluted duringfixturerounds of financing.

Anti dilution protection: Anti-dilution protection allows an investor to receive

additional equity in the company if it dilutes his position by selling securities with a
lesser value than the securities of the investor. The full ratchet is a tool by which the
investors receive additional stock at a rate calculated by using the lowest price of the
dilutive securities sold by the company. The fiiU ratchet means that in a down financing
round founders will give up additional equity to their venture investors and will
significantly dilute their ovmership position.(Silicon India, 2008).^*^
Full ratchet refers to an anti-dilution provision that, for any shares of common stock sold
by a company after the issuing of an option (or convertible security), applies the lowest
sale price as being the adjusted option price or conversion ratio for existing
shareholders.(Investopedia)'''

Exit Rights: Venture capitalists usually liquidate their investment in a company through
the sale of the company or through initial public offering of the stocks of the company or
through redemption or through buy back of the shares by the management of the
company. There are certain rights that the venture capitalists may insist on, which are
known as Tag Along Rights and Drag Along Rights. Tag along rights give the investors
the right to include their stock in any sale of stock by management. Drag along rights
give the investors the right to force management to sell their stock in any sale of stock by

54
the investors. (ZeroMillion.com)'**
The primary purpose of drag-along rights are to ensure that the investor's shares won't be
held hostage in the event of a favorable acquisition or merger event. Drag-along rights
permit the holder of the rights to force the other shareholders to sell their shares if there is
a third-party offer for the purchase of company. (Koester A.Eric)'*'
Tag-along rights refer to a contractual obligation used to protect a minority shareholder in
a venture capital deal. If a majority shareholder sells his or her stake, then the minority
shareholder has the right to join the transaction and sell his or her minority stake in the
company. It is also referred to as co-sale rights.(Investopedia)^*^
These are the most common contents of a term sheet. This list of contents is only
indicative and is not exhaustive. The actual contents of a term sheet may vary from deal
to deal.

2.14.0 Relationship And Agreement Between The Venture Capital Fund Managers
And Investors
In the venture capital industry, the fund managers are known as General Partners and the
investors who invest in the fund are known as Limited Partners. The parties share a long
term relationship, which is based on mutual trust and a fair alignment of interests
between both parties. The relationship is complex as the objectives of the fund managers
and investors change and may not always match. (Westemann, 2008).^'
The following are some of the key provisions in the agreement between Limited Partners
and General Partners:

Management fee: This is a fee charged by the General Partner for managing the fund. It
varies from 1.5% to 2.5% of committed capital. This may vary over the life of the fund,
generally decreasing over time as the Limited Partners' original committed capital is paid
back from investment returns. The reason for decreasing the fee is that, maximum efforts
of the general partner are in the first five to six years of the fund as compared to the

55
monitoring and distribution phase of the fund. An ahemative to the percentage fee system
is a budget based fee. An annual budget is developed by the General partner and Limited
Partners with the help of the advisory board to operate the partnership on a break-even
basis. This preserves the incentive for the General partner to seek its compensation
through the fund's profits rather than through the management fees.

Carried interest: This refers to the general partner's share in the profits of the venture
capital fund. Typically, a fund must return the capital given to it by the Limited Partners
before the general Partner can share in the profits of the fund. The General partners
usually receive 20% of the net profits as "carried Interest", and in some cases they even
get 25% to 30%. This fee is also known as "Carry" or "Promote". In some agreements
there is clause that a minimum rate of return on the capital invested is earned before the
general Partner can earn carried interest. This minimum rate of return is known as the
"Hurdle Rate" or "Preferred Return". Hurdle rate usually is in the range of 5% to 10%.
Some agreements require that the General Partner should generate sufficient profits to
repay original management fees and the preferred return before the General Partner can
earn any carry. Some agreements allow the general Partners to earn carry on deal-by-deal
basis, that is, the General Partner receives the carried interest on the profits of each deal
as it is liquidated.

Commitment: This refers to the maximum amount of capital that an individual Limited
Partner agrees to invest in the fund. The commitment includes management fees charged
by the fund managers as well as other fund expenses.

Drawdown: Out of the total funds committed, the General Partner draws fimds as and
when they are required for investments. This is called drawdown.

Distribution and Clawbacks: When the venture capitalists make an exit either through a

56
strategic sale or merger or acquisition or a public offering, the agreement specifies how
the profits are to be allocated. The timing and form of distribution will be fixed. This may
include a Clawback provision, which allows a Limited Partner to claim a part of the
carried interest earned by the General Partners on account of earlier profitable
investments, if there are significant losses on subsequent investments.

Termination and No-fault Divorce: Limited partners can terminate their participation in
a fund under extreme circumstances, such as the death or withdrawal of key members of
the general partner group.

Investment: venture capital refers to a dedicated pool of fimd, which essentially means
the funds are raised for investments in specific sectors/industries or stage. This is stated
in the agreement. (Note on Limited Partnership Agreement, 2003)^^

2.15.0 Insights Gained

Venture capital refers to finance provided at early stages of the life cycle of iimovative
enterprises. Therefore, venture capitalists undertake considerable risks. It is very different
fi-om other sources of finance. Venture capital has certain distinct featiires that
differentiate itfi-omconventional sources of finance.

2.16.0 Conclusions
Thus venture capital is a unique financial intermediary. It differs from other conventional
sources of finance in many respects. It has a imique nature and features and the venture
capital fimding process is different from other sources of finance. In the United States the
organised form of venture capital emerged almost a decade before it emerged in India.
The venture capitalists and their investors share a very complex relationship. The
existence of innovations, entrepreneurship and a favourable regulatory frame work
encourage the growth of venture capital.

57
 Chandra, Prasanna. (1994). Appendix 23B-Venture Capital. Fundamentals of Financial Management.
(p.565). New Delhi: Tata McGraw Hill.

2
Pandey I. M. (1996). Strategic Role of Venture Capital. Venture Capital-The Indian Experience, (p.2).
New Delhi: Prentice Hall.

^ (E.d) Paxson Dean., & Wood, Douglas. (1997). Encyclopedic Dictionary of Finance, (p. 195).
Massachusetts: Blackwell Publishers.

4
Verma J. C. (1997). Venture Capital Financing in India, (p. 18). New Delhi: Response Books.
Moles, Peter., & Terry, Nicholas. (1999). The Handbook of International Financial Terms, (p.583).
New York: Oxford University Press.
* Reuters Financial Glossary. (2000). (p. 157). London: Pearson Education

7
Gupta S.L., & Taneja, Satish. (2002). Sources of Finance. Entrepreneur Development-New Venture
Creation. (p.250).. New Delhi: Galgotia Publishing Company.
' Rustagi, R.P. (2003). Venture capital. Financial Management, (pp.1105-1115). New Delhi: Galgotia
Publishing Company.

9
Bannock, Graham., Davis, Evan, Trott, Paul., & Uncles, Mark. (2004). Dictionary of Business. (p.381).
London: Profile Books Limited.

Surendra, Sundararajan. (2004). Book of Financial Terms. (p.230). New Delhi: Tata McGraw Hill.
" Hammett, Mike. (2006). In (e.d.). Clark, John. Dictionary of International Trade Finance, (p.259). New
Delhi: Biztantra, An Imprint of Dreamtech Press.

'^ Dictionary of Banking and Finance. (2008). (p.l91). New Delhi:New Century Publications.

'^ Web site of Reliance Technology Ventures Limited. Retrieved May 5,2009, from
http://www.rtvl.co.in/rtvl/HTML/aboutus overview.html

Robbie, Ken., Wright, Mike et.al. (n.d). Determinants of required return in venture capital investments:
A five country study. Retrieved April 28, 2009, from http://www.u-bourgogne.fr/LEG/wp/1020701.PDF

" Kenny, Martin et.al. (2002). Scattering Geese-The VC Industries of East Asia. A report to the World
Bank, Brief Working Paper: 146. Retrieved August 12, 2008, from
http://brie.berkelev.edu/publications/wp 146.pdf

'* The official website of SIDBI Venture Capital. Retrieved April 23,2009, from

58
http.//www.sidbiventure.co.in/

Under Small Business Investment Company (SBIC) programme, privately managed investment funds
are formed to provide equity and or debt capita! to small businesses in the US.

" Kenny, Martin. (2004). Building Venture Capital Industries: Understanding the US and Israeli
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