PROJECT ON VENTURE CAPITALISTS

Semester-III, PGeMBA 2006-08, MET’s AMDC

Prepared by:
1. Krunal Shah 6156
2. Gautam Foria 6045
3. Ishita Kohli 6083
4. Niral Chandarana 6023
5. Pratik Parekh 6122
6. Sneha Lalwani 6087
7. Vivek Jain 6064
8. Brinda Jogani 6069
 DECLARATION

We the members of Group No. 3 students of Mumbai Educational Trust,

PGeMBA – Finance, Sem-3 hereby declare that we have completed the project on
VENTURE CAPITAL in academic year 2007-08. The information submitted is
free from any errors to the best of our knowledge.

CERTIFICATE

We the members of Group No. 3 students of Mumbai Educational Trust, PG-

eMBA – Finance, Sem-3 hereby declare that with respect to the subject on
Financial Management - II, we have completed the project on Venture Capital in
academic year 06-07.under the control and guidance of our college Prof. Vijay
Paradkar.

DATE OF SUBMISSION:

ACKNOWLEDGEMENT

During the perseverance of this project we were supported by different people,

whose names if not mentioned would be inconsiderate on our part.

We would like to thank with affection and appreciation and acknowledge our
indebt ness to Prof. Vijay Paradkar, visiting faculty of Mumbai Educational Trust,
Bandra who initiated us in the preparation of a Project on Venture Capital. The
learning and knowledge that we have gained in the process of preparation of this
project has been tremendous and we would like to thank Prof. Vijay Paradkar for
providing us with the opportunity to work on this project.

We owe sincere gratitude towards each and everyone who have given a helping
hand in the completion of this project.

INDEX
Sr. No. TOPICS
I. Executive Summary
II. Indian Financial Sector
III. Concept Of VC
IV. Venture Capital Flow
V. Features of A VC
VI. VC – The History
VII. Private Equity
VIII. Types of VCs
IX. SEBI Regulations For VCs
X. SEBI Regulations For
Foreign VCs
 XI. Valuation Methods Used
By VCs
XII. Financial Instruments Used
By VCs
XIII. Stages Of VC Investment
XIV. Documentation
XV. Difference Between A VC &
A Banker/Money Manager
XVI. An Exercise: Launching &
Managing A VCF
XVII. Bibliography
I. EXECUTIVE SUMMARY
A number of technocrats are seeking to set up shop on their own and capitalize
on opportunities. In the highly dynamic economic climate that surrounds us
today, few ‘traditional’ business models may survive. Countries across the globe
are realizing that it is not the conglomerates and the gigantic corporations that
fuel economic growth any more. The essence of any economy today, is the small
and medium enterprises. In the year 2006, venture money invested in India was
$3 bn and is expected to reach $6.5 bn by the end of this year.

This growing trend can be attributed to rapid advances in technology in the last
decade. Knowledge driven industries like InfoTech, health-care, manufacturing,
entertainment and services have become the cynosure of bourses worldwide. In
these sectors, it is innovation and technical capability that are big business-
drivers. This is a paradigm shift from the earlier physical production and
‘economies of scale’ model.

However, starting an enterprise is never easy. There are a number of parameters

that contribute to its success or downfall. Experience, integrity, prudence and a
clear understanding of the market are among the sought after qualities of a
promoter. However, there are other factors, which lie beyond the control of the
entrepreneur. Prominent among these is the timely infusion of funds. This is
where the venture capitalist comes in, with money, business sense and a lot
more.
 II. INDIAN FINANCIAL SECTOR
The financial sector in India is characterized by liberal and progressive policies,
vibrant equity and debt markets and prudent banking norms. India’s financial
sector has been one of the fastest growing sectors in the economy. India has a
financial system that is regulated by independent regulators in the sectors of
banking, insurance, capital markets etc.

2.1. Size
• Total banking assets stood at around $ 600 billion
• Assets owned by India’s mutual funds crossed the Rs 4 trillion-mark
• India’s entire stock of financial assets--equity, corporate and government debt
and bank deposits--is valued at US$ 1.1 trillion
• More than 80 venture capital and private equity funds operate in India.

2.2. Structure
• Public Sector (Government owned) banks account for 75% of the banking
assets; however, Indian private banks and foreign banks are growing at a
rapid pace.
• Standard Chartered Bank, Citibank and HSBC are the top three foreign banks
in India accounting for more than 65% of the total assets of foreign banks
• Most of the global players in banking & financial services – Morgan Stanley,
Merrill Lynch, JP Morgan, Deutsche Bank, UBS, ABN Amro, Barclays, Calyon
etc. - have presence in India
• The Mutual Funds industry has both domestic and foreign players like - UTI
Mutual Fund, Prudential ICICI, HDFC, Franklin Templeton, Birla and Tata
Funds.

2.3. Banking System

The Indian Banking sector has greatly benefited from the structural reforms over
the last decade. This coupled with recent treasury gains & improved quality of
credit portfolios has made balance sheets of majority of banks appear to be in a
far healthier state than they have historically been. Apart from the improvement
in underlying business fundamentals, the sector’s prospects have been boosted
by an upturn in the economy and increased demand from both the corporate and
the retail clientele. In today’s scenario banking has assumed a technology
intensive and customer-friendly face with focus on the ease and speed of
operations.

An array of services is provided today from retail banking to corporate banking

and industrial lending to investment banking.

The Reserve Bank of India (RBI) controls and supervises the banking industry. It
also prescribes broad parameters of banking operations within which the
country’s banking and financial system functions.

2.4. Insurance Sector

The Insurance sector in India has been traditionally dominated by state owned
Life Insurance Corporation and General Insurance Corporation and its four
subsidiaries. Government of India has now allowed FDI in insurance sector up to
26%, which has seen a number of new joint venture private companies entering
the life and general insurance sectors, and their market share is rising at a rapid
pace. Insurance Development and Regulatory Authority (IRDA) is the regulatory
authority in the insurance sector developed under the provisions of the Insurance
Development and Regulatory Authority Act, 1999.

2.5. Capital Market

India has a transparent; highly technology – enabled and well regulated stock /
capital market. A vibrant, well-developed capital market facilitates investment and
economic growth. The capital market transactions today involve lots of checks
and balances with efficient electronic trading and settlement systems. Today the
stock markets are buoyant and have a range of players including mutual funds,
FIIs, hedge funds, corporate and other institutions. Securities and Exchange
Board of India regulate the Indian capital markets. India’s capital market
comprises of 23 stock exchanges with over 9000 listed companies. Bombay
Stock Exchange (BSE) is one of the oldest exchanges in Asia. National Stock
Exchange (NSE) is third largest exchange in the world in terms of number of
trades. These exchanges constitute an organized market for securities issued by
the Central and State Governments, public sector companies and public limited
companies. The average daily turnover of BSE is around 4,000 crores and that of
NSE is 9,000 crores. The stock exchanges provide an efficient and transparent
market for trading in equity, debt instruments and derivatives. The stock
exchanges are demutualised, and have been converted into companies now, in
which brokers only hold minority share holding. In addition to the SEBI Act, the
Securities Contracts (Regulation) Act, 1956 regulates the stock markets.

2.6. Mutual Funds

The Indian mutual fund industry is one of the fastest growing sectors in the Indian
capital and financial markets. The mutual fund industry in India has seen
dramatic improvements in quantity as well as quality of product and service
offerings in recent years.
The industry has grown in size and the total assets under management (AUM)
stood at Rs 4, 02,035.88 crores in May 2007(equivalent to US$ 100 billion).
Almost all varieties of schemes are offered today. The Mutual fund industry
operates in a strict regulatory environment and conforms to the best international
standards. Association of Mutual Funds in India (AMFI) is a trade body of all the
mutual funds in India. It is a non-profit organisation set-up to promote and protect
the interests of mutual funds and their unit holders. SEBI is the regulator of the
mutual fund industry in India.

2.7. Non Banking Finance Companies

Non Banking Financial Companies (NBFCs) have played a crucial role in
broadening the access to financial services, enhancing competition and in the
diversification of the financial sector. NBFCs are increasingly being recognized
complementary to the banking system, capable of spreading risks at times of
financial distress. NBFCs are recognized as an integral part of the financial
system with an impetus to improve the credibility of the entire sector. Today,
NBFCs are present in the competing fields of vehicle financing, hire purchase,
lease, personal loans, working capital loans, consumer loans, housing loans,
loans against shares, investments, distribution of financial products, etc. The total
number of NBFCs registered with the RBI in India in 2006 stood at 13,014.

2.8. Credit Rating Agencies

India’s credit rating agencies are world reckoned. The credit rating agencies rate
corporate debt and equity securities such as debentures, shares and commercial
paper. Today, credit ratings have become necessary because it has become
mandatory for companies to obtain a credit rating before issuing convertible and
non-convertible debentures. The four important credit rating agencies in India are
Credit Rating Information Services of India Limited (CRISIL) Investment
Information and Credit Rating Agency of India (ICRA), Credit Analysis and
Research Ltd. (CARE) Today the rating agencies have diversified and forayed
into a variety of services such as risk management, strategy, corporate advisory,
IT, across various sectors. The credit rating agencies are regulated by SEBI
through separate regulations.
2.9. Venture Funds
Venture capital can be used as a financial tool for development, within the range
of SME finance, by playing a key role in business start-ups, existing small and
medium enterprises (SME) and overall growth in developing economies. Venture
capital acts most directly by being a source of job creation, facilitating access to
finance for small and growing companies which otherwise would not qualify for
receiving loans in a bank, and improving the corporate governance and
accounting standards of the companies.

India is a prime target for venture capital and private equity today, owing to
various factors such as fast growing knowledge based industries, favorable
investment opportunities, cost competitive workforce, booming stock markets and
supportive regulatory environment among others. The sunrise sectors that
attract venture funds are healthcare, education, financial services,
hospitality, media & entertainment, ITES and InfoTech. Indian venture Capital
Association is the apex association of VC funds in the country. India has more
than 80 venture Funds registered with SEBI.

III. CONCEPT OF VC
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 potentially. 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 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”.
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.

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.

What is Venture Capital?

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 is the investment of long term risk finance in new and untried enterprises that
are “lacking in a stable record of growth.” 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.

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 VC 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 VC 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.
Usury 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
own participants, and sufficient upside potential entrepreneurs to attract high
quality ideas that will generate high returns.
IV. VENTURE CAPITAL FLOW
4.1. Venture Capitalist
A venture capitalist (VC) is a person who makes investments in potentially stable
growing companies.

VC is a fund manger who gets a fee to invest in companies that has growth
potential and provides expected returns to its investors.

With venture capital, the venture capitalist acquires an agreed proportion of the
equity of the company in return for the requisite funding.

Investors in venture capital funds are typically very large institutions such as
pension funds, financial firms, insurance companies, and university endowments-
all of which put a small percentage of their total funds into high risk investments.

In return for financing one or two year of financing company’s start ups, VC
expect a ten times return of capital over five years.

Usually VC expects a return of between 25% and 35% per year over the lifetime
of the investment. Because these investments represent such a tiny part of the
institutional investors’ portfolios, venture capitalists have a lot of latitude. What
leads to invest in these funds is not the specific investment but firms overall track
record.

While investing a VC looks into the following:

 A strong committed management team, established performance record and
a high degree on integrity
 Sustainable competitive advantage
 Scalability of operations
 Potential for above average profitability leading to attractive returns on
investment
 Subscription to equity/ equity type instruments
 Unlisted companies preferably in small scale/ small scale graduating to
medium scale
 Availability of exit route for Venture Capital investment

A typical VC allocates its time in the following fashion:

 Deal flow and solicitation…10%
 Screening and evaluation…10%
 Terms and negotiation…5%
 Board meetings and monitoring…25%
 Consulting, recruiting and assisting…45%
 Exiting…5%
One myth is that VC invests in good people and good ideas. The
reality is that they invest in good industries that are
competitively forgoing the market.

In effect VC focuses on the middle part of classic industry S-Curve. They avoid
both the early stages, when technologies are uncertain and market stages are
unknown and the later stage when competitive shakeouts and consolidations are
inevitable and growth rates slow dramatically.

Growing within high growth segments is a lot easier than doing so in low, no or
negative growth ones as every businessman knows. In other words regardless of
the talent or charisma an individual entrepreneur may posses they rarely receive
backing from VC if they are in low growth industry. During this adolescent period
of high and accelerating growth, it can be extremely hard to distinguish the final
winners from the losers because their financial performance and growth rate
looks strikingly similar. At this stage, all companies are struggling to deliver
products to this product-starved market. Thus the critical challenge for the VC is
to identify competent management that can execute-that is, supply the growing
demand.

This need for high returns makes venture funding an expensive capital source for
companies, and most suitable for businesses having large up-front capital
requirements which cannot be financed by cheaper alternatives such as debt.
That is most commonly the case for intangible assets such as software, and
other intellectual property, whose value is unproven. In turn this explains why
venture capital is most prevalent in the fast-growing technology and life sciences
or biotechnology fields.
Picking the wrong industry or betting on a technology risk is an unproven market
segment is something VC’s avoid. By investing in areas with high growth rates,
VC primarily consign their risk to the ability of the company’s management to
execute.

Because of the strict requirements venture capitalists have for potential

investments, many entrepreneurs seek initial funding from angel investors, who
may be more willing to invest in highly speculative opportunities, or may have a
prior relationship with the entrepreneur. Furthermore, many venture capital firms
will only seriously evaluate an investment in a start-up otherwise unknown to
them if the company can prove at least some of its claims about the technology
and/or market potential for its product or services. To achieve this, or even just to
avoid the dilutive effects of receiving funding before such claims are proven,
many start-ups seek to self-finance until they reach a point where they can
credibly approach outside capital providers such as VCs or angels. This practice
is called "bootstrapping".

VC investing in high growth segments is likely to have exit opportunities because

investment bankers are to 8% money raised through an IPO.
As long as VC are able to exit the company and industry before it tops out, they
can reap extra ordinary returns at relatively low risk.

4.2. Venture Capital Fund

A venture capital fund (VCF) is a pooled investment vehicle (often a limited

partnership) that primarily invests the financial capital of third-party investors in
enterprises that are too risky for the standard capital markets or bank loans.

Venture Capital Fund shall make investment in the venture capital undertaking as
enumerated below:

• At least 75% of the investible funds shall be invested in unlisted equity

shares or equity linked instruments.

• Not more than 25% of the investible funds may be invested by way of:
 Subscription to initial public offer of a venture capital undertaking whose
shares are proposed to be listed subject to lock-in period of one year.

 Debt or debt instrument of a venture capital undertaking in which the

venture capital fund has already made an investment by way of equity.

The venture capital fund shall issue a placement memorandum, which shall
contain details of the terms, and conditions subject to which monies are
proposed to be raised from investors.

The Venture Capital Fund shall file with the Board for information, the copy of the
placement memorandum or the copy of the contribution or subscription
agreement entered with the investors along with a report of money actually
collected from the investor.

VCF promotes growth in the companies they invest in and managing the
associated risk to protect and enhance their investors' capital.

VCF typically source most of their funding from large investment institutions.

VCF Invest the amount in companies with high growth potential or in companies,
which have the ability to quickly, repay.

VCF Exit through the company listing on the stock exchange, selling to a trade
buyer or through a management buyout.
Most venture capital funds have a fixed life of 10 years, with the possibility of a
few years of extensions to allow for private companies still seeking liquidity. The
investing cycle for most funds is generally three to five years, after which the
focus is managing and making follow-on investments in an existing portfolio.

In a typical venture capital fund, the general partners receive an annual

management fee equal to 2% of the committed capital to the fund and 20% of the
net profits (also known as "carried interest") of the fund; a so-called "two and 20"
arrangement, comparable to the compensation arrangements for many hedge
funds. Strong Limited Partner interest in top-tier venture firms has led to a
general trend toward terms more favorable to the venture partnership, and many
groups now have carried interest of 25-30% on their funds. Because a fund may
run out of capital prior to the end of its life, larger VCs usually have several
overlapping funds at the same time; this lets the larger firm keep specialists in all
stages of the development of firms almost constantly engaged. Smaller firms
tend to thrive or fail with their initial industry contacts; by the time the fund cashes
out, an entirely-new generation of technologies and people is ascending, whom
the general partners may not know well, and so it is prudent to reassess and shift
industries or personnel rather than attempt to simply invest more in the industry
or people the partners already know.

4.3. 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.

Venture capital general partners (also known in this case as "venture capitalists"
or "VCs") 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.

Other positions at venture capital firms include venture partners and

entrepreneur-in-residence (EIR). Venture partners "bring in deals" and receive
income only on deals they work on (as opposed to general partners who receive
income on all deals). EIRs are experts in a particular domain and perform due
diligence on potential deals. EIRs are engaged by VC firms temporarily (six to 18
months) and are expected to develop and pitch startup ideas to their host firm
(although neither party is bound to work with each other). Some EIRs move on to
roles such as Chief Technology Officer (CTO) at a portfolio company.

4.4. Nature and Scope

Merchant bankers can assist venture proposals of technocrats, with high
technology that are new and high risk, to seek assistance from venture capital
funds for technology based industries which contribute significantly to growth
process. Public issues are not available on such Greenfield ventures.

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.

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 n 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.
V. FEATURES OF VC
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.

5.1. 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 commercially viable
⇒ Operation Risk- operations may not be cost effective resulting in increased
cost and decreased gross margins.

Normally three out of every ten units financed by Venture capital succeed.

5.2. 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.

5.3 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 dividends can be delayed, Equity investment implies that investors bear
the risk of venture and would earn a return commensurate with the success in
the form of capital gains.
5.4. 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 one seat 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.

5.5. 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. The process of having significant returns takes several years and calls on
the capacity and talent of venture capitalist and entrepreneurs to reach fruition.

5.6. 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 for seven to ten years. VC understands this illiquidity and factors in his
investment decisions.
VI. 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 VCF set up
was the one by Rockefeller Family that started a special called VENROCK in
1950, to finance new technology companies.

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.

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.

6.1. 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. 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 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. These, he argued, were massive in scale, but also politically motivated,
too focused on defense, housing and such specialized technologies as space
exploration, agriculture, and aerospace. 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 (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.
6.2. Venture Capital In India

The developmental financial institutions like IDBI, ICICI and State Financial
Corporations possibly did this activity in the past. These institutions promoted
entities in the private sector with debt as an instrument of funding.

For a long time funds raised from public were used as a source of VC. This
source however depended a lot on the market vagaries. And with the minimum
paid up capital requirements being raised for listing at the stock exchanges, it
became difficult for smaller firms with viable projects to raise funds from public.

In India, the need for VC was recognised in the 7th five-year plan and long term
fiscal policy of GOI. In 1973 a committee on Development of small and medium
enterprises highlighted the need to faster VC as a source of funding new
entrepreneurs and technology. VC financing really started in India in 1988 with
the formation of Technology Development and Information Company of India Ltd.
(TDICI) - promoted by ICICI and UTI.

The first private VC fund was sponsored by Credit Capital Finance Corporation
(CFC) and promoted by Bank of India, Asian Development Bank and the
Commonwealth Development Corporation viz. Credit Capital Venture Fund. At
the same time state level financial institutions started Gujarat Venture Finance
Ltd. and APIDC VENTURE CAPITAL LTD. Sources of these funds were the
financial institutions, foreign institutional investors or pension funds and high net-
worth individuals. Though an attempt was also made to raise funds from the
public and fund new ventures, the venture capitalists had hardly any impact on
the economic scenario for the next eight years.

India is prime target for venture capital and private equity today, owing to various
factors such as fast growing knowledge based industries, favorable investment
opportunities, cost competitive workforce, booming stock markets and supportive
regulatory environment among others.

The sectors where the country attracts venture capital are IT and ITES, software
products, banking, PSU disinvestments, entertainment and media,
biotechnology, pharmaceuticals, contract manufacturing and retail. An offshore
venture capital company may contribute up to 100 percent of the capital of a
domestic venture capital fund and may also set up a domestic asset
management company to manage the fund. Venture capital funds (VCF) and
venture capital companies (VCC) are permitted up to 40 percent of the paid up
corpus of the domestic unlisted companies. This ceiling would be subject to
relevant equity investment limit in force in relation to areas reserved for SSI.
Investment in a single company by a VCF/VCC shall not exceed 5 percent of the
paid up corpus of a domestic VCF/VCC. The automatic route is not available.
Indian companies received almost no Private Equity (PE) or Venture Capital (VC)
funding a decade ago. This scenario began to change in the late 1990s with the
growth of India’s Information Technology (IT) companies and with the
simultaneous dot-com boom in India. VCs started making large investments in
these sectors, however the bust that followed led to huge losses for the PE and
VC community, especially for those who had invested heavily in start-ups and
early stage companies. After almost three years of downturn in 2001-2003, the
PE market began to recover towards the end of 2004. PE investors began
investing in India again, except this time they began investing in other sectors as
well (although the IT and BPO sectors still continued to receive a significant
portion of these investments) and most investments were in late-stage
companies. Early-stage investments have been dwindling or have, at best,
remained stagnant right through mid-2006.

6.3.The PE and VC Investment Boom in 2000 and Its Aftermath

1996-1997 - Beginning of PE/VC activity in India:

The Indian private equity (PE) and venture capital (VC) market roughly started in
1996-1997 and it scaled new heights in 2000 primarily because of the success
demonstrated by India in assisting with Y2K related issues as well as the overall
boom in the Information Technology (IT), Telecom and the Internet sectors,
which allowed global business interactions to become much easier. In fact, the
total value of such deals done in India in 2000 was $1.16 billion and the average
deal size was approximately US $4.14 million.

2001-2003 - VC/PE becomes risk averse and activity declines:

Not surprisingly, the investing in India came “crashing down” when NASDAQ lost
60% of its value during the second quarter of 2000 and other public markets
(including those in India) also declined substantially. Consequently, during 2001-
2003, the VCs and PEs started investing less money and in more mature
companies in an effort to minimize the risks. For example:
(a) The average deal size more than doubled from $4.14 million in 2000 to $8.52
million in 2001
(b) The number of early-stage deals fell sharply from 142 in 2000 to 36 in 2001
(c) Late-stage deals and Private Investments in Public Equity (PIPEs) declined
from 138 in 2000 to 74 in 2001, and
(d) Investments in Internet-related companies fell from $576 million in 2000 to
$49 million in 2001. This decline broadly continued until 2003.

2004 onwards - Renewed investor interest and activity:

Since India’s economy has been growing at 7%-8% a year, and since some
sectors, including the services sector and the high-end manufacturing sector,
have been growing at 12%-14% a year, investors renewed their interest and
started investing again in 2004. As Figure 1 shows, the number of deals and the
total dollars invested in India has been increasing substantially. For example, US
$1.65 billion in investments were made in 2004 surpassing the $1.16 billion in
2000 by almost 42%. These investments reached US $2.2 billion in 2005, and
during the first half of 2006, VCs and PE firms had already invested $3.48 billion
(excluding debt financing). The total investments in 2006 are likely to be $6.3
billion, a number that is more than five times the amount invested in 2000.

PE investment expands beyond IT and ITES:

A very important feature of the resurgence in the PE activity in India since 2004
has been that the PEs are no longer focusing only on the IT and the ITES (IT
Enabled Services, commonly known as “Business Process Outsourcing” or BPO)
sectors. This is partly because the growth in the Indian economy is no longer
limited to the IT sector but is now spreading more evenly to sectors such as bio-
technology and pharmaceuticals; healthcare and medical tourism; auto-
components; travel and tourism; retail; textiles; real estate and infrastructure;
entertainment and media; and gems and jewellery. Figure 2 shows the division
across various sectors with respect to the number of deals in India in 2000, 2003
and the first half of 2006.
Early Stage VC Investments during 2000-2006:
Since the Purchase Power Parity (PPP) in India is approximately a factor of 5 (as
in, a factor of 5 is used to normalize the GDPs of US & India on a PPP basis),
analysis shows that early stage VC investments in India should include those that
are $8 million or less. In fact, we can classify early stage investments further into
Seed, Series A and Series B investments depending upon their value.

Figure below highlights an approximate comparison of the typical range of Seed,

Series A, and Series B funding in India versus that in the US (actual dollar
amounts; not adjusted in terms of PPP).

Figure given below provides a break-up of the total value of investments into
early-stage investments (primarily by VCs) and late-stage investments and
PIPEs (primarily by PEs). Even within early-stage investments, seed investments
declined the most during 2000-2003 and have essentially remained negligible
during 2004-2006.
Figure below shows the break-up of early-stage investments by Seed and Series
A and B investments. In a nuance, perhaps unique to India, since the Indian
upper middle class has become quite affluent during the last 7-10 years, the
entrepreneurs are relying more and more on family and friends for seed funding,
and since emerging entrepreneurs come from this upper middle class, the need
for seed funding from VCs could remain low for many years to come.

In the year 2006 Venture money invested in India was $3bn and
is expected to reach $6.5bn by the end of the year.
VII. PRIVATE EQUITY
Private equity is a broad term that commonly refers to any type of non-public
Ownership Equity securities that are not listed on a public exchange. Since they
are not listed on a public exchange, any investor wishing to sell private equity
securities must find a buyer in the absence of a public marketplace. There are
many transfer restrictions on private securities. Investors in private securities
generally receive their return through one of three ways: an initial public offering,
a sale or merger, or a recapitalization.
Private equity firms generally receive a return on their investment through one of
three ways: an IPO, a sale or merger of the company they control, or a
recapitalization. Unlisted securities may be sold directly to investors by the
company (called a private offering) or to a private equity fund, which pools
contributions from smaller investors to create a capital pool.

Considerations for investing in private equity funds relative to other forms of

investment include:
 Substantial entry costs, with most private equity funds requiring significant
initial investment (usually upwards of $100,000) plus further investment for
the first few years of the fund called a 'drawdown'.

 Investments in limited partnership interests (which are the dominant legal

form of private equity investments) are referred to as "illiquid" investments
that should earn a premium over traditional securities, such as stocks and
bonds. Once invested, it is very difficult to gain access to your money, as it is
locked-up in long-term investments that can last for as long as twelve years.
Distributions are made only as investments are converted to cash; limited
partners typically have no right to demand that sales be made.

 If the private equity firm can't find good investment opportunities, they will not
draw on our commitment. Given the risks associated with private equity
investments, you can lose all your money if the private-equity fund invests in
failing companies. The risk of loss of capital is typically higher in venture
capital funds, which back young companies in the earliest phases of their
development, and lower, in mezzanine capital funds, which provide interim
investments to companies which have already proven their viability but have
yet to raise money from public markets.

 Consistent with the risks outlined above, private equity can provide high
returns, with the best private equity managers significantly outperforming the
public markets.

For the above-mentioned reasons, private equity fund investment is for those
who can afford to have their capital locked in for long periods of time and who are
able to risk losing significant amounts of money. This is balanced by the potential
benefits of annual returns, which range up to 30% for successful funds. Most
private equity funds are offered only to institutional investors and individuals of
substantial net worth. The law often requires this as well, since private equity
funds are generally less regulated than ordinary mutual funds.
VIII. TYPES OF VCS
8.1. Incubators
Incubator is a company or facility designed to foster entrepreneurship and help
startup companies usually technology-related, to grow through the use of shared
resources, management expertise and intellectual capital.
Kanwal Rekhi School of Information Technology (KReSIT) is a business
incubators at IIT Mumbai is the best example of business incubators in India.

8.2. Angle Investors

An angel investor (known as a "business angel" in Europe, or simply an "angel")
is an affluent individual who provides capital for a business start-up, usually in
exchange for ownership equity. Angels typically invest their own funds, unlike
venture capitalists, who manage the pooled money of others in a professionally-
managed fund. However, a small but increasing number of angel investors are
organizing themselves into angel networks or angel groups to share research
and pool their investment capital.
Angel investments bear extremely high risk, and thus require a very high
return on investment. Because a large percentage of angel investments are
lost completely when early stage companies fail, professional angel investors
seek investments that have the potential to return at least 10 or more times their
original investment within 5 years, through a defined exit strategy, such as plans
for an initial public offering or an acquisition.
Angel investors are often retired entrepreneurs or executives, who may be
interested in angel investing for other reasons in addition to pure monetary
return. These include wanting to keep abreast of current developments in a
particular business arena, mentoring another generation of entrepreneurs, and
making use of their experience and networks on a less-than-full-time basis. Thus,
in addition to funds, angel investors can often provide valuable management
advice and important contacts.

8.3. Venture Capitalist

Venture capitalists are organizations which pooled in money from various
investors in a professionally managed fund. VCs are inclined toward the
turnaround ventures that entail some investment risk but offer the potential for
above average future profits.
Sources of venture capital includes wealthy individual investors; subsidiaries of
banks and other corporations organized as small business investment
companies (SBICs); groups of investment banks and other financing sources
who pool investments in venture capital funds or Venture Capital Limited
Partnerships.
8.4. Private Equity players
Equity capital that is made available to companies or investors but not quoted on
a stock market. The funds raised through private equity can be used to develop
new products and technologies, to expand working capital, to make acquisitions,
or to strengthen a company's balance sheet. KKR (Kohlberg Kravis Roberts),
Blackstone and Vestar Capital Venture and ICICI venture are examples of private
equity players.
Private equity funds typically control management of the companies in which they
invest, and often bring in new management teams that focus on making the
company more valuable.

8.5. Types of Venture Capital firms

There is quite a variety of types of venture capital firms. They include:

1. Traditional partnerships: which are often established by wealthy families

to aggressively manage a portion of their funds by investing in small
companies. These funds are typically established as partnerships that invest
the money of their institutional limited partners. The partners typically include
corporate pension funds, government pension funds, private individuals,
foreign investors, corporations and insurance companies. These include
venture capital funds that are focused on investing in minority businesses or
minority markets.

2. Investment banking firms: which usually trade in more established

securities, but occasionally form investor syndicates for venture proposals.

3. Manufacturing companies: which have sometimes looked upon

investing in smaller companies as a means of supplementing their R & D
programs (Some "Fortune 500" corporations have venture capital operations
to help keep them abreast of technological innovations).

4. Small Business Investment Corporations (SBICs): which are licensed

by the Small Business Administration (SBA) and which may provide
management assistance as well as venture capital.

In addition to these venture capital firms there are individual private investors and
finders. Finders, which can be firms or individuals, often know the capital industry
and may be able to help the small company seeking capital to locate it, though
they are generally not sources of capital themselves. Care should be exercised
so that a small business owner deals with reputable, professional finders whose
fees are in line with industry practice. Further, it should be noted that venture
capitalists generally prefer working directly with principals in making investments,
though finders may provide useful introductions.

8.6. Parties involved

1. Entrepreneurs
The word entrepreneur derived from the French verb enterprendre, which means
“to undertake”. It is very difficult to define entrepreneur but Peter Drucker and
Francies Walker explain their views on entrepreneur.
It is the qualities of the entrepreneur that define entrepreneur. Innovative, risk
taking ability, passionate, visionary, change agent and many more qualities that
makes entrepreneur apart from others and define what he is.
Entrepreneurs has various types but broadly classified according to: the type of
business, the use of technology, the motivation, the growth, the stages of
development, area, gender and age, the sale of operation and others.
In the flow entrepreneur creates an idea which creates the entire flow.
Entrepreneur has to sell its idea to the Venture Capitalist. In turn entrepreneur
receives the fund (money) to implement his idea into reality.

2. Venture Capitalists
He is the one who supports the idea of the entrepreneur and in turn makes fund
available to the entrepreneur. Venture capitalist posses a good experience of his
area and provide expertise to the entrepreneur. Venture capitalist makes money
for themselves by making market for entrepreneurs, investors and bankers
Venture capitalist will raise money from the investors who expect high returns.
Venture capitalist takes the help of bankers to issues IPOs and in turn received
the initial outflow.

3. Investors
These are the private investors who expect high return as they invest in the
business which is full of risk. They invest in from of money and received return in
form of money as well. Venture capitalists raise money from these investors to
invest in entrepreneur’s idea.

4. Bankers
An investment banker helps the venture capitalist to float the IPOs in the market.
They are the one who help the venture capitalist to exit from the VC.
8.7. How funds flow between the parties
IX. SEBI REGULATIONS FOR VCs
9.1. DEFINITIONS:
“Venture capital fund” means a fund established in the form of a trust or a
company including a body corporate and registered under these regulations
which—
(i) Has a dedicated pool of capital;
(ii) Raised in a manner specified in the regulations; and
(iii) Invests in accordance with the regulations;

“Venture capital undertaking” means a domestic company—

(i) Whose shares are not listed on a recognized stock exchange in India.
(ii) Which is engaged in the business for providing services, production or
manufacture of article or things or does not include such activities or sectors
which are specified in the negative list by the Board with the approval of the
Central Government by notification in the Official Gazette in this behalf.

9.2. REGISTRATION OF VENTURE CAPITAL FUNDS

Application for Grant of Certificate:
(a) Any company or trust or a body corporate proposing to carry on any activity
as a venture capital fund on or after the commencement of these regulations
shall make an application to the Board for grant of a certificate.
(b)Any company or trust or a body corporate, which on the date of
commencement is carrying any activity as a venture capital fund without a
certificate shall make an application to the Board for grant of a certificate within a
period of three months (maximum of six months in special cases) from the date
of such commencement.
(c) An application for grant of certificate shall be accompanied by a
nonrefundable application fee.
(d) Any company or trust or a body corporate who fails to make an application for
grant of a certificate within the period specified therein shall cease to carry on
any activity as a venture capital fund.
(e) The Board may in order to protect the interests of investors appoint any
person to take charge of records, documents, securities and for this purpose also
determine the terms and conditions of such an appointment.

Eligibility Criteria:
For the purpose of the grant of a certificate by the Board the applicant shall have
to fulfill in particular the following conditions, namely:—

(a) if the application is made by a company :—

(i) Memorandum of association as has its main objective, the carrying on of the
activity of a venture capital fund;
(ii)It is prohibited by its memorandum and articles of association from making an
invitation to the public to subscribe to its securities;
(iii) Its director or principal officer or employee is not involved in any litigation
connected with the securities market which may have an adverse bearing on the
business of the applicant;
(iv) Its director, principal officer or employee has not at any time been convicted
of any offence involving moral turpitude or any economic offence;
(v) It is a fit and proper person

(b) If the application is made by a trust—

(i) The instrument of trust is in the form of a deed and has been duly registered
under the provisions of the Indian Registration Act, 1908 (16 of 1908);
(ii) The main object of the trust is to carry on the activity of a venture capital fund;
(iii) The directors of its trustee company, if any or any trustee is not involved in
any litigation connected with the securities market which may have an adverse
bearing on the business of the applicant;
(iv) The directors of its trustee company, if any, or a trustee has not at any time,
been convicted of any offence involving moral turpitude or of any economic
offence;
(v) The applicant is a fit and proper person;

(c) If the application is made by a body corporate—

(i) It is set up or established under the laws of the Central or State Legislature,
(ii) The applicant is permitted to carry on the activities of a venture capital fund,
(iii) The applicant is a fit and proper person,
(iv) The directors or the trustees, as the case may be, of such body corporate
have not been convicted of any offence involving moral turpitude or of any
economic offence,
(v) The directors or the trustees, as the case may be, of such body corporate, if
any, are not involved in any litigation connected with the securities market which
may have an adverse bearing on the business of the applicant;

(d) The applicant has not been refused a certificate by the Board or its certificate
has not been suspended or cancelled under regulation.

Furnishing of information, clarification:

The Board may require the applicant to furnish such further information as it may
consider necessary.

Consideration of application:
An application which is not complete in all respects shall be rejected by the
Board:
Provided that, before rejecting any such application, the applicant shall be given
an opportunity to remove, within thirty days further on being satisfied that it is
necessary to extend the period by such further time not exceeding ninety days.

Procedure for grant of certificate:

(a) If the Board is satisfied that the applicant is eligible for the grant of certificate,
it shall send intimation to the applicant.
(b) On receipt of intimation, the applicant shall pay to the Board; the registration
fee.
(c) The Board shall on receipt of the registration fee grant a certificate of
registration.

Procedure where certificate is not granted:

(a) After considering an application made under regulation , if the Board is of the
opinion that a certificate should not be granted, it may reject the application after
giving the applicant a reasonable opportunity of being heard.
(b) The decision of the Board to reject the application shall be communicated to
the applicant within thirty days.

9.3. INVESTMENT CONDITIONS AND RESTRICTIONS

Minimum investment in a Venture Capital Fund:
(a) A venture capital fund may raise monies from any investor whether Indian,
Foreign or non-resident Indian by way of issue of units.
(b) No venture capital fund set up as a company or any scheme of a venture
capital fund set up as a trust shall accept any investment from any investor which
is less than five lakh rupees:
Provided that nothing contained in sub-regulation (2) shall apply to investors
who are,—
(i) Employees or the principal officer or directors of the venture capital fund, or
directors of the trustee company or trustees where the venture capital fund has
been established as a trust;
(ii) The employees of the fund manager or asset Management Company;
(c) Each scheme launched or fund set up by a venture capital fund shall have
firm commitment from the investors for contribution of an amount of at least
rupees five crores before the start of operations by the venture capital fund.

Investment conditions and restrictions:

All investment made or to be made by a venture capital fund shall be subject to
the following conditions, namely:—
(a) Venture capital fund shall disclose the investment strategy at the time of
application for registration;
(b) Venture capital fund shall not invest more than 25% corpus of the fund in one
venture capital undertaking;
(i) Venture capital fund may invest in securities of foreign companies subject to
such conditions or guidelines that may be stipulated or issued by the Reserve
Bank of India and the Board from time to time.
(c) Shall not invest in the associated companies; and
(d) Venture capital fund shall make investment as enumerated below:
(i) At least 66.67% of the investible funds shall be invested in unlisted equity
shares or equity linked instruments of venture capital undertaking.
(ii) Not more than 33.33% of the investible funds may be invested by way of:
(ii.a) Subscription to initial public offer of a venture capital undertaking whose
shares are proposed to be listed
(ii.b) Debt or debt instrument of a venture capital undertaking in which the
venture capital fund has already made an investment by way of equity.
(ii.c) Preferential allotment of equity shares of a listed company subject to lock in
period of one year;
(ii.d) The equity shares or equity linked instruments of a financially weak
company or a sick industrial company (a company, which has at the end of the
previous financial year accumulated losses, which has resulted in erosion of
more than 50% but less than 100% of its net-worth as at the beginning of the
previous financial year) whose shares are listed.
(ii.e) Special Purpose Vehicles which are created by a venture capital fund for
the purpose of facilitating or promoting investment in accordance with these
Regulations.
(e) Venture capital fund shall disclose the duration of life cycle of the fund.

Prohibition on listing:
No venture capital fund shall be entitled to get its units listed on any recognized
stock exchange till the expiry of three years from the date of the issuance of units
by the venture capital fund.

9.4. GENERAL OBLIGATIONS AND RESPONSIBILITIES

Prohibition on inviting subscription from the public:
No venture capital fund shall issue any document or advertisement inviting offers
from the public for the subscription or purchase of any of its units.

Private placement:
A venture capital fund may receive monies for investment in the venture capital
fund only through private placement of its units.

Placement memorandum or subscription agreement:

(a) The venture capital fund shall—
(i) Issue a placement memorandum which shall contain details of the terms and
conditions subject to which monies are proposed to be raised from investors; or
(ii) Enter into contribution or subscription agreement with the investors which
shall specify the terms and conditions subject to which monies are proposed to
be raised.
(b) The Venture Capital Fund shall file with the Board for information, the copy of
the placement memorandum or the copy of the contribution or subscription
agreement entered with the investors along with a report of money actually
collected from the investor.

Contents of placement memorandum:

The placement memorandum or the subscription agreement with investors shall
contain the following, namely:-
(a) Details of the trustees or Trustee Company and the directors or chief
executives of the venture capital fund;
(b) (i) The proposed corpus of the fund and the minimum amount to be raised for
the fund to be operational;
(ii) The minimum amount to be raised for each scheme and the provision for
refund of monies to investor in the event of non-receipt of minimum amount;
(c) Details of entitlements on the units of venture capital fund for which
subscription is being sought;
(d) Tax implications that are likely to apply to investors;
(e) Manner of subscription to the units of the venture capital fund;
(f) The period of maturity, if any, of the fund;
(g) The manner, if any, in which the fund shall be wound up;
(h) The manner in which the benefits accruing to investors in the units of the trust
are to be distributed;
(i) Details of the fund manager or asset Management Company if any, and the
fees to be paid to such manager;
(j) The details about performance of the fund, if any, managed by the Fund
Manager;
(k) Investment strategy of the fund;
(l) Any other information specified by the Board.

Maintenance of books and records:

(a) Every venture capital fund shall maintain for a period of eight years books of
account, records and documents which shall give a true and fair picture of the
state of affairs of the venture capital fund.
(b) Every venture capital fund shall intimate the Board, in writing, the place where
the books, records and documents are being maintained.

Power to call for information:

(a) The Board may at any time call for any information from a venture capital fund
with respect to any matter relating to its activity as a venture capital fund.
(b) Where any information is called for shall be furnished within the time specified
by the Board.

Submission of reports to the Board:

The Board may at any time call upon the venture capital fund to file such reports
as the
Board may desire with regard to the activities carried on by the venture capital
fund.

Winding-up:
(a) A scheme of a venture capital fund set up as a trust shall be wound up,
(i) When the period of the scheme, if any, mentioned in the placement
memorandum is over;
(ii) If it is the opinion of the trustees or the trustee company, as the case may be,
that the scheme shall be wound up in the interests of investors in the units;
(iii) If seventy-five per cent of the investors in the scheme pass a resolution at a
meeting of unit-holders that the scheme be wound up; or
(iv) If the Board so directs in the interests of investors.
(b) A venture capital fund set up as a company shall be wound up in accordance
with the provisions of the Companies Act, 1956.
(c) The trustees or trustee company of the venture capital fund set up as a trust
or the Board of Directors in the case of the venture capital fund is set up as a
company (including body corporate) shall intimate the Board and investors of the
circumstances leading to the winding up of the Fund or Scheme.

Effect of winding-up:
(a) On and from the date of intimation, no further investments shall be made on
behalf of the scheme so wound up.
(b) Within three months from the date of intimation, the assets of the scheme
shall be liquidated, and the proceeds accruing to investors in the scheme
distributed to them after satisfying all liabilities.
(c) Notwithstanding anything as asset and subject to the conditions, if any,
contained in the placement memorandum or contribution agreement or
subscription agreement, as the case may be, in specie distribution of assets of
the scheme, shall be made by the venture capital fund at any time, including on
winding up of the scheme, as per the preference of investors, after obtaining
approval of at least 75% of the investors of the scheme.

9.5. INSPECTION AND INVESTIGATION

Board’s right to inspect or investigate.
The Board may suo motu or upon receipt of information or complaint appoints
one or more persons as inspecting or investigating officer to undertake inspection
or investigation of the books of account, records and documents relating to a
venture capital fund.

Notice before inspection or investigation.

Before ordering an inspection or investigation, the Board shall give not less than
ten days notice to the venture capital fund.

9.6. CASE OF DEFAULT

Liability for action in case of default:
Without prejudice to the issue of directions or measure under regulation 29, a
venture capital fund which—
(a) contravenes any of the provisions of the Act or these regulations;
(b) Fails to furnish any information relating to its activity as a venture capital fund
as required by the Board;
(c) Furnishes to the Board information which is false or misleading in any
material particular;
(d) Does not submit periodic returns or reports as required by the Board;
(e) Does not co-operate in any enquiry, inspection or investigation conducted by
the Board;
(f) Fails to resolve the complaints of investors or fails to give a satisfactory reply
to the Board in this behalf;
Shall be dealt with in the manner provided in the Securities and Exchange Board
of India
(Procedure for Holding Enquiry by Enquiry Officer and Imposing Penalty)
Regulations,
2002.

9.6. AMOUNT TO BE PAID AS FEES

Application fee Rs. 1, 00,000
Registration fee Rs. 10, 00,000

9.7. NEGATIVE LIST

(a) Non-banking financial services excluding that NBFC which are registered with
RBI and have been categorized as Equipment Leasing or Hire Purchase
Companies.
(b) Gold financing excluding those Companies which are engaged in gold
financing for jewellery.
(c) Activities not permitted under industrial policy of Government of India.
(d) Any other activity which may be specified by the Board in consultation with
Government of India from time to time.
 X. SEBI REGULATIONS FOR
FOREIGN VCs
10.1. DEFINITIONS:
“Designated bank" means any bank in India which has been permitted by the
Reserve Bank of India to act as banker to the Foreign Venture Capital Investor.

"Domestic custodian" means a person registered under the Securities and

Exchange Board of India (Custodian of Securities) Regulations, 1996.

“Equity linked instruments" includes instruments convertible into equity share

or share warrants, preference shares, debentures compulsorily; or optionally
convertible into equity.

"Foreign venture capital investor" means an investor incorporated and

established outside India, is registered under these Regulations and proposes to
make investment in accordance with these Regulations.

"Investible funds" means the fund committed for investments in India net of
expenditure for administration and management of the fund.

"Venture Capital Fund" means a Fund established in the form of a Trust, a

company including a body corporate and registered under Securities and
Exchange Board of India (Venture Capital Fund) Regulations, 1996, which
(i) Has a dedicated pool of capital;
(ii) Raised in the manner specified under the Regulations; and
(iii) Invests; in accordance with the Regulations.

"Venture capital undertaking" means a domestic company:-

(i) Whose shares are not listed in a recognized stock exchange in India;
(ii) Which is engaged in the business of providing services, production or
manufacture of articles or things, but does not include such activities or sectors
which are specified in the negative list by the Board, with approval of Central
Government, by notification in the Official Gazette in this behalf."

10.2. REGISTRATION OF FOREIGN VENTURE CAPITAL

INVESTORS
Application for grant of certificate: For the purposes of seeking registration
under these regulations, the applicant shall make an application to the Board with
the application fee as specified
Eligibility Criteria:
For the purpose of the grant of a certificate to an applicant as a Foreign Venture
Capital Investor, the Board shall consider the following conditions for eligibility,
namely: -

(a) The applicants track record, professional competence, financial soundness,

experience, general reputation of fairness and integrity.
(b) Whether the applicant has been granted necessary approval by the Reserve
Bank of India for making investments in India;
(c) Whether the applicant is an investment company, investment trust,
investment partnership, pension fund, mutual fund, endowment fund, university
fund, charitable institution or any other entity incorporated outside India; or
(d) Whether the applicant is an asset management company, investment
manager or investment Management Company or any other investment vehicle
incorporated outside India;
(e) Whether the applicant is authorized to invest in venture capital fund or carry
on activity as foreign venture capital investors;
(f) Whether the applicant is regulated by an appropriate foreign regulatory
authority or is an income tax payer; or submits a certificate from its banker of its
or its promoter’s track record where the applicant is neither a regulated entity nor
an income tax payer.
(g) The applicant has not been refused a certificate by the Board.
(h) Whether the applicant is a fit and proper person.

Furnishing of information, clarification

The Board may require the applicant to furnish such further information as it may
consider necessary.

Consideration of application
An application which is not complete in all respects shall be rejected by the
Board:
Provided that, before rejecting any such application, the applicant shall be given
an opportunity to remove, within thirty days of the date of receipt of
communication, the objections indicated by the Board.
Provided further that the Board may, on being satisfied that it is necessary to
extend the period specified above may extend such period not beyond ninety
days.

Procedure for grant of certificate

(a) If the Board is satisfied that the applicant is eligible for the grant of certificate,
it shall send intimation to the applicant.
(b) On receipt of intimation, the applicant shall pay to the Board; the registration
fee.
(c) The Board shall on receipt of the registration fee grant a certificate of
registration.
Procedure where certificate is not granted
(a) On considering an application made if the Board is of the opinion that a
certificate should not be granted, it may reject the application after giving the
applicant a reasonable opportunity of being heard.
(b) The decision of the Board to reject the application shall be communicated to
the applicant.

10.3. INVESTMENT CONDITIONS AND RESTRICTIONS

Investment Criteria for a Foreign Venture Capital Investor
All investments to be made by a foreign venture capital investors shall be subject
to the following conditions: -
(a) It shall disclose to the Board its investment strategy.
(b) It can invest its total funds committed in one venture capital fund.
(c) It shall make investments as enumerated below:
(i) At least 66.67% of the investible funds shall be invested in unlisted equity
shares or equity linked instruments of Venture Capital Undertaking.
(ii) Not more than 33.33% of the investible funds may be invested by way of:
(ii.a) Subscription to initial public offer of a venture capital undertaking whose
shares are proposed to be listed.
(ii.b) Debt or debt instrument of a venture capital undertaking in which the foreign
venture capital investor has already made an investment by way of equity.
(ii.c) Preferential allotment of equity shares of a listed company subject to lock in
period of one year.
(ii.d) The equity shares or equity linked instruments of a financially weak
company or a sick industrial company (a company, which has at the end of the
previous financial year accumulated losses, which has resulted in erosion or
more than 50% but less than 100% of its net worth as at the beginning of the
previous financial year) whose shares are listed.
(ii.e) Special Purpose Vehicles which are created for the purpose of facilitating or
promoting investment in accordance with these Regulations.
(d) It shall disclose the duration of life cycle of the fund.

10.4. GENERAL OBLIGATIONS AND RESPONSIBILITIES

Maintenance of books and records
(a) Every Foreign Venture Capital Investor shall maintain for a period of eight
years, books of accounts, records and documents which shall give a true and fair
picture of the state of affairs of the Foreign Venture Capital Investor.
(b) Every Foreign Venture Capital Investor shall intimate to the Board, in writing,
the place where the books, records and documents are being maintained.

Power to call for information

(a) The Board may at any time call for any information from a Foreign Venture
Capital Investor with respect to any matter relating to its activity as a Foreign
Venture Capital Investor.
(b) Where any information is called for it shall be furnished within the time
specified by the Board.
General Obligations and Responsibilities
(a) Foreign Venture Capital Investor or a global custodian acting on behalf of the
foreign venture capital investor shall enter into an agreement with the domestic
custodian to act as a custodian of securities for Foreign Venture Capital Investor.
(b) Foreign Venture Capital Investor shall ensure that domestic custodian takes
steps for,-
(i) Monitoring of investment of Foreign Venture Capital Investors in India
(ii) Furnishing of periodic reports to the Board
(iii) Furnishing such information as may be called for by the Board.
Appointment of designated bank
Foreign Venture Capital Investor shall appoint a branch of a bank approved by
Reserve Bank of India as designated bank for opening of foreign currency
denominated accounts or special non-resident rupee account.

10.5. INSPECTION AND INVESTIGATIONS

Board's right to inspect or investigate
The Board may, suo-moto or upon receipt of information or complaint, cause an
inspection or investigation to be made in respect of conduct and affairs of any
foreign venture capital investor by an Officer whom the Board considers fit for.
Notice before inspection or investigation
Before ordering an inspection or investigation, the Board shall give not less than
ten days notice to the venture capital fund.

10.6. IN CASE OF DEFAULT

Board's right to suspend or cancel certificate of registration
Without prejudice to the appropriate directions or measures board may after
consideration of the investigation report, initiate action for suspension or
cancellation of the registration of such Foreign Venture Capital Investor:
Provided that no such certificate of registration shall be suspended or cancelled
unless the procedure specified is complied with.

Suspension of certificate
The Board may suspend the certificate where the Foreign Venture Capital
Investor:
(a) Contravenes any of the provisions of the Act or these regulations;
(b) Fails to furnish any information relating to its activity as a Foreign Venture
Capital Investor as required by the Board;
(c) Furnishes to the Board information which is false or misleading in any
material particular;
(d) Does not submit periodic returns or reports as required by the Board;
(e) Does not co-operate in any enquiry or inspection conducted by the Board;
Cancellation of certificate
The Board may cancel the certificate granted to a Foreign Venture Capital
Investor: -
(a) When the Foreign Venture Capital Investor is guilty of fraud or has been
convicted of an offence involving moral turpitude;
Explanation: The expression "fraud" has the same meaning as is assigned to it in
section 17 of the Indian Contract Act, 1872. (9 of 1872)
(b) The Foreign Venture Capital Investor has been guilty of repeated defaults. or
(c) Foreign Venture Capital Investor does not continue to meet the eligibility
criteria laid down in these regulations;
(d) Contravenes any of the provisions of the Act or these regulations.

Action against intermediary

The Board may initiate action for suspension or cancellation of registration of an
intermediary holding a certificate of registration under section 12 of the Act who
fails to exercise due diligence in the performance of its functions or fails to
comply with its obligations under these regulations.
Provided that no such certificate of registration shall be suspended or cancelled
unless the procedure specified in the regulations applicable to such intermediary
is complied with.

Appeal to Securities Appellate Tribunal

Any person aggrieved by an order of the Board under these regulations may
prefer an appeal to the Securities Appellate Tribunal in accordance with section
15T of the Act.

Amount to be paid as fees

Application fee (US$) 5, 000
Registration fee shall be payable at the time of registration
for grant of certificate (US $) 20, 000

10.6. NEGATIVE LIST

(a) Non-banking financial services excluding those Non – Banking Financial
companies which are registered with Reserve Bank of India and have been
categorized as Equipment Leasing or Hire Purchase companies.
(b) Gold financing excluding those companies which are engaged in gold
financing for jewellery.
(c) Activities not permitted under the Industrial Policy of Government of India
(d) Any other activity wshich may be specified by the Board in consultation with
the Government of India from time to time.
TAXATION
In 2002, Under new rules in India, the entire income of registered VC funds,
whether foreign or domestic, is exempt from Indian income tax, subject to
certain conditions. But to take advantage of this tax-exempt status, funds
must register with the regulator, the Securities and Exchange Board of
India.

In late 2000, Sebi issued the Foreign Venture Capital Investor Regulations, 2000.
They apply to foreign venture capital investors (FVCI) incorporated and
established outside India and which propose to invest in India. Until recently,
FVCIs avoided registering themselves with Sebi due to the extremely confusing
regulatory and tax position. FVCIs preferred to operate from overseas, usually
through a liaison office in India. However, this was no longer the case following
the enactment of the Regulations, and also amendment to the Indian Income Tax
Act, 1961 (IT Act).

The clear advantages of registration notwithstanding, there were an argument

that it is mandatory anyway. This view was based on Section 12(1B) of the Sebi
Act, 1992, which provides that no person may sponsor or carry on any venture
capital fund without a certificate of registration from Sebi, in accordance with the
Regulations. Failure to register may amount to a contravention of the provisions
of Section 12(1B) of the Sebi Act, 1992, which can lead to heavy fines.

This view proceeds on the assumption that a distinction must be made between
a non-resident making a foreign direct investment (FDI) and an FVCI. This
distinction is established from the nature of the agreements entered into by a
foreign investor with the Indian investee companies and its promoters, and also
whether the foreign investor otherwise carries on the business of being a venture
capital fund outside India.

This contention was reinforced when India's central bank, the Reserve Bank of
India (RBI), amended the Foreign Exchange Management (Transfer or Issue of
Security by a Person Resident outside India) Regulations, 2000, to specifically
bring within its fold investments by a Sebi-registered FVCI in a domestic, Sebi-
registered venture capital fund or an unlisted Indian company. The effect of the
amendment is that such an investment will no longer be regarded as FDI, but as
a separate category of investment. The advantage of such treatment is that
shares issued by unlisted Indian companies to an FVCI will not be subject to
compliance with the usual price guidelines and the FVCI may acquire or
purchase the shares issued by unlisted Indian companies at a price that is
mutually agreed between the buyer and the seller or issuer.
Advantages of Regisration
The obvious advantage of registration is that, under the IT Act, its income is tax
free. But another advantage is that under the normal FDI rules, all FDI investors
require the central government's prior permission to invest in a similar field to any
of its previous investments or tie ups. In other words, automatic approval is not
allowed and a no-objection certificate of the Indian investee company (with whom
there is an existing tie up) is required. However, Sebi-registered FVCIs are
exempted from this requirement.

There is no minimum capitalization requirement for being registered as an FVCI.

It can invest either in a domestic fund or in a domestic company whose shares
are not listed on a recognized stock exchange in India (it does not matter if its
shares are listed on a stock exchange outside India, such as the NASDAQ or
NYSE) and is not engaged in any activity except real estate, non-banking
financial services or gold financing (a venture capital undertaking). While granting
registration, Sebi will take into account the FVCI's track record, reputation of the
group and financial soundness. While it can invest its total funds even in one
domestic fund, it cannot invest more than 25 per cent of its committed funds in
any one venture capital undertaking (and at least 75 per cent of such
investments must be in equity).

The Regulations require an FVCI to appoint a domestic custodian as well as

open a non-resident rupee or foreign currency account with a designated bank.
Banks are allowed to offer forward cover (for hedging against forex risk) to FVCIs
to the extent of their inward remittance. Registration fees payable to Sebi are
about $11,000.

Taxation of FVCI
Under Section 90(2) of the IT Act, a non-resident assessee based in a country
with which India has a double taxation avoidance agreement (DTAA), may opt to
be taxed either under the IT Act or the DTAA, whichever is more beneficial?

Under Section 10(23FB) of the IT Act, any income of a registered FVCI is exempt
from income tax. The FVCI can carry on business in India through a permanent
establishment in India, and yet its entire income would be tax free. On the other
hand, if the FVCI opts to be taxed under the DTAA and it has a permanent
establishment in India, its Indian income will not be tax free.

The tax exemption under section 10(23FB) has to be read with section 115U of
the IT Act, which confers a pass-through status on Sebi-registered venture funds.
Investors in such funds would be liable to tax in respect of the income received
by them from the FVCI in the same manner as it would have been, had the
investors invested directly in the venture capital undertaking. In other words,
income earned by an FVCI by way of dividend, interest or capital gains, upon
distribution, would continue to retain the same character in the hands of its
investors.

This brings us to a question as to what is the nature of the income derived by an

FVCI from its Indian investments. While dividend declared by an Indian company
is tax free in the hands of any recipient, including an FVCI, the gains, an FVCI
would make upon exit from an Indian investment, was so far regarded as capital
gains. However, the Authority for Advance Ruling on March 7 2001 held that
profits made by a private equity fund or venture capital fund should be taxed as
business profits and not as capital gains.

Are non-resident investors in an FVCI, therefore, liable to pay Indian income tax
on what they receive from the FVCI as business profits, even though the FVCI
itself does not have to pay any tax? Although Section 115 U begins with the
words ‘Notwithstanding anything contained in any other provisions of this Act',
and it would override the normal provisions relating to taxability of individual
items of income, it cannot override Section 90(2) relating to DTAA provisions.
India is a signatory to the Vienna Convention on the Law of Treaties and,
therefore, tax treaties have a special status as compared to domestic tax
legislation and would prevail unless there is an express specific domestic
provision to override the treaty. In the present case, it does not appear to be the
intention of the legislature that Section 115 U should override Section 90(2).

Accordingly, a non-resident investor in an FVCI, who receives dividend from the

FVCI, is entitled to characterize the same as dividend under the DTAA, by opting
to be taxed under the DTAA and not the IT Act. Due to its very recent enactment,
obviously, there is no precedent or case law and, therefore, it is not improbable
that the Indian tax authorities may contend that the investor is not entitled to the
DTAA benefit in view of Section 115 U and is liable to pay tax on business profits
in India. Tax planning structures could be worked out to protect against such an
eventuality, however remote it may be.

Taxing The Carry

Under the Sebi regulations relating to mutual funds, it is mandatory that a mutual
fund must have a separate asset management company (AMC). However, the
Regulations do not make this a mandatory requirement for an FVCI. This
difference is critical from the viewpoint of tax because while the income of an
FVCI is tax free, the income of a domestic AMC is subject to 35.7 per cent tax in
India (48 per cent for a foreign AMC). It is not advisable for an offshore AMC to
render services to an FVCI by deploying its personnel to India for carrying out
various activities such as validation of business plans, due diligence, etc, as the
Indian tax authorities may contend that such AMC is deemed to have a
permanent establishment in India and liable to be taxed in India on such part of
the ‘carry' as is attributable to its operations in India.

Structuring FVCI’s
On account of its favorable DTAA with India, Mauritius has become a favorite
jurisdiction for investing into India. An obvious question arises. If the FVCI is to
avail of the total tax exemption under Section 10(23FB), why does it require to be
incorporated in Mauritius or any other country with which India has a favorable
DTAA? The answer is, that having regard to the legislative fickleness with which
the IT Act is amended annually, even if the tax exemption provisions contained in
Section 10(23FB) are withdrawn, the FVCI could then rely upon the provisions of
the DTAA, so that its income continues to be tax free. So, there is dual
protection. Of course, in such an event, the FVCI cannot have a permanent
establishment in India.

The FVCI can be incorporated as a Mauritius offshore company and will be a tax
resident of Mauritius. This process is quick and user friendly. The second step is
to register with Sebi as an FVCI. If the FVCI intends to have a place of business
in India, under the Foreign Exchange Management (Establishment in India of
Branch or Office or other place of Business) Regulations, 2000, it will require RBI
approval.

Before investing in a venture capital undertaking, the FVCI will have to apply to
RBI, through Sebi, for permission. Given the manner in which these Regulations
are drafted, it appears that the FVCI may have to obtain such permission on a
case-by-case basis, every time it makes an investment. However, in practice,
RBI may grant a general or blanket permission as in the case of foreign
institutional investors.

Conclusion
As is evident from the above analysis, there are still a couple of grey areas which
require tax planning for FVCI and their investors. While Sebi efficiently handles
registration, formal permissions under Exchange Control Laws are still required.
However, the entire process of setting up an FVCI is much simpler now and can
be completed in as little as 90 days. The total tax exemption makes these
investments very attractive indeed.

Investment through a Venture Capital Fund

A venture capital fund, which registers in accordance with the Securities and
Exchange Board of India (“SEBI”) guidelines and complies with specified
investment restrictions will receive pass through tax benefits on certain types of
investments (no capital gains or withholding tax on dividends).
The investments that qualify for pass through benefits are:
Biotechnology
Information technology relating to hardware and software development
Nanotechnology
Seed research and development
Research and development of new chemical entities in the pharmaceutical sector
Dairy industry
Poultry industry
Production of bio fuels
Hotels/convention centers of a certain description and size

Other than investment, the permitted activities of a fund, however, are limited. No
services such as incubation services may be provided. A separate entity would be needed
in order to provide such services. There may also be restrictions on where the fund can
raise money. There are two additional advantages of investment through a SEBI
registered fund. Upon an IPO in India, all shares held pre-IPO are locked up for one year.
This lock up requirement does not apply to shares held by SEBI registered VC funds
provided such shares have been held for at least one year prior to the IPO. Secondly,
there is a proposal to treat nominee directors of SEBI registered funds as independent
directors under the corporate governance guidelines for listed companies which could
help in complying with the guidelines.

Investment through Mauritius

Presently, in India there is no capital gains tax on sales of shares of an Indian
company held over one year and sold through a stock exchange and an 11.33%
capital gains tax on such sales if the shares in an Indian company are held for
less than a year. Sales of shares in a private company, i.e., a company not listed
on a stock exchange, are taxed at a 22.66% rate for shares held for more than a
year and at 33.99% for shares held for less than a year. The Mauritius approach
to investing in India, detailed below, is therefore most advantageous when the
Indian company is the primary exit vehicle for investor liquidity and such exit is a
sale when the company is private. The benefit of the capital gains tax exemption
would not apply if the Mauritius company is formed with the objective of trading in
securities, as opposed to long term investment in operating companies. Thanks
to the India-Mauritius tax treaty (the “Treaty”) the India tax on sales of shares of
an Indian company can be avoided if the seller is a Mauritius company so long as
the Mauritius Company does not have a “permanent establishment” in India. In
other words, there is no Indian tax on sales of shares in an Indian company by a
Mauritius company that does not have a permanent establishment in India
regardless of whether the shares are of a company listed on a stock exchange or
of a private company and regardless of the holding period. Otherwise, the
proceeds of a sale of shares in an Indian company are taxed in India unless the
shares are sold through a stock exchange and have been held for at least one
year. While there is a lower tax rate on dividends for Mauritius tax residents
under the Treaty, corporate dividends declared by an Indian company are
presently not taxed in the hands of the recipient upon payment in India of a
dividend tax (presently 17%) by the Indian company that declares the dividend.
Under the Mauritius approach, a Global Business Company Category 1 (formerly
known as an Offshore Company), regulated by the Mauritius Financial Services
Development Act 2001, is formed to make the investment(s). Certain
requirements must be met in order to receive a Mauritius tax residency certificate
for purposes of the Treaty including:

• Two local directors approved by the Mauritius Financial Services

Commission
• Bank account in Mauritius; and
• Compliance with Mauritius corporate formalities.

The tax residency certificate is sufficient evidence for India tax authorities to
accept the status of Mauritius tax residence according to Union of India vs. Azadi
Bachao Andolan, 2003 SOL 619.
The Indian government is advocating changes in the Treaty which would reduce
the tax benefits of using Mauritius. As of February 2007, Mauritius has agreed to
have tax residency certificates be effective for only one year at a time and to
impose new undertakings as a condition for issuing a certificate

• Two directors resident in Mauritius at all times;

• Resident directors of “appropriate caliber” who can exercise independence
of mind and judgment;
• All meetings of the Board held, chaired and minuted in Mauritius
• All accounting records kept at the company’s registered office in Mauritius
at all times
• fenwick & west 2007 update to structuring venture capital and other
investments in India
• All of a company’s banking transactions channeled through a bank
account in Mauritius.

A U.S. investor should not underestimate the legal and operating requirements of
the Mauritius structure. For example, funds to be invested in or loaned to the
India subsidiary should be wired first to the Mauritius company prior to
investment in India as opposed to a wire transfer of funds directly from the U.S.
investor to the India company. A wire transfer directly from the U.S. to India is an
investment in the India company by the U.S. company not the Mauritius
company. The Board of Directors of the Mauritius company should approve the
investment and funds should be wired to the Indian company from the Mauritius
company. All such actions take time and documentation in order to comply with
corporate governance requirements.

Business income of any non-Indian company is taxed in India if such non-Indian

company has a “permanent establishment” in India which generates such
income. This result obtains regardless of where the non-Indian company is
formed, i.e., Mauritius, Cyprus, Singapore or the United States.

Having an India subsidiary is a necessary but not sufficient condition for a

Mauritius company (as well as any other non-Indian company) to avoid
permanent establishment status. If a Mauritius company is deemed to have a
permanent establishment in India and its activities are determined to be the
business of trading in securities within India ( on the basis of guidelnes put forth
in circular 4 of 2007), then the profits arising from the sale of such “stock –in –
trade” will be treated as business income in India (not as capital gains).

There are several recent tax rulings that need to be considered in avoiding
permanent establishment status. Under Rulings 442 and 566 of the India Tax
Authority for Advance Rulings (“AAR”), activities such as the Mauritius company
engaging an Indian firm for providing custodial services for securities or being an
investment adviser that has no decision making authority will not by themselves
constitute having a permanent establishment in India. Investment decisions must,
however, be made outside of India.

In addition, the effective management of the Mauritius company must not be

carried out in India. Whether the effective management of a company is in India
or Mauritius or elsewhere is a question of fact. If there is no permanent
establishment in India, business income on the sale of the securities of India
investments by the Mauritius company is not taxable in India. An Indian
subsidiary that provides only backend fulfillment services for the U.S. parent
usually will not cause the U.S. parent to be deemed to have a permanent
establishment in India. The Indian subsidiary’s activities may, however,
sometimes cause the parent to have a permanent establishment in India. For
example, if the India subsidiary exercises authority to conclude contracts, secure
orders or deliver goods on behalf of the parent. The implication of the India
subsidiary being treated as a permanent establishment of the parent is that it
causes the global income of the parent derived from the activity in India to be
taxed in India, and not merely the amount billed by the subsidiary for services
rendered to parent.

In the case of Morgan Stanley & Co v. DIT, the AAR examined whether a U.S.
company had a permanent establishment in India under the Treaty based on (1)
outsourcing certain services to its subsidiary in India and (2) deputation of
personnel to the subsidiary. The personnel deputed to India were engaged either
for providing stewardship services to the Indian company or to work under the
control of the Indian company. The AAR held that the outsourcing activity by the
U.S. company to its subsidiary did not result in the parent having a permanent
establishment in India. The AAR, however, held that the deputation arrangement
in India would result in a permanent establishment of the parent. Therefore, the
income deemed to have been derived by the U.S. company from the deputation
activity in India would be taxable in India. Until March 31, 2009, income arising
from export revenues from software and BPO activities rendered from a
“Software Technology Park Unit,” is liable to be taxed only at the minimum
alternative tax rate of 11.33% instead of the normal corporate tax rate of 33.99%
provided the transactions between parent and subsidiary are at arms length
prices. It is not clear whether this benefit will be extended beyond March 31,
2009.

Investment through cyprus

Another alternative would be to route investment into India through Cyprus rather
than through Mauritius. India and Cyprus are also parties to a tax treaty. The tax
treatment for capital gains
from the sale of shares in an Indian company held by a Cyprus holding company
is the same as through Mauritius so long as the Cyprus company does not have
a “permanent establishment” in India. There is no capital gains tax in either India
or Cyprus on the sale of the shares.
Cyprus has a slight economic advantage over Mauritius when an investment is
by way of a mix of equity and debt.

The interest payable to the Cyprus company is subject to a withholding tax of

10% instead of the normal rate of 20% for interest paid out of India. The
withholding tax in India on interest payable to a Mauritius company is 15% so
there is a slight economic advantage to using Cyprus if there is a major debt
component of the investment. The disadvantage of using a Cyprus holding
company is there is less precedent on the requirements for tax residency. A
Cyprus company will be deemed to be a tax resident only if its management and
control is in Cyprus. Companies managed and controlled from outside of Cyprus
do not receive any benefits under the Cyprus-India tax treaty. Whether the
effective management of a company is in India or Cyprus or elsewhere is a
question of fact.

Investment through singapore

As with Mauritius and Cyprus, the primary benefit under the India-Singapore
Double Taxation Agreement (the “Agreement”); which became effective on
August 1, 2005, is no capital gains tax in either India or Singapore on the sale of
the shares of the Indian company by a Singapore company so long as the
Singapore company does not have a “permanent establishment” in India.

The requirements for Singapore tax residency are much greater than in Mauritius
or Cyprus. The Singapore company must satisfy expenditure requirements and
likely have sustainable and continuous business operations in Singapore. Annual
expenditures on operations in Singapore must be at least $200,000 (SGD) in the
24 months immediately prior to when the gains are realized.

Impact of new budget on VC funds

First on the pass through benefits: The Finance Bill, 2007 proposes to restrict the
pass through status for Venture Capital Funds ("VCFs")/Venture Capital
Companies ("VCCs") to only income from investment in domestic unlisted
company engaged in certain specified businesses such as IT, bio-tech etc
("VCU").

Currently, VCFs/ VCCs enjoy complete pass-through status under Section

10(23FB), irrespective of nature of income. Instead, the income is taxed in the
hands of its investors at the time of distribution under Section 115U, on a pass-
through basis.

The proposed amendment raises several issues in respect of income of VCF

from non-VCUs.
Firstly, being in the nature of a Trust vehicle, the taxation of VCFs would now be
guided by the complex principles relating to trust taxation. Whilst this taxation
regime for Trusts also aims at one-level taxation, the implications could be
manifold ranging from complex trust taxation provisions, issues relating to
characterization as business income or capital gains, taxation on accrual basis
rather than on distribution to investors, tax implications for foreign investor in
VCF (availability of treaty benefit), etc.
Further, in case of VCCs, the proposed amendment would result in two levels of
taxation - i.e. tax in the hands of VCC and on distribution of income to the
investors. It is also doubtful as to whether the DDT provisions would apply to
VCCs having mixed investments.
Also, the existing non-VCU investments that have already been made by VCFs
would be governed by the proposed provisions. It would be unjust to subject
these investments to the proposed regime considering that the investments were
made based on the complete pass-through status which was made available to
VCFs.

To conclude, with the proposed amendment, the Government has discouraged

venture capital from making long term investments in India in key sectors such as
Infrastructure/ real estate development.
XI. VALUATIONS
11.1. What Does A Venture Capiltalist Look In For A
Business?
Venture capitalists are high-risk investors and, in accepting these risks, they
desire a higher return on their investment. The venture capitalist manages the
risk -return ratio by only investing in businesses that fit their investment criteria
and after having completed extensive due diligence.

Venture capitalists have differing operating approaches. These differences may

relate to the location of the business, the size of the investment, the stage of the
company, industry specialization, structure of the investment and involvement of
the venture capitalists in the company's activities. The entrepreneur should not
be discouraged if one venture capitalist does not wish to proceed with an
investment in the company. The rejection may not be a reflection of the quality of
the business, but rather a matter of the business not fitting with the venture
capitalist's particular investment criteria.

Venture capital is not suitable for all businesses, as a venture . capitalist typically
seeks:
 Superior businesses Venture capitalists look for companies with superior
products or services targeted at fast-growing or untapped markets with a
defensible strategic position. Alternatively, for leveraged management
buyouts, they are seeking companies with high borrowing capacity, stability
of earnings and an ability to generate surplus cash to quickly repay debt.

 Quality and depth of management Venture capitalists must be confident

that the firm has the quality and depth in the management team to achieve .its
aspirations. Venture capitalists seldom seek managerial control; rather, they
want to add value to the investment where they have particular skills including
fundraising, mergers and acquisitions. international marketing and networks.

 Corporate governance and structure In many ways the introduction of a

venture capitalist is preparatory to a public listing. The venture capitalist will
want to ensure that the investee company has the willingness to adopt
modem corporate governance standards, such as non-executive directors,
including a representative of the venture capitalist. Venture capitalists are put
off by complex corporate structures without a clear ownership and where
personal and business assets are merged.

 Appropriate investment structure As well as the requirement of being an

attractive business opportunity, the venture capitalist will also be seeking to
 structure a satisfactory deal ___ to_produce the anticipated [mancial returns
to ~vestors.

 Exit plan Lastly, venture capitalists look for clear exit routes for their
investment such as public listing or a third¬party acquisition of the investee
company.

11.2. The Process Of Venture Capital Financing

The venture capital investment process has variances/features that are context
specific and vary from industry, timing and region. However, activities in a
venture capital fund follow a typical sequence. The typical stages in an
investment cycle are as below:
1. Generating a Deal Flow
2. Initial Evaluation: This involves the initial process of assessing the feasibility
of the project.
3. Due diligence: In this stage an in-depth study is conducted to analyze the
feasibility of the project.
4. Investment valuation
5. Deal structuring and negotiation: Having established the feasibility, the
instruments that give the required return are structured.
6. Documentation: This is the process of creating and executing legal
documents to protect the interest of the venture.
7. Monitoring and Value addition: In this stage, the project is monitored by
executives from the venture fund and undesirable variations from the
business plan are dealt with.
8. Exit: This is the final stage where the venture capitalist devises a method to
come out of the project profitably.

Origination of deal
A continuous flow of deal is essential for the venture capital business. Deals may
originate in various ways: (i) referral system, (ii) active search and (iii)
intermediaries. Referral system is an important source of deals. Deals may be
referred to VCFs by their parent organisations, trade partners, industry
associations, friends etc. Yet another important source of deal flow is the active
search through networks, trade fairs, conferences, seminars, foreign visits etc. A
third source, used by venture capitalists in developed countries like USA, is
certain intermediaries who match VCFs and the potential 'entrepreneurs.

Screening – Analyzing business plans and selecting the opportunities

Venture capital is a service industry, and VCFs generally operate with a small
staff. In order to save on time and to select the best ventures, before going for an
in-dept analysis, VCFs carry out initial screening of all projects on the basis of
some broad criteria. For example, the screening process may limit projects to
areas in which the venture capitalist is familiar in terms of, technology, or
product, or market scope.
Thus, an initial screening is carried out to satisfy the venture capitalist of certain
aspects of the project. These include
 Competitive aspects of the product or service
 Outlook of the target market and their perception of the new product
 Abilities of the management team
 Availability of other sources of funding
 Expected returns
 Time and resources required from the venture capital firm
 size of investment
 geographical location
 stage of financing

Through this screening the venture firm builds an initial overview about the
 Technical skills, experience, business sense, temperament and ethics of the
promoters
 The stage of the technology being used, the drivers of the technology and the
direction in which it is moving
 Location and size of market and market development costs, driving forces of
the market, competitors and share, distribution channels and other market
related issues
 Financial facts of the deal
 Competitive edge available to the company and factors affecting it
significantly
 Advantages from the deal for the venture capitalist
 Exit options available

Due Diligence
Once a proposal has passed through initial screening, it is subjected to a detailed
evaluation or due diligence process. Most ventures are new and the
entrepreneurs may lack operating experience. Hence, a sophisticated, formal
evaluation is neither possible nor desirable. The venture capitalists, thus, may
rely on a subjective, but comprehensive, evaluation. They evaluate the quality of
entrepreneur before appraising the characteristics of the product, market or
technology. Most venture capitalists ask for a business plan to make an
assessment of the possible risk and return on the venture. Business plan
contains detailed information about the proposed venture.

Areas of due diligence would include

• General Assessment
• Business plan analysis
• Contract details
• Collaborators
• Corporate objectives
• SWOT analysis
• Time scale of implementation
• People
• Managerial abilities, past performance and credibility of promoters
• Financial background and feedback about
promoters from bankers and previous lenders
• Details of Board of Directors and their role in
the activities
• Availability of skilled labor
• Recruitment process
• Products/services, technology and process
Here the research depends upon the nature of the industry into which the
company is planning to enter. Some of the areas generally considered are
Technical details, manufacturing process and patent rights
Competing technologies and comparisons
• Raw materials to be used, their
availability and major suppliers, reliability of these suppliers
• Machinery to be used and its
availability
• Details of various tests conducted
regarding the new product
• Product life cycle
• Environment and pollution related
issues
• Secondary data collection on the
product and technology, if so available
• Potential entrants and barriers to
entry
• Supplier and buyer bargaining
power
• Channels of distribution
• Marketing plan to be
followeduture sales forecasts
• Market Main customers Future
demand for the product
• Competitors in the market for the
same product category and their strategy
Pricing strategy
Finance
 Financial forecasts for the next 3-5 years
 Analysis of financial reports and balance sheets of firms already promoted or
run by the promoters of the new venture
 Cost of production
 Wage structure details
 Accounting process to be used
 Financial report of critical suppliers
 Returns for the next 3-5 years and thereby the returns to the venture fund
 Budgeting methods to be adopted and budgetary control systems
 External financial audit if required

Sometimes, companies may have experienced operational problems during their

early stages of growth or due to bad management. These could result in losses
or cash flow drains on the company. Sometimes financing from venture capital
may end up being used to finance these losses. They avoid this through due
diligence and scrutiny of the business plan.

A venture capitalist tries to maximize the upside potential of any project. He tries
to structure his investment in such a manner that he can get the benefit of the
upside potential ie he would like to exit at a time when he can get maximum
return on his investment in the project. Hence his due diligence appraisal has to
keep this fact in mind.

The evaluation of ventures by VCFs in India includes the following steps:

• Preliminary evaluation The applicant is required to provide a brief profile of

the proposed venture to establish prima facie eligibility. Promoters are also
encouraged to have a face-to-face discussion to clarify issues.

• Detailed evaluation Once the project has crossed the qualifying hurdle
through initial evaluation, the proposal is evaluated in greater detail. A lot of
stress is placed on techno-economic evaluation. Most of the VCFs involve
experts for the technical appraisal, whenever necessary. The venture
evaluation in India, after receipt of the business plan, starts with a detailed
evaluation of the entrepreneur's background. VCFs in India expect the
entrepreneur to have:
 integrity
 long-term vision
 urge to grow
 managerial skills
 commercial orientation.

11.3. INVESTMENT VALUATION

How do VC’S value businesses:
The investment valuation process is an exercise aimed at arriving at ‘an
acceptable price’ for the deal

Some of the methods used by VC’S to value a business are:

• Discounted cash flow method ( DCF)
• Price/ earnings method ( PE )
• Price/ book value method ( PBV )

11.4 DISCOUNTED CASHFLOW METHOD

It basically includes the following:
Net Present Value Method
The net present value (NPV) method is the classic economic method of
evaluating the investment proposals. It is a DCF technique that explicitly
recognises the time value of money. It correctly postulates that cash flows arising
at different time periods differ in value and are comparable only when their
equivalents--present values--are found out.

The following steps are involved in the calculation of NPV:

• Cash flows of the investment project should be forecasted based on

realistic assumptions.
• Appropriate discount rate should be identified to discount the forecasted
cash flows. The appropriate discount rate is the project's opportunity cost of
capital, which is equal to the required rate of return expected by investors on
investments of equivalent risk.
• Present value of cash flows should be calculated using the opportunity
cost of capital as the discount rate.
• Net present value should be found out by subtracting present value of
cash outflows from present value of cash inflows. The project should be
accepted if NPV is positive (i.e., NPV > 0).

Evaluation of the NPV Method

NPV is the true measure of an investment's profitability. It provides the most
acceptable investment rule for the following reasons:
• Time value It recognizes the time value of money-a rupee received today
is worth more than a rupee received tomorrow.
• Measure of true profitability It uses all cash flows occurring over the
entire life of the project in calculating its worth. Hence, it is a measure of the
project's true profitability. The NPV method relies on estimated cash flows
and the discount rate rather than any arbitrary assumptions, or subjective
considerations.
• Value-additivity The discounting process facilitates measuring cash flows
in terms of present values; that is, in terms of equivalent, current rupees.
Therefore, the NPV s of projects can be added. For example, NPV (A + B)
=NPV (A) + NPV (B). This is called the value-additivity principle. It implies that
if the NPVs of individual projects are known, the value of the firm will increase
by the sum of their NPV s. Also if the values of individual assets are known,
the firm's value can simply be found by adding their values. The value-
additivity is an important property of an investment criterion because it means
that each project can be evaluated, independent of others, on its own merit.
 • Shareholder value The NPV method is always consistent with the
objective of the shareholder value maximization. This is the greatest virtue of
the method.
• Cash flow estimation The NPV method is easy to use if forecasted cash
flows are known. In practice, it is quite difficult to obtain the estimates of cash
flows due to uncertainty.
• Discount rate It is also difficult in practice to precisely measure the
discount rate.
• Mutually exclusive projects When alternative (mutually exclusive)
projects with unequal lives, or under funds constraint are evaluated the NPV
method need to be used cautiously. The NPV rule may not give unambiguous
results in these situations.
• Ranking of projects The ranking of investment projects as per the NPV
rule is not independent of the discount rates. 1 Let us consider an example.

Suppose two projects-A and B-both costing Rs 50 each.

Project A returns Rs 100 after one year and Rs 25 after two years. On the other
hand, Project B returns Rs 30 after one year and Rs 100 after two years. At
discount rates of 5 per cent and 10 per cent, the NPV of projects and their
ranking are as follows:

NPV at 5 % Rank NPV at 10% Rank

Project A 67.92 II 61.57 I
Project B 69.27 I 59.91 II

It can be seen that the project ranking is reversed when the discount rate is
changed from 5 per cent to 10 per cent. The reason lies in the cash flow patterns.
The impact of the discounting becomes more severe for the cash flow occurring
later in the life of the project; the higher is the discount rate, the higher would be
the discounting impact. In the case of Project B, the larger cash flows come later
in the life. Their present value will decline as the discount rate increases.

Internal Rate Of Return Method

The internal rate of return (IRR) method is another discounted cash flow
technique, which takes account of the magnitude and timing of cash flows. Other
terms used to describe the IRR method are yield on an investment, marginal
efficiency of capital, rate of return over cost, time-adjusted rate of internal return .

Evaluation of IRR Method

IRR method is .like the NPV method. It is a popular investment criterion since it
measures profitability as a percentage and can be easily compared with the
opportunity cost of capital.

IRR method has following merits:

• Time value The IRR method recognizes the time value of money.
 • Profitability measure It considers all cash flows occurring over the entire
life of the project to calculate its rate of return.
• Acceptance rule It generally gives the same acceptance rule as the NPV
method.
• Shareholder value It is consistent with the shareholders' wealth
maximization objective. Whenever a project's IRR is greater than the
opportunity cost of capital, the shareholders' wealth will be enhanced.

Like the NPV method, the IRR method is also theoretically a sound investment
evaluation criterion. However, IRR rule can give misleading and inconsistent
results under certain circumstances.

Some of the problems of the IRR method:

• Multiple rates A project may have multiple rates, or it may not have a
unique rate of return. These problems arise because of the mathematics of
IRR computation.
• Mutually exclusive projects It may also fail to indicate a correct choice
between mutually exclusive projects under certain situations.
• Value additivity unlike in the case of the NPV method, the value additivity
principle does not hold when the IRR method is used-IRRs of projects do not
add. 1 Thus, for Projects A and B, IRR(A) + IRR(B) need not be equal to IRR
(A + B). Consider an example given below.

The NPV and IRR of Projects A and B are given below:

Co C1 NPV@lO% IRR
Project
(Rs) (Rs) (Rs) (%)
A -100 +120 +9.1 20.0
B -150 +168 +2.7 12.0
A+B -250 +288 +11.8 15.2

It can be seen from the example that NPVs of projects add:

NPV(A) + NPV(B) = NPV(A + B) = 9.1 + 2.7 = 11.8, while
IRR(A) + IRR(B) * IRR(A + B) = 20%+ 12%* 15.2%

Profitability Index
Another time-adjusted method of evaluating the investment proposals is the
benefit-cost (B/e) ratio or profitability index (PI). Profitability index is the ratio of
the present value of cash inflows, at the required rate of return, to the initial cash
outflow of the investment The formula for calculating benefit-cost ratio or
profitability index is as follows:
 N
PV of cash PV(Cr) ∑ Cr
PI= inflows = = r +C0 (5)
r
Initial cash =1 (1+k)
outlay

Acceptance Rule
The following are the PI acceptance rules:
• Accept the project when PI is greater than one PI > 1
• Reject the project when PI is less than one. PI < 1
• May accept the project when PI is equal to one PI = 1

The project with positive NPV will have PI greater than one.
PI less than means that the project's NPV is negative.

Evaluation of PI Method
Like the NPV and IRR rules, PI is a conceptually sound method of appraising
investment, it projects. It is a variation of the NPV method, and requires the same
computations as the NPV method.

• Time value It recognises the time value of money.

• Value maximisation It is consistent with the shareholder value
maximisation principle. A project with PI greater than one will have positive
NPV and if accepted, it will increase share-holders' wealth.
• Relative profitability In the PI method, since the present value of cash
inflows is divided by the initial cash outflow, it is a relative measure of a
project's profitability.

Like NPV method, PI criterion also requires calculation of cash flows and
estimate of the discount rate. However, in practice, estimation of cash flows and
discount rate pose problems.

Price/ Earnings Method

The price / earnings (PE) multiple or ratio is the most widely used and misused of
all multiples. Its simplicity makes it an attractive choice in applications ranging
from pricing initial public offerings to making judgments on relative value, but its
relationship to firms, financial fundamentals is often ignored, leading to significant
errors and applications.

The use and misuse of PE ratios:

There are number of reasons PE ratio is used so widely in valuation.

• First, it is an initiatively appealing statistic that
relates the price paid to current earnings.
 • Second, it is simple to compute for more stocks
and is widely available making comparisons across stocks simple
• Third it can be a proxy for a number of other
characteristics of the firm including risk and growth

While there are good reasons for using PE ratios, there is wide potential for
misuse.

• One reason given for using PE ratio is that it

eliminates the need to make assumptions about the risk, growth, paid out
ratios, all of which have to be estimated for discounted cash flow valuation.
This is disingenuous, because PE ratio is ultimately determined by the very
same parameters that determine value in discounted cash flow models. Thus,
the use of PE ratios is a way, for some analyst, to avoid having to be explicit
about their assumptions on their risk, growth, and payout ratios. This maybe
convenient, but it is certainly not a legitimate for using PE ratios.
• Another reason for using the PR ratios of
comparable firm is that there are much more likely to reflect market, moods
and perceptions. Thus, investors are upbeat about retail stocks, the PE ratios
of these stocks will be higher to reflect this optimism.. Again, this can be a
weakness, especially when market makes systematic errors in valuing entire
sectors.

Determination of the PE ratios:

Payout ratio during the high growth and stable periods: PE ratio increases as the
payout ratio increases

Riskiness; the PE ratio becomes lower as riskiness increases

Expected growth rate in earnings in other the high growth and stable periods: the
PE ratio increases as the growth rate increase, in either period.

Problem with PE ratios

There are general problems associated with the estimation of PE ratios that
makes its use troublesome. First, PE ratios are not meaningful when the earning
per share is negative. While, this can be partially overcome by using normalized
or average earnings per share, the problem cannot be eliminated.

Second, the volatility of earnings can cause the PE ratio to change dramatically
from period to period. For cyclical firms, earnings will follow the economy,
whereas the prices reflect expectation about the future. Thus, it is not uncommon
for the PE ratio of a cyclical firm to peak at the depths of a recession and bottom
out at the peak of an economic boom.
Conclusion:
The PE ratio and the other earnings multiples which are widely used in
valuations, have the potential to be misused. These multiples are ultimately
determined by the same fundamentals that determine discounted cash flow value
- expected growth, risk, and payout ratios to the extent that there are differences
in fundamentals across countries, across time and across companies, the
multiples will also be different. A failure to control for these differences in
fundamentals can lead to erroneous conclusions based purely upon a direct
comparison of multiples.

Price/ Book Value Multiples

General issues in estimating and using pbv ratios:

The book value of equity is the difference between the book value of assets and
the book value of liabilities. The measurement of the book value of assets is
largely determined by accounting convention.

Book value versus market value:

The market value of an asset reflects its earning power and expected cashflows.
Since the book value of an asset reflects it’s original cost, it might deviate
significantly from the from the market value if the earning power of the asset has
increased or declined significantly since its acquisition.

Advantages of using PBV ratios:

There are several reasons why investors find the price/ book value ratio useful in
investment analysis.
The first is that book value provides a relatively stable, intuitive measure of value
which can be compared to the market price. For investors who instinctively
mistrust discounted cashflow estimates of value, it is a much simpler benchmark
for comparison.
The second is that, given reasonably consistent accounting standards across
firms, PBV ratios can be compared across similar firms for signs of under – or
overvaluation.
The third is that, even firms with negative earnings, which cannot be valued using
price/ earnings ratios, can be evaluated using PBV ratios.

Disadvantages of using PBV ratios:

There are several disadvantages associated with measuring and using price/
book value ratios.
First, book values are affected by accounting decisions on depreciation and other
variables. When accounting standards vary widely across firms, the PBV ratios
may not be comparable across firms.
Second, book value may not carry much meaning for service firms that do not
have significant fixes assets as compared to other firms.
Third, the book value of on equity can become negative if a firm has a sustained
string of negative earnings reports, leading to negative PBV ratios.

Determination of PBV ratios:

• Return on equity: earning per share / book
value per share.
• The PBV ratio is an increasing function on the
return on equity.
• Payout ratio in both the high growth and stable
growth periods:
• The PBV ratio increases as the payout ratio
increases.
• Riskiness ( through the discounting rate r) :
• The PBV ratio becomes lower as the riskiness
increases.
• Growth rate in earnings, in both the high
growth and stable growth periods:
• The PBV ratio increases as the groth rate
increases, in either period.

Conclusion:
The relationship between price and book value is much more complex. The PBV
ratio of a firm is determined by its expected payout ratio, its expected growth rate
in earnings, and its riskiness.

The most important determinant, however, is the return on equity earned by the
firm – higher returns lead to higher PBV ratios and lower returns lead to lower
PBV ratios.

The mismatch that should draw investor attention is the one between return on
equity and PBV ratios – high PBV ratios with low returns on equity are
overvalued and low PBV ratios with high returns on equity are undervalued.

11.5. Valuation A Call On Three Factors

• Growth
• Risk
• Management quality
1. GROWTH:
Valuation of any business largely depends on the growth prospects of the
company.
• How much is the growth of the company
• How sustainable is the growth of the company
• For long is the growth evaluated

2. RISK
Risk is also one of the important factors to value the business of an entrepreneur.
The various aspects to be looked for are
• The external and the internal risk that is the price risk .
• The manageable and non-managable risk.
• The mitigatin factors that is the brand and distribution risk.

3. MANAGEMENT QUALITY
Management quality is also to be evaluated properly before valuing a business.
The important factors to be considered in evaluating management quality are
• the reputation of the management
• the competence of the management
• the vision of the company
• the corporate governance of the management

11.6. Reasons Why VC’s Won’t Fund A Business Plan

1. Untested product with insufficient demand - Just b’cos your friends think it is
brilliant does not make it so!
2. Faulty or inconsistent ACCESS TO SUPPLY for product creation (People -
Management Team)
3. Faulty or inconsistent MARKET ACCESS for product (distribution, sales and
marketing don’t just happen)
4. Insufficient capital (5-10% should already have been raised)
5. Inexperienced or unskilled management
6. Bad organizational structure
7. Lack of necessary infrastructure

11.7. Deal structuring

Once the venture has been evaluated as viable, the venture capitalist and the
venture company negotiate the terms of the deal, viz, the amount, form and the
price of the investment. This process is termed as deal structuring.
The agreement also includes the protective covenants and earn – out
agreements.
Covenants include the venture capitalist’s right to control the venture company
and to change its management if needed, buyback arrangements, acquisition,
making initial public offerings, etc.
Earned out agreements specify the entrepreneur’s equity share and objective to
be achieved.

Venture capitalists generally negotiate deals to ensure protection of their

interests. They would like a deal to provide for a return commensurate with the
risk, influence over the firm through broad membership, minimum taxes,
investment liquidity, right to replace management in case of poor managerial
performance, etc.

The venture companies like deal to be structured in such a way that their interest
are protected. They would like to earn reasonable returns, minimize taxes, have
enough liquidity to operate their businesses and remain in commanding position
of their businesses.

There are number of common concerns shared by both the venture capitalist and
the venture companies. They should be flexible, and have a structure that
protects their interest and provides enough incentives to both to co – operate
with each other.

Post – investment activities

Once the deal has been structured and agreement finalized, the venture
capitalist generally assumes the role of a partner and collaborator. He also gets
involved in shaping the direction of the venture. This may be done via a formal
representation on the board of directors, or informal influence in improving the
quality of marketing, finance and other managerial qualities. The degree of the
venture capitalist’s involvement depends on this policy. It may not, however, be
desirable for a venture capitalist to get involved in the day – to – day operations
of the venture. If a financial or managerial crisis occurs, the venture capitalist
may intervene, and even install a new management team.
 XII. FINANCIAL INSTRUMENTS
USED BY VCs
All the Venture Capital firms invest in shares, either Equity or Preference and
sometimes both of the Investee Companies.
The following methods of financing are being used by Venture Capital Funds

12.1. Equity Shares

When Venture Capitalists (VC’s), invest in Equity Shares of Investee Company,
they expect that the sustained growth of the venture financed will lead to the
growth of the value of the investee companies and its shares

Preference Shares
 Redeemable Preference Shares
These shares are redeemed as Preference shares when the Venture has
been established, providing an easy exit

 Convertible Preference Shares

These are converted to common Equity on a later date enabling the VC to
earn Capital Gain
 Debt
 Convertible Debt
1. Debenture
This can be in the form of tradable debt that is later converted into Equity
2. Convertible Loan
This can be in the form of Non Tradable Debt that is later converted into
Equity

 Non Convertible Debt

1. Conventional Loan
This is a loan that carries a fixed rate of Interest and a pre-determined
payment schedule

2. Conditional Loan
It is a Quasi Equity Instrument, which does not carry a fixed rate of interest
or a pre determined repayment schedule but is liquidated by payment of
Royalty on sales. It is akin to Equity in the sense that the returns to the
financer are performance based. The Royalty is payable only if the
Venture succeeds and the investee company makes Sale

3. Income Notes
This is a type of loan that carries a flexible nominal interest. The
repayment of the principal is specified over a period besides there is a
Royalty on Sales

4. Non Convertible Debentures

These are pure Debt instruments with a Fixed Interest Rate and
Repayment Schedule but are in the form of tradable security

Off late, VC’s have started using a variety of innovative Quasi Equity
Instruments. The important ones are as follows:

1. Optionally Convertible Debentures

Based on the Performance around third year of operation, the VC can opt
for conversion of the Debenture as Equity

2. Partially Convertible Debentures

This is a convertible debt wherein a part is converted into Equity to enable
the VC to gain from the success of the Venture and the balance remains
as a Fixed Interest Debt

3. Bridge Loans
These are Short Term Loans provided to a company contemplating a
Public Issue to increase its Valuation
 4. Shares Warrants
This is a Right granted to the investor to purchase Equity Shares at a pre
determined price on a later date. This normally provides for the expansion
finance required by the investee company and ensures capital gains from
successful Ventures
In Accordance with the world wide practice the bulk of VC investment in
India is in Equity shares. Initially there was a higher proportion of
conventional loan but later it was reduced and its place is been taken by
various innovative Quasi Equity Instruments. With VC financing getting
mature, Preference Shares and Convertible Debts are becoming more
popular. Today VC funds use more than one instrument for their
investments

XIII. STAGES OF VC INVESTMENT

There are 5 Investments stages widely used by the industry to invest. These
stages are defined as under

13.1.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 financing provided to companies when the
Initial Concept of the business is being formed

13.2.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

13.3.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

13.4.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

13.5.Turnaround Financing
Capital provided for companies that are in operational or financial difficulties
where the additional funds would help in Turnaround Situations

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 VC funds are a part of
every stage and are also actively participating in Turnaround Stages through
buyouts and takeovers.

XIV. DOCUMENTATION
The different legal documents that are to be created and executed by the
venture firm are

14.1. Shareholders agreement

This agreement is made between the venture capitalist, the company and the
promoters. The agreement takes into account

a. Capital structure
b. Transfer of shares: This lays the condition for transfer of equity between
the equity holders. The promoters cannot sell their shares without the prior
permission of the venture capitalist.
c. Appointment of Board of Directors
d. Provisions regarding suspension / cancellation of the investment:
The issues under which such cancellation or suspension takes place are
default of covenants and conditions, supply of misleading information,
inability to pay debts, disposal and removal of assets, refusal of disbursal
by other financial institutions, proceedings against the company, and
liquidation or dissolution of the company.

 Equity subscription agreement - This is the agreement between the

venture capitalist and the company on
a. Number of shares to be subscribed by the venture capitalist
 b. Purpose of the subscription
c. Pre-disbursement conditions that need to be met
d. Submission of reports to the venture capitalist
e. Currency of the agreement

 Deed of Undertaking - The agreement is signed between the promoters and

the venture capitalist wherein the promoter agrees not to withdraw, transfer,
assign, pledge, hypothecate etc their investment without prior permission of
the venture capitalist. The promoters shall not diversify, expand or change
product mix without permission.

 Income Note Agreement - It contains details of repayment, interest, royalty,

conversion, dividend etc.

 Conditional Loan Agreement - It contains details on the terms and

conditions of the loan, security of loan, appointment of nominee directors etc.

 Deed of Hypothecation, Shortfall Undertaking, Joint and Several Personal

Guarantee, Power of Attorney etc.

 Whenever there is a modification in any of the agreements, then a

Supplementary Agreement is created for the same.
14.2. Monitoring and Follow up
The role of the venture capitalist does not stop after the investment is made in
the project. The skills of the venture capitalist are most required once the
investment is made. The venture capitalist gives ongoing advice to the promoters
and monitors the project continuously.
It is to be understood that the providers of venture capital are not just financiers
or subscribers to the equity of the project they fund. They function as a dual
capacity, as a financial partner and strategic advisor.
Venture capitalists monitor and evaluate projects regularly. They are actively
involved in the management of the of the investor unit and provide expert
business counsel, to ensure its survival and growth. Deviations or causes of
worry may alert them to potential problems and they can suggest remedial
actions or measures to avoid these problems. As professional in this unique
method of financing, they may have innovative solutions to maximize the
chances of success of the project. After all, the ultimate aim of the venture
capitalist is the same as that of the promoters – the long-term profitability and
viability of the investor company.

The various styles are:

 Hands-on Style - suggests supportive and direct involvement of the
venture capitalist in the assisted firm through Board representation and
regularly advising the entrepreneur on matters of technology, marketing and
general management. Indian venture capitalists do not generally involve
themselves on a hands-on basis bit they do have board representations.
  Hands-off Style involves occasional assessment of the assisted firms
management and its performance with no direct management assistance
being provided. Indian venture funds generally follow this approach.
 Intermediate Style venture capital funds are entitled to obtain information
about the assisted projects on a regular basis.

14.3. Exit Routes

After the unit has settled down to a profitable working and the enterprise is
in a position to raise funds through conventional resources like capital
market, financial institution or commercial banks, the venture capitalist
liquidate their investment and make and exit from the investee company.

The ultimate objective of a Venture Capitalist is to realize from his investment by

selling off the same at a substantial capital gain. Thus a venture capital firm
converts the value of appreciation into cash. The funds realized are deployed into
new ventures.
In fact, at the time of making their investment, the venture capitalist plan their
potential exit. This is usually done in consultation with the promoters. In spite of
the same, venture capitalists and entrepreneurs sometime differ on the
timings of the exit.
Venture firms vary in terms of their expectation; some prefer a shorter term
prospective than others. Even in one venture capital firm the exit period has been
found to differ from venture to venture. It depends upon a number of factors like
type of industry, the stage of the investee company, extent of investment by a
venture capitalist, besides environmental factors like perceived competition,
particularly future level of competition, technological obsolesce etc. play an
important role.
The investee company has to prepare and make suitable adjustments in its
capital structure at the time of realization by the venture capitalist. The
convertible preference shares and convertible loans must be converted to
ordinary equity before the exit by the venture capitalist. In case of non-convertible
preference shares and loans by the venture capitalist these are to be redeemed.
At exit the special rights granted to the venture capitalist cease to operate and
venture capital firms normally withdraw their nominees from the board of the
investee company.

The venture capitalist firms have a motto ‘exit at the maximum possible profit
or at a minimum possible loss – in case of a failed investment’.
The exit can be voluntary or involuntary. Liquidation or receivership of a
failed venture is a case of involuntary exit. The voluntary exit can have four
alternative routes for disinvestment:
1. Buy back of shares by promoters or company
2. Sale of stock (shares)
3. Selling to a new investor
4. Strategic / Trade sale
1. BUY BACK / SHARES REPURCHASE
Buy back or shares repurchase has the following distinct forms:
 The investee company has to buyback its own shares for cash from its
venture capitalist using its internal accruals
 The promoters and their group buys back the equity stake of venture
capitalist.
 The employees’ stock trusts are formed which, in turn, buy the share
holding of the venture capitalist in the company.
 The route is suited to the Indian conditions because it keeps the ownership
and control of the promoters intact. Indian entrepreneurs are often very
touchy about ownership and control of their business. Hence in India, first a
buy back option is normally given to the promoters or to the company and
only on their refusal the other disinvestment routes are looked into. The exact
price is mutually negotiated between the entrepreneur and the venture
capitalist. The price is determined considering the book value of shares,
future earning potential of the venture, Price / Earning ratio of similar listed
companies.

The companies were not allowed to buy back their shares in India; however, with
effect from the amendment in the Companies Act (1999) the companies can do
so now.

Purchase by Employee’s Stock Ownership Trust a method used by some

entrepreneurs to buy out the venture capitalist is to set up an employee’s stock
ownership trust (ESOT). The ESOT is like a pension and profit-sharing plan,
except that it buys stock in your company rather than stock of large traded
companies. The ESOT obtains money through contributions by the company and
therefore builds up cash. The ESOT can also borrow from the bank on the basis
of the projected future contributions by the company. The ESOT uses the money
to buy the stock that is owned by the venture capital firm. This is a relatively
painless way for the company to buy back the equity ownership held by the
venture capital firm. Contributions by the company to the ESOT are tax
deductible.

Exit by Puts and Calls

When the investment was negotiated, the entrepreneur may have set up a formal
arrangement that provides for exit for the venture capitalist. This may be in the
form of “puts” and “calls.” As we noted earlier, a put is a right given to the venture
capitalist to require the company to buy the venture capitalist’s ownership in the
company at a predetermined formula. The call provision gives the entrepreneur,
or the company, the right to purchase the venture capitalist’s ownership by the
same or similar formulas.
There are probably as many put-and-call formulas as there are minds thinking
about how to structure deals. However, there are seven popular ones that are
considered.
a. Price-Earnings Ratio
P/E Ratio is probably the most popular formula that treats the company’s stock
like the stocks traded on national stock exchanges. The earnings per share are
figured for the shares owned by the venture capitalist. A popular price-earnings
(PE) ratio is selected from public stocks in the same industry. That PE ratio is
multiplied by the earnings per share to come up with a price per share that the
entrepreneur or the company will pay to the venture capitalist for the stock he
owns.

b. Book Value
A less common formula is based on book value of the company. It’s simple to
compute the book value per share for stock owned by the venture capitalist. That
would be the price the entrepreneur or the company would pay for the shares
owned by the venture capital company. Book value per share is seldom used
because in the early years of a company’s development the company usually has
a small book value. It’s only in older companies that have been around long
enough to establish a good book value that this becomes the method of valuing
the venture capitalist’s equity position.

c. Percentage of Sales
Sometimes it is inappropriate to use the earnings of the company in a price-
earnings formula because in the early years of development, particularly in a
start-up company, the earnings may be low owing to heavy depreciation or
research and development expenses. It may take several years for the company
to become profitable. Using pretax earnings may seem to be more appropriate.
However, pretax earnings are held low often because of heavy salaries or heavy
expenditures for promotion. In such a case, it may be easier for the entrepreneur
to take the normal profit before tax as a percentage of sales typical for the
industry. Find statistics on the industry in publications on business statistics. It is
found that most companies similar to the entrepreneurs have a pre-tax earnings
of 10 percent of sales. It would be simple, then, to take 10 percent of this
company’s sales and pretend that number is the profit before taxes. Then the
entrepreneur would determine earnings per share by using the hypothetical profit
before taxes. Using the industry price-earnings ratio, he could easily determine
what the value of the stock owned by the venture capital company would be
worth if the hypothetical earnings existed. This can be the method used for
buying back the shares owned by the venture capital firm.
Using the percentage of sales formula to value and buy back the shares owned
by the venture capitalist can be very expensive.

d. Multiple of Cash Flow

In some industries cash flow is a more accurate barometer of how the business
is doing than are profit-and-loss statements based on generally accepted
accounting principles. Using an eight-to-ten-times cash flow formula, we might
say a company is worth millions of dollars more than a price-earnings ratio of the
profit-and-loss statement would indicate. If we assume a company is worth ten
times cash flow, it is simple to compute the value of the percentage of the
company owned by the venture capitalist. You can use this as the method for
buying back his equity position.
The cash flow formula may work quite well for a stable company, but could be
extremely expensive in an asset-heavy, leverage buy-out situation. For example,
in a leverage buy-out you may have inflated the value of the assets in order to
shelter income. However, when these heavily depreciated assets are removed in
the calculation of cash flow, the cash flow number will be much higher than the
profit before-tax figure. The price the entrepreneur or Co. will have to pay for the
equity of the venture capitalist can be high if it is based on cash flow.

e. Multiple of Sales
The value of some companies in certain industries is based on a multiple of
sales. Radio stations traditionally sell at two to three times gross sales. If you
determine the value of a company to be two and a half times gross sales, it
would be simple then to compute the value of the venture capitalist’s percentage
of equity ownership and pay him that amount for his ownership in the company.
As in the percentage-of-sales calculation above, the multiple-of-sales valuation
also means you will be paying for a company that may or may not have earnings.
Many investors in the radio business buy a poorly-run station on a multiple- of-
sale calculation knowing full well that the station’s earnings cannot possibly pay
back the investment. The investor who is buying the station must put in enough
money to carry the station until its sales and earnings can be increased. In fact,
the earnings must increase drastically if he is to pay back any debt and get an
adequate return on the money invested.

f. Appraised Value
It is often easy to find an expert individual or a stock brokerage firm to appraise
the value of the equity ownership held by the venture capital company. The
appraisal will probably be based on a combination of some of the items above.
Appraisals are usually computed by two methods. First, the value of the company
is determined by its earning power, both past and future. This formula is similar
to the price earnings ratio used above. Second, the values of the assets (bricks
and mortar) are determined as if they were sold at auction as part of an orderly
liquidation. From this liquidation the appraiser subtracts all debts outstanding,
and the remaining value is the appraised value. The bricks-and-mortar formula is
similar to the book-value calculations, except there it includes an appraisal of the
assets and a restated new book value based on their appraised value. When
these two figures do not agree, the appraiser usually selects something close to
the higher of the two. For example, if the bricks-and-mortar formula was higher
than the earnings formula, the appraiser would assume that the highest and best
use of the company was to sell all of its assets.

g. Prearranged Cash Amount

Of course, a simple formula would be to base a put-and-call option on a single
cash amount. That is, at the end of three years the venture capital firm would
have the right to require the company to buy its equity ownership position for a
certain amount, say, $200,000. Although this method saves a great deal of
negotiating and appraising at the end of three years, people find it difficult to
agree on a value at the beginning of the investment period.

2. SALE OF SHARES ON THE STOCK EXCHANGE

The venture capitalist can exit by getting the company listed on the stock
exchange and selling his equity in the primary or secondary market using any of
the following three methods:
 Sale of shares on stock exchange after listing shares
Venture capitalists generally invest at the start up stage and propose to
disinvest their holding after the company brings out an IPO for raising funds
for expansion. This listing on stock exchange provides an exit route from
investment.

 Initial Public Offer (IPO) / Offer for sale

When the existing entrepreneurs opt out of buy back, the venture capitalist
opts for disinvesting their stocks through public offering.

The major advantages are:

a. The public issue provides liquidity to the business, which is useful for the
company.

b. The process establishes the fair price of the company’s securities. Venture
capitalist can obtain a higher price for his equity and the same is useful for the
promoters as it increases the valuation of the company.

c. Quite often the new stock is offered for sale rather than the venture capitalist’s
equity or sometimes a part of venture capitalist’s equity is clubbed with the new
equity. This on one hand improves the company’s net worth and provides funds
for growth and expansion, one the other enables the venture capitalists to get a
higher price of its equity after listing.

d. It paves the way for the company to raise funds for future growth, as it is
easier and less costly for the listed companies to raise capital from the market.

e. The company may get a tax break as listed companies usually pay tax at a
lower rate.

f. Public listed companies normally have a higher credit-rating, the growing

companies will not have to depend on internal accruals for financing expansion.

Several promoters have reservations to going public. These include:

a. High cost of raising money through stock market. The cost includes
underwriter’s commission, the expenses of merchant bankers, attorneys,
auditors, printing and publicity besides listing fee of the stock exchange. These
costs have increased over the years.

b. Going public results in dilution of ownership. The original entrepreneurs

have the additional task of informing the new shareholders about the company’s
activities and answering their queries.

c. The disclosure requirements as per the listing agreement of the stock

exchange and SEBI dissuade some promoters. Those who feel uncomfortable
giving information about the director’s remunerations, details of company’s
ownership or information about sales, borrowings profits etc. may like to avoid
public issue.

d. The listed companies are required to disclose sufficient information about their
operations. The competitors can abuse this information. The knowledge
about the company’s profitability sometimes leads co labour problems with
workers demanding higher wages.

e. Listed companies cannot keep their dealings with interconnected companies

where promoters have a confidential interest undercover. This harms the
promoter’s interest.

It is preferred where venture is successful and its internal generations are

adequate to meet immediate fund for expansion. Therefore no IPO is envisaged
and instead a part of existing equity is offered for sale. Disinvestment by a public
issue is dependent on the stock market conditions particularly the primary
market. The stock markets are cyclic in nature. The state-of the stock market and
its volatility acts as a considerable deterrent to this option. During boom period
when the stock market is raising it is easier to disinvest by this route and the
venture capitalist gets a higher price for its investment. When the market is in
recession floating the public issue is an undesirable exit route. However if the
decision to go public has been made, the venture capitalist would like to exit if he
can get a good return on his investment. In case he expects a much higher return
by delaying the exit, he will wait longer.

Disinvestment on OTC
An active capital market supports the venture capital activities. It enables the
venture capitalists to get a suitable valuation for their investment. Besides the
regular stock exchange a well developed OTC market where dealers can trade in
shares. This imparts liquidity and breadth to the market. The OTC market
enables the new and smaller companies not eligible for listing on a regular stock
exchange to be listed at an OTC exchange and thus provides liquidity to the
investors. For instance in U.S. the National Association of Securities Dealers
Automated Quotation System (NASDAQ) is an important OTC market. Today
NASDAQ has a concentration of technology stocks and is considered the hub of
venture capital activity in U.S.
As per the recommendations of a number of committees, an OTC exchange was
required in India. As a result ‘Over the Counter Exchange of India (OTCEI)’ was
set up.

3. CORPORATE / TRADE SALE

The venture capital firm and the entrepreneur together sell the enterprise to a
third party mostly a corporate entity. Herein the promoters also exit from the
venture along with the venture capitalist. This is called a corporate, strategic or
trade sale. The reasons for this sale can be varied, difficulty in running the
business profitability or a perceived competition from more established big
business houses having huge resources and business synergy. Trade sales are
very popular in U.S. and U.K. Entrepreneurs with a solid idea and revenue
models have been able to get much higher valuations through this route. The
sale of Hotmail by Sabeer Bhatia to Microsoft for $400 million as against the
valuation of $200 million by the venture capitalist Dough Carlise is a fine
example.

On the other hand, where operations of an existing venture are modest, a higher
exit valuation may be achieved in the market rather than by a trade sale, as the
market investors are usually swayed by the appeal of the sector in which
the venture operates rather than the quality of its specific business
operations.

Modalities: The modalities of the trade sale differ from case to case depending
upon the nature of operations, its size, the requirements of the buyer, etc. The
sale can be in cash, against the shares of the acquiring company or the
combination of the two. The equity owners get the shares of the buyer-company
in lieu of the shares being sold by them. Such sales have the advantage that the
seller does not have to pay any tax as the transaction involves only exchange of
shares. There are occasions when the equity is sold by the owners against notes
to be received from the buyer. These notes are often secured by the assets of
the company and are redeemed at the predetermined intervals. The deferred
payment through notes is popular as it helps in tax planning by the seller.

The appropriate disinvestment modalities of a corporate / trade sale

depend on the needs of the seller and the strengths of the buyer company
besides keeping in view of the tax considerations. At times, it is through a
management buy-out or buy-in, which in turn may be financed partially by
another venture capital fund. Formalities involved in sale / transfer of enterprises
have restricted smooth exit for venture capitalist. It is important to note that in
India if the investee company is a listed company at the time of trade sale, then
the provisions of listing agreement are attracted besides the provisions of the
SEBI regulations of merger and acquisitions are also applicable.
Management Buy-Outs: Venture capital buy-outs are both a successful
investment strategy for venture capital investment as well as an efficient exit
route. Buy-out financed by another venture capitalist primarily by providing debt
is known as leveraged buy-out. Buy-out without participation by another
investor is called management buy-out. Here in the current management
group purchases the stake of the venture capitalist. The stock options and
sweat equity have made management buy-out possible in India.

Management buy-outs are important in venture capital market for various

reasons:
 MBO’s provide an opportunity to managers to become entrepreneurs.
 Venture capital investment in buy-out has a lower investment risk than
early stage investment.
 MBO’s help smaller enterprises to adapt to technological changes.

Buy-in is similar to buy-out but involves new management from outside and
improvement in the operations of the venture. Incoming new management is
often unfamiliar with the operations of the venture hence the acquiring company
may feel that the continuity of the existing entrepreneur will be beneficial for the
business; the services of the original entrepreneur are retained. This helps in
implementing the remaining parts of the original ideas and also provides
continuity to the venture. For instance Bhatia remained his company’s top
executive after it became a subdivision of Microsoft’s Web basics.

4. SELLING TO A NEW INVESTOR

Many a times for their exit venture capitalist and/or the promoters locate a new
investor, a corporate body or another venture capital firm. The new investors
are normally those who find some sort of synergy between the investee
company and their existing operations such that the relationship is useful to
both the companies. This route is also used when the promoters want to get
rid of the venture capitalist.
Some venture capitalists, as a policy concentrate their activities to startups and
early stage investments. Such venture capital funds exit paving way for the
venture capital fund specializing in the later stage investment or buy out deals.
Often a growing venture needs second stage financing, if the existing venture
capitalist as a policy does not commit funds for the second stage it normally
locates another venture capitalist that finds the investment attractive enough to
enter.

Pre-Requite For The Efficient Exit Mechanism

 Legal Framework
 Smooth procedures for sale / transfer of enterprises
 Efficient stock Market
 Mechanism for listing and trading of equity of smaller companies
 XV. DIFFERENCE BETWEEN A VC
AND BANKERS/MONEY
MANAGERS
• Banker is a manager of other people's money while the venture capitalist is
basically an investor.
• Venture capitalist generally invests in new ventures started by technocrats
who generally are in need of entrepreneurial aid and funds.
• Venture capitalists generally invest in companies that are not listed on any
stock exchanges. They make profits only after the company obtains listing.
• The most important difference between a venture capitalist and conventional
investors and mutual funds is that he is a specialist and lends management
support and also
 Financial and strategic planning
 Recruitment of key personnel
 Obtain bank and other debt financing
 Access to international markets and technology
 Introduction to strategic partners and acquisition targets in the region
 Regional expansion of manufacturing and marketing operations
 Obtain a public listing

Difference Between Venture Finance and Debt Finance

Venture Finance Debt Finance

Objective Maximize return Interest payment
Holding period 2-5 years Short/long term
Instruments Common shares, convertible bonds, Loan, factoring, leasing
options, warrants
Pricing Price earnings ratio, net tangible Interest spread
assets
Collateral Very rare Yes
Ownership Yes No
Control Minority shareholders, rights Covenants
protection, board members
Impact on B/S of Reduced leverage Increased leverage
financed
Exit Mechanism Public offering, sale to third party, sale Loan repayment
to entrepreneur
 XVI. AN EXERCISE:
Launching & Managing a Venture
Capital Fund
16.1. Launching A Vc Fund
Coming Together:
Four friends Aman, Sid, Shivam & Amita who have known each other for many years
decide to start a venture capital firm together. They have a vast experience of more than
10 years working in the industry and in varied capacities. Aman holds an engineering
degree and has vast experience in operations. Sid is a Chartered Accountant, while
Shivam and Amita are MBAs from premiere institutes having specialized knowledge and
vast experience in Marketing and Human Resource respectively. The four aspiring
Venture Capitalists worked together in a venture capital firm and had an outstanding
record working as a team. They thus understand and trust each other’s working style
which is of prime importance in any new venture.

Investment Focus:
They strongly believe in the entrepreneurial skills of young Indians and would like to
support new ventures. They believe that they can help budding entrepreneurs and also
create decent amount of wealth by leveraging their knowledge and contacts in the
industry. They also believe that there is a huge need for early stage financing in the
industry today as most of the VCs & PEs are interested mainly in later stage financing
due to higher returns in lesser time period.

After working through the numbers, they decide to start their firm by raising $100 million
to invest. They name their fund as Venture Capital Fund of India (VCFI). They decide to
form a Pvt. Ltd. Co. to limit personal liability as this involves huge amount of money.
They appoint themselves as the directors of the company with a fixed salary.

Gathering Funds:
Aman & Shivam who have great convincing power use their contacts in the industry to
gather the funds from investors like the corporates, individuals, and banks for their VC
fund.

Promising returns:
From VCFI’s perspective these investors are their customers and Aman & Shivam have
promised to invest their money wisely and fetch them higher returns than what they
would have got by investing in other avenues like MFs, stock markets, debt markets or
even any other venture capital fund. Now as they will be investing in early stage
companies the risk will be more and hence the returns expected by their investors would
also be higher. Suppose the investors expect an average return of 20% y-o-y from a
venture fund which invests in later stage of companies, then they might expect a return
of at least 25% from VCFI, excluding the fees paid to them.
Setting up the fund:
Once the money is received from the investors the four put it in a ‘fund’ which will invest
in young companies. They decide that the fund will be a “closed ended fund” with a 10
year duration, which means that they can not add any more funds to this fund until the
end of 10 years when it matures. At the end of 10 years VCFI will have to give the
money back to the investors plus what they have earned, minus their fees, their share
from profits and any money that they might have lost. VCFI may also decide to return the
money back to investors the interim period.

Setting the control structure:

It’s an act of faith: investors commit their money to a fund, and cede control over the
decision making for the life of the fund – usually 10 years.
The control, and therefore the pressure, is on Aman, Sid, Shivam & Amita, the
promoters in the fund, to make investments that deliver a financial return to their
Investors that makes everybody happy.

16.2. Financial Factors

Negotiate:
Just as in any deal, the terms of the fund are negotiable: the control, the payback
requirements, the share of upside that goes to the Investors or the Promoters of VCFI.
VCFI is a new fund, so their negotiating power is fairly neutral – they are happy to play
along with the industry norms on the fee structure.
Management Fees:
Generally, a venture firm is allowed to take a small percentage of the fund every year,
usually around 2% or 2.5% of the total fund amount, to pay the firm’s operating
expenses. In VCFI’s case that means that they would be allowed to use $2.5 million
each year to pay their operating expenses if they set the fees at 2.5%.
However, that amount is not paid to VCFI on top of the $100 million fund, but rather is
subtracted from the total.
This creates a nice tension as VCFI’s performance is measured as if they were investing
the entire $100 million. Thus, more money they spend on themselves in the form of
management fees, the less they have left to invest. Therefore, the money they do invest
has to work that much harder – their deals have to perform that much better to make the
returns they have promised.
Thus they option to spend less than the permitted amount on management fees, and
return the balance to the fund. This allows them to both look prudent to their investors,
as well as lower the pressure on their investments.

Does VCFI get anything extra?

Venture capitalists are supposed to make money at the same time as their Investors.
The goal of this compensation arrangement is to align incentives: VCFI and their
Investors should be motivated by the same goals. To this end, VCFI, unlike investment
bankers, will not get paid a “transaction fee”. Instead, they will share in the “upside” or
the gains created by investing their fund. They have negotiated a typical arrangement
that will give the venture firm 20% of the gains.
The 20% share that goes to VCFI is not based on the amount of money they have
invested, but rather on the work they have put into the process.
Therefore, this percentage is referred to as a “carried interest”.
If VCFI invests the entire fund of $100 million, and if they make some good investments,
at the end of 10 years they might have built a total value of the fund of $800 million. First
they pay back to the Investors their original investment of $100 million. Then, in the
arrangement they have negotiated, VCFI takes 20% of the remaining $700 million, i.e.
$140 million. The Investor Partners receive the balance, or $560 million which is 5.6
times their initial investment.

16.3. Getting Down To Business: Performance Pressure

On VCs
High expectations by investors:
In the light of recent stock market performance, maybe delivering a minimum of 25%
annual returns doesn’t sound like such a challenge. But VCFI has to return a minimum
25% over the life of the fund, net of the rather substantial fee which is a big challenge.

Where does VCFI invest?

VCFI has primarily decided to go for early stage financing of companies. According to
the current market conditions and expertise of its promoters it decides to finance
companies in the following sectors:
1. Technology
2. Retail
3. Biotechnology
4. Power (non-conventional)

How does it find companies to invest in?

VCFI will use the contacts of its promoters with other VCs, investors and companies to
create a pipeline of investment opportunities to invest. It also plans to tie up with various
educational institutions, R&D institutions, and also hold contests to create a deeper
pipeline.

How much do they invest?

The promoters of VCFI decide to divide the $100 million pie into four investment areas
as shown below
 Investment Pie

25% Technology

Retail

Biotech
25% 30%

Power (non-
20% convnetional)

Structuring deals:
The promoters of VCFI decide to use both debt and equity instruments, to structure their
deals which they enter into with young companies. The criteria for choosing the type of
instruments it uses to design a deal will depend on factors like perceived risk of the
business, current size of the company, financial strength of the promoters, experience,
skills and credibility of promoters, standing of the company as compared to its
competitors, expected returns from business and so on.

In accordance with the general market practice VCFI would like to keep majority of their
investments in equity shares. They plan to use equity and quasi equity instruments like
Preference Shares and Convertible Debts respectively.

Setting the deadlines & targets:

VCFI has negotiated its fund’s life with the promoters as 10 years. So if the average time
from investment to exit is 5 – 7 years, then it means that VCFI must invest the entire
fund during the first 3 – 5 years.
So if VCFI promises to give 26% returns on $100 million at the end of 10 years, then the
total amount of money it should have at the end of 10 years will be around $1 billion
excluding the management fees.
That means that on average, the venture capitalists at VCFI have to make 10 times their
money on the deals in which they invest. Given that some of their investments do fail,
one can see that VCFI promoters can’t afford to invest in companies with limited
potential. But once they get going some of the pressure will be taken off the overall
value, because they will return some capital in the intervening years. They will not wait
until the last minute to give funds back.

“You’re only as good as your last exit,” explained a leading venture capitalist to the
newcomers at VCFI. The implicit requirement in delivering returns is, of course, that the
venture capitalist has to “realize” his return. In other words, it’s not good enough to point
to a fast growing company and a fast growing balance sheet. Venture capitalists have to
actually hand cash or freely tradable shares back to their Limited Partners during or at
the end of the 10 year fund.
Therefore, VCFI must be able to “exit” their investments in order to capture the upside
from their deals. You only get into a deal, if you can see several good ways to get out.

16.4. Strategies for Success

Diversify the deals:
In order to succeed in their investments as well as mitigate risk VCFI balance the types
of deals: sub-segments of industry, and mixing earlier and slightly later stage deals; and
by simply having multiple investments.

The promoters of VCFI divide responsibility of monitoring and also help in managing the
companies whom they finance. They set themselves a target to handle 2-3 new
investments each year for the duration of the fund. So if they finance 32 ventures in total,
then they assign 8 companies to each promoter, over the life of the fund, to monitor and
work closely with. Off course they can take each others help if they feel that the skills or
knowledge of the other person can help the company that they have financed as a VC.
Thus, by diversifying their portfolio, dividing the work and keeping the number of
investments at manageable levels they not only can minimize risk but also make sure
that they do not allow things to go out of hands.

While doing the math, they also realize that if each partner can only invest in 8 deals,
with 4 promoters at VCFI, the average deal size will have to work out to just over $3
million over time. If some deals fail, that means that the companies have to be able put
$5 million to effective use, with the investments in each company staged over time.

With these assumptions and projections the four promoters at VCFI close their fund and
start the process of analyzing and selecting companies in which they would like to
invest.
 XVII. BIBLIOGRAPHY

References :
1. www.sebi.gov.in
2. Principles of Financial Management by I.M. Pandey
3. www.indiavca.org
4. www.nenindia.org
5. Investment Valuation by Aswath Damodaran