Project for Corporate Regulation (HONS I): VENTURE CAPITAL FUNDS

Project on:
VENTURE CAPITAL FUNDS
Submitted to: Dr. Y. Papa Rao
On: 7.4.2015
Submitted by: VIVEK KUMAR PANDEY
Section: C
Project for Corporate Regulation
(Hons. I)
Roll No. : 174
Semester: VIII, B.A LLB. (Hons.)

Hidayatullah National Law University,

Raipur, Chhattisgarh.

DECLARATION
1

Project for Corporate Regulation (HONS I): VENTURE CAPITAL FUNDS

I hereby declare that this project report entitled

VENTURE CAPITAL FUNDS
is genuine and written by me, as my Corporate Regulation , (Honors I) project, with my
own effort and that no part has been plagiarized without citations.

Project for Corporate Regulation (HONS I): VENTURE CAPITAL FUNDS

ACKNOWLEDGEMENTS
I have taken efforts in this project. However, it would not have been possible without the kind
support and help of many individuals. I would like to extend my sincere thanks to all of them. I
am highly indebted to Dr. Y. Papa Rao, Faculty of Corporate Regulation, for putting trust in
me and giving me a project topic as such as this and for having the faith in me to deliver.
It is with his guidance and constant supervision and support in completing the project. I would like
to express my gratitude towards my parents & member of HNLU for their kind co-operation and
encouragement which help me in completion of this project.
My thanks and appreciations also go to my colleagues in developing the project and people who
have willingly helped me out with their abilities.
Vivek Kumar Pandey
Semester: VIII

Project for Corporate Regulation (HONS I): VENTURE CAPITAL FUNDS

TABLE OF CONTENTS
DECLARATION..........2
ACKNOWLEDGEMENTS..
3
TABLE

OF

CONTENTS....

...

.4
INTRODUCTION.....5
OBJECTIVES..........6
RESEARCH

METHODS

AND

DATA

BASE...

..6
CHAPTER I: INTRODUCTION TO VENTURE CAPITAL FUNDS- MEANING AND
SIGNIFICANC...7
CHAPTER II: STRUCTURING VENTURE CAPITAL FUNDS..10
CHAPTER III OPERATION OF VENTURE CAPITAL FUNDS.14
CHAPTER IV INDIA IS ATTRACTIVE FOR RISK CAPITAL..18
CHAPTER V: CRITICAL FACTORS FOR SUCCESS OF VENTURE CAPITAL
INDUSTRY...24
CONCLUSION...........................2
5
REFERENCES...25

Project for Corporate Regulation (HONS I): VENTURE CAPITAL FUNDS

INTRODUCTION
Venture capital and private equity funds are becoming increasingly popular routes of foreign
investment into India. Venture capital funds (VCF) are professional money managers who
provide risk capital to businesses. They assume various forms; however, they all share the
common trait of making investments in privately held companies at an early stage on the belief
that the investee companies have the potential to provide them a very high rate of return on the
investment made.
Venture capital is money provided by an outside investor to finance a new, growing, or troubled
business. The venture capitalist provides the funding knowing that theres a significant risk
associated with the companys future profits and cash flow. Capital is invested in exchange for an
equity stake in the business rather than given as a loan, and the investor hopes the investment
will yield a better-than-average return.
Venture capital is an important source of funding for start-up and other companies that have a
limited operating history and dont have access to capital markets. A venture capital firm (VC)
typically looks for new and small businesses with a perceived longterm growth potential that will
result in a large payout for investors.

Project for Corporate Regulation (HONS I): VENTURE CAPITAL FUNDS

A venture capitalist is not necessarily just one wealthy financier. Most VCs are limited
partnerships that have a fund of pooled investment capital with which to invest in a number of
companies. They vary in size from firms that manage just a few million dollars worth of
investments to much larger VCs that may have billions of dollars invested in companies all over
the world. VCs may be a small group of investors or an affiliate or subsidiary of a large
commercial bank, investment bank, or insurance company that makes investments on behalf
clients of the parent company or outside investors. In any case, the VC aims to use its business
knowledge, experience and expertise to fund and nurture companies that will yield a substantial
return on the VCs investment, generally within three to seven years.
Not all VC investments pay off. The failure rate can be quite high, and in fact, anywhere from 20
percent to 90 percent of portfolio companies may fail to return on the VCs investment. On the
other hand, if a VC does well, a fund can offer returns of 300 to 1,000 percent.
In additional to a portion of the equity, a VC expects to have a say in how its portfolio company
operates. Ideally, the VC fosters growth at the company through its involvement in managerial,
strategic, and planning decisions. To do this, the VC relies on the expertise of its general partners
who may be former CEOs, bankers, or experts in a particular industry. In most cases, one or
more general partners of the VC take Board of Director positions at a portfolio company. They
may also help recruit key executives to the portfolio company.

Project for Corporate Regulation (HONS I): VENTURE CAPITAL FUNDS

OBJECTIVES

To study about meaning of Venture Capital Funds.

To know about its structure and its operation.
To critically analyze the venture capital funds.

RESEARCH METHODOLOGY
This research project is descriptive and analytic in nature and mainly based on secondary sources
which include books and web pages on this topic. Ive referred to various books kept in the library.
These methods do not include field work and mainly depend on electronic resources. I owe my chief
source of inspiration to our respected faculty. The data base referred is not copied from any other
source and is purely authentic and genuine.

Project for Corporate Regulation (HONS I): VENTURE CAPITAL FUNDS

CHAPTERIZATION
CHAPTER I: INTRODUCTION TO VENTURE CAPITAL FUNDS- MEANING AND
SIGNIFICANCE
Venture capital is a specific type of finance well suited to the requirements of new technology
based firms. The combination of research and development, intangible assets, negative earnings,
uncertain prospects and absence of a proven track record, which are characteristic of start-up and
pre-commercial initiatives, leads to an unacceptably high perception of risk for conventional
financial institutions and debt financing. Venture capital addresses the consequent financing gap
through equity participation.
Venture capital was conceived in 1946 in the US, but its growth only accelerated in the late
1970s. In Europe, venture capital only started in the 1980s. In the last two decades venture
capital has grown to become a well-established sector with recognised conventions and practices,
such as:
Development of venture capital firms managing pools of capital predominantly structured as
limited partnership venture capital funds with clear fees and incentives for the fund's
performance;

Project for Corporate Regulation (HONS I): VENTURE CAPITAL FUNDS

Specialisation of venture capital funds in terms of phase of company development and type of
financing (seed, start-up, second-/third-stage, etc), sectoral and geographical focus, etc;
Type of venture capital firm: run by private individuals (independent), subsidiary of a financial
institution (captive), corporate entity (corporate venturing) or affiliated to public authority;
Accepted principles for raising funds, assessing investment proposals (due diligence),
monitoring (growing) the investments (investee companies) and planning the exits (investment
1

realisation) from the early stages of an investment. Venture capital can be seen to consist of a

demand and a supply cycle. 2

The former represents the demand for capital for the creation and growth of companies - by
implication SMEs. The cycle starts with the necessity for seed capital, to fund an initial idea or
basic research. It proceeds with the funding requirements of the successive stages of a company's
growth, such as test marketing, product development, full-scale production through to final
market rollout. The cycle closes with the exit, typically a private trade sale or initial public
offering (IPO) on a stock market, and the reimbursement of the invested capital plus gains. Each
stage is associated with a different level of risk during which the nascent SME requires sufficient
and appropriate funding to sustain growth and avoid liquidity constraints, which may endanger
its ultimate commercial success and access to conventional debt financing. Similarly, venture
capital firms can be viewed as representative of the supply cycle, starting with the creation of a
venture capital fund, typically having a 10-year life span, raising the necessary funds from
capital providers (investors) and marketing and investing the fund in investee initiatives and
companies over the first 2-3 years. In subsequent years the fund managers play an active role in
monitoring, advising and growing the value of investees so that in the later years of the fund's
life, investments can be exited from successfully. The cycle renews itself with the venture capital
firm launching a new fund3
1 see <http://www.iosrjournals.org/iosr-jbm/papers/Vol4-issue2/G0424670.pdf> as accessed on 1st april
2015.
2 http://en.wikipedia.org/wiki/Venture_capital > as acessed on 1 st April 2015/
3 http://www.moneycontrol.com/glossary/mutual-fund/what-is-venture-capital-what-are-venture-capitalfunds_1599.html as acessed on 1st Aprill 2015.

Project for Corporate Regulation (HONS I): VENTURE CAPITAL FUNDS

Venture Capital Fund Management:

It is thorough due diligence process of investees prior to investment, requiring fund managers to
have specific technology expertise, to ensure a sectorally balanced supply of capital and avoid
any herding behaviour where investment decisions mimic market trends rather than add value as experienced in the recent past with the dotcom bubble to the detriment of biotechnology
investments; o thorough monitoring of investees, requiring fund managers to provide commercial
and managerial support, as well as to supply successive capital infusions adapted to the growth
pattern characteristic of each sector and to the specific type of product or service under
development; o congruence of the exit route and the characteristics of the investee's assets,
including platform building to achieve critical mass and accelerate exit.4
The role of venture capital
A person with an idea, discovery or invention the budding entrepreneur will first commit his
savings to test his concept. Failing this, or when extra funding is required, he will turn to his
immediate family and friends with a request for financial support. However, funding needs are
likely to rapidly exceed the entrepreneur's own and immediate entourage resources, especially if
his concept proves worthy of further development. This is the phase where seed finance is
required. Seed finance from a venture capital fund or a business angel might typically be in the
range of up to a couple of hundred thousand euros to support the development of an innovation.
The entrepreneur will use the funds to prove and develop his concept, to research the market
potential and to prepare a business plan. If successful, the entrepreneur will also have to start
building a management team, probably with5 the assistance of the capital provider. This is
important because the entrepreneur possibly a scientist or engineer is unlikely to have the
marketing, financial and other managerial skills necessary to bridge the forthcoming
commercialisation gap. 6
4 http://business.gov.in/business_financing/venture_capital.php as acessed on 12th March 2015;
5 http://www.sebi.gov.in/cms/sebi_data/commondocs/vcfnew_p.pdf as accessed on 1st April 2015.
http://www.investopedia.com/terms/v/vcfund.asp as acessed on 31st March 2015.
6

Project for Corporate Regulation (HONS I): VENTURE CAPITAL FUNDS

The nascent company will require more capital to prepare for and initiate commercial operations.
By this phase the company will have completed market studies, assembled the key management,
developed a business plan and be ready to do business. However, in the absence of any sales
revenue, let alone profits, the company will be relying upon start-up and early-stage finance to
progress. Start-up and early-stage finance can range up to several million euros. In the absence of
a track record by which to judge the company, the venture capital fund in deciding whether to
provide capital will rely on its perception of the company's ultimate success and, therefore, on
the thoroughness of the business plan and the experience and robustness of the company's
management. The venture capital fund will seek to protect its investment, usually provided in the
form of an equity participation in the company, by imposing certain conditions, such as vetting
or appointing key management and being represented on the company's board. As the company
expands, its needs for capital will commensurately grow.
Capital may be required to increase production capacity, develop products and markets or to
provide additional working capital. By this stage, the company will have sales revenue and
probably will be generating a profit, which, however, may be insufficient to fund its expansion. It
may, therefore, revert to its capital provider for second-/third-stage finance. Depending on the
sector of the company's activity and its phase of development, second-/ third-stage finance may
range well above ten million euros. By now, the company will have a track record to assist the
venture capital fund in deciding whether to provide capital. However, largely the same criteria
and conditions for providing start-up and early-stage finance would apply. Additionally, the
venture capital fund is likely to limit its exposure to a particular company by syndicating its
investment with other funds. 7
Ultimately, a successful company will reach a development phase when it will be ready for an
initial public offering (IPO) on a stock market and become a fully fledged public (quoted)
company. Depending on the sector, IPOs are made before the company is profitable, like in the
biotechnology 5 For a comprehensive analysis of business angels, namely the different behaviour
of business angels and venture capitalists in financing entrepreneurship, see van Osnabrugge and
Robinson (1999a) and European Commission (2000)
7 http://www.legalservicesindia.com/article/article/regulatory-aspects-of-venture-capital-in-india-2651.html as acessed on 1st April 2015.

Project for Corporate Regulation (HONS I): VENTURE CAPITAL FUNDS

CHAPTER II: STRUCTURING VENTURE CAPITAL FUNDS

The three (3) most common types of venture capital funds are as follows:
Domestic Funds8
For domestic funds (i.e., where the funds are going to be raised in India), the structure most
commonly used involves the establishment of a domestic investment vehicle which pools funds
from the investors, and also a separate investment advisor for carrying on asset management
activities and identifying possible investee companies. The domestic investment vehicle is either
a trust or company. It is pertinent to note that unlike in the US or the UK, India does not
recognize limited partnerships. Due to operational flexibility, trusts have been the most favoured
option for domestic VCFs.9

Offshore Funds
Here, an investment vehicle in the form of a limited liability company or limited liability
partnership organized in an offshore tax favorable jurisdiction makes portfolio investments into
Indian companies. Mauritius, which has a favorable tax treaty with India, is routinely used to
locate the investment vehicle (see discussion below). Usually, there is an offshore manager to
administer the assets of the fund, and an investment advisor in India for identifying deals and
prospective investment opportunities.
However, in such a structure, the relationship between the Indian advisor, the overseas manager
and the offshore fund must be structured very carefully. This is important so as to avoid a
situation where the offshore fund is deemed to have a permanent establishment (PE) in India,
which can have adverse tax implications.10
8 http://www.thebhc.org/sites/default/files/beh/BEHprint/v023n2/p0001-p0026.pdf as accessed on 1st
April 2015.
9 http://www.smoothridetoventurecapital.com/PVI.A02_Venture.Capital.Industry.in.India.pdf as accessed
on 2nd April 2015.
10 http://www.ojasventures.com/ as accessed on 12th March 2015.

Project for Corporate Regulation (HONS I): VENTURE CAPITAL FUNDS

Unified Funds
This structure is generally used where domestic investors are also expected to participate in the
fund. In this structure, a domestic investment vehicle is established in India preferably as a trust
(alternatively, as a company) in addition to the offshore fund. This domestic trust is registered
with the Securities Exchange Board of India as a venture capital fund. The domestic investors
directly contribute to the domestic trust, whereas overseas investors pool their investments into
the offshore fund, which, in turn, invests in the domestic trust. The portfolio investments are
made by the trust, which will generally have a domestic manager or advisor.11
This structure is preferred from a tax perspective as well. As the Indian advisor is not connected
with the offshore fund directly and it draws its compensation from the domestic trust, the
chances of the Indian advisor being considered as the offshore funds PE are fairly slim12
CHAPTER III OPERATION OF VENTURE CAPITAL FUNDS
The operation of a venture capital fund can be viewed as a cycle8 . The cycle starts with the
fund raising process; proceeds through the investment in, monitoring of, and adding value to
firms; and concludes as the management team exits successful deals (see section 2.6) and returns
capital to their investors. The cycle renews itself with the management team raising of a new
fund. The fund raising process may take up several months during which the management
team seeks commitments from investors. To do this the management team prepares an
Information Memorandum, which, in addition to the principal terms and conditions outlined
above, will provide information on:
the fund's investment strategy, focus (stage, sector, geographical region, etc) and rationale;
the target size of the fund and its minimum size for first closure, with respective closing dates;

11 http://articles.economictimes.indiatimes.com/2014-05-26/news/50098927_1_idg-ventures-india-tigerglobal-lee-fixel as acessed on 2nd April 2015.

12 http://economictimes.indiatimes.com/definition/venture-capital as accessed on 3rd April 2015.

Project for Corporate Regulation (HONS I): VENTURE CAPITAL FUNDS

the market of potential investee companies and the proposed marketing strategy to
generate deal-flow;

13

Final version the management team's experience and capacity to

assess the proposed deals to perform the required due diligence

; the decision-making process to ensure the fund is soundly invested;
the expected number, individual size and relative importance to the size of the fund of the
deals;
the management team's attitude to investee companies (e.g. hands-on management, board
participation, etc) and ability to add value, grow the companies over a period of time and realise
the investments (exit);14
the reporting to investors (annual reports, meetings) and the envisaged investor relation
committees and advisory board. Already during the fund raising process, the management team
will have started marketing the fund to identify and attract investment opportunities.
Established venture capital firms and teams, with funds under management, may regularly be
receiving requests from earlier contacts and require less active marketing. Depending on the
focus and investment strategy of the venture capital firm, the contacts may be oriented towards
academia and R&D foundations (seed and start-up financing). Otherwise, contacts would be in
the area of conventional financial institutions (growth and later stage). In any case, the venture
capital firm will seek to expand continuously its network of contacts, also by relying on the due
diligence of previous and current deals. Of course marketing through contacts will be
supplemented by normal advertising of the fund in the specialist press and by participation and
presentations in conferences and fairs. With the fund closed and marketing under way, deals will
start flowing to the management team for assessment and, depending on the outcome of the due
diligence, possible financing.15

13 See Gompers and Lerner (1999, 2000) 12 Financing innovative firms through venture capital C.
Christofidis/O. Debande 22/02/01
14 https://hbr.org/2014/08/vc-funding-can-be-bad-for-your-start-up/ as accessed on 3rd April 2015.
15 https://www.mycapital.com/VenetureCapital101_MyCapital.pdf as acessed on 2nd April 2015.

Project for Corporate Regulation (HONS I): VENTURE CAPITAL FUNDS

venture capital industry in India is still at a nascent stage. With a view to promote innovation,
enterprise and conversion of scientific technology and knowledge based ideas into commercial
production, it is very important to promote venture capital activity in India. Indias recent
success story in the area of information technology has shown that there is a tremendous
potential for growth of knowledge based industries. This potential is not only confined to
information technology but is equally relevant in several areas such as bio-technology,
pharmaceuticals and drugs, agriculture, food processing, telecommunications, services, etc.
Given the inherent strength by way of its skilled and cost competitive manpower, technology,
research and entrepreneurship, with proper environment and policy support, India can achieve
rapid economic growth and competitive global strength in a sustainable manner.
A flourishing venture capital industry in India will fill the gap between the capital requirements
of Manufacture and Service based startup enterprises and funding available from traditional
institutional lenders such as banks. The gap exists because such startups are necessarily based on
intangible assets such as human capital and on a technology-enabled mission, often with the
hope of changing the world. Very often, they use technology developed in university and
government research laboratories that would otherwise not be converted to commercial use.
However, from the viewpoint of a traditional banker, they have neither physical assets nor a lowrisk business plan.
Not surprisingly, companies such as Apple, Exodus, Hotmail and Yahoo, to mention a few of the
many successful multinational venture-capital funded companies, initially failed to get capital as
startups when they approached traditional lenders. However, they were able to obtain finance
from independently managed venture capital funds that focus on equity or equity-linked
investments in privately held, high-growth companies. Along with this finance came smart
advice, hand-on management support and other skills that helped the entrepreneurial vision to be
converted to marketable products.16
A similar investor preference for start-up IT companies is being seen, though not of the same
magnitude. Yet, it is apparent that investors are willing to take higher risks for a potentially
higher reward by investing in start-up companies. Until 1998, the venture creation phenomenon
16https://www.sec.gov/divisions/investment/guidance/im-guidance-2013-13.pdf as acessed on 4th April
2015.

Project for Corporate Regulation (HONS I): VENTURE CAPITAL FUNDS

for the IT sector in India had been quite unsatisfactory. Some experts believe that India lacks
strong anchor companies like HP and Fairchild, which funded the start-ups of early Silicon
Valley entrepreneurs. Others believe that Indian entrepreneurs are not yet globally connected and
are often unwilling to share equity with a quality risk capital investor. There was also a
perception that startups in India do not typically attract the right managerial talent to enable rapid
growth. Finally, exit options were considered to be few, with the general feeling that
entrepreneurs were unwilling to sell their start-ups even if it was feasible. 17
As a result, much of the risk capital available was not quickly deployed. However, since March
1999, things have been changing dramatically for the better. The venture capital phenomenon has
now reached a take-off stage in India. Risk capital in all forms is becoming available more freely.
As against the earlier trend, where it was easy to raise only growth capital, even financing of
ideas or seed capital is available now. The number of players offering growth capital and the
number of investors is rising rapidly.
The successful IPOs of entrepreneur-driven Indian IT companies have had a very positive effect
in attracting investors. The Indian government initiatives in formulating policies regarding sweat
equity, stock options, tax breaks for venture capital along with overseas listings have all
contributed to the enthusiasm among investors and entrepreneurs, as has the creation of the
dot.com phenomenon. In India, the venture capital creation process has started taking off.
All the four stages - including idea generation, start-up, growth ramp-up and exit processes - are
being encouraged. However, much needs to be done in all of these areas, especially on the exit
side.

CHAPTER IV INDIA IS ATTRACTIVE FOR RISK CAPITAL:India certainly needs a large pool of risk capital both from home and abroad. Examples of the
US, Taiwan and Israel clearly show that this can happen. But this is dependent on the right
regulatory, legal, tax and institutional environment; the risk-taking capacities among the budding
17 http://www.treasury.gov/resource-center/sb-programs/Documents/VC%20Report.pdf as accessed on
3rd April 2015.

Project for Corporate Regulation (HONS I): VENTURE CAPITAL FUNDS

entrepreneurs; start-up access to R&D flowing out of national and state level laboratories;
support from universities; and infrastructure support, such as telecoms, technology parks, etc.
Steps are being taken at governmental level to improve infrastructure and R&D. Certain NRI
organizations are taking initiatives to create a corpus of US$150m to strengthen the infrastructure
of IITs. More focused attempts will be required in all these directions. Recent phenomena, partly
ignited by success stories of Indians in the US and other places abroad, provide the indications of
a growing number of young, technically-qualified entrepreneurs in India. Already there are
success stories in India. At the same time, an increasing number of savvy, senior management
personnel have been leaving established multinationals and Indian companies to start new
ventures. The quality of enterprise in human capital in India is on an ascending curve. The
environment is ripe for creating the right regulatory and policy environment for sustaining the
momentum for high-technology entrepreneurship. Indians abroad have leapfrogged the value
chain of Role of Venture technology to reach higher levels. At home in India, this is still to
happen.18
By bringing venture capital and other supporting infrastructure, this can certainly become a
reality in India as well. India is rightly poised for a big leap. What is needed is a vibrant venture
capital sector, which can leverage innovation, promote technology and harness the ongoing
knowledge explosion. This can happen by creating the right environment and the mindset needed
to understand global forces. When that happens we would have created not Silicon Valley' but
the Ind Valley' - a phenomenon for the world to watch and reckon with.
A viable venture capital industry depends upon a continuing flow of investment opportunities
capable of growing sufficiently rapidly to the point at which they can be sold yielding a
significant annual return on investment. If such opportunities do not exist, then the emergence of
venture capital is unlikely. In the U.S. and Israel such opportunities occurred most regularly in
the information technologies.
Moreover, in every country, with the possible exception of the U.S., any serious new opportunity
has to be oriented toward the global market, because few national markets are sufficiently large
to generate the growth capable of producing sufficient capital gains. Since Independence, the
18 http://www.kauffman.org/~/media/kauffman_org/research%20reports%20and%20covers/2012/05/we
%20have%20met%20the%20enemy%20and%20he%20is%20us(1).pdf as accessed on 3rd April 2015.

Project for Corporate Regulation (HONS I): VENTURE CAPITAL FUNDS

Indian government strove to achieve autarky and the protection of Indian markets and firms from
multinational competition guided nearly every policy the information technology industries
were no exceptions. 19
The protectionist policy had benefits and costs. The benefit was that it contributed to the creation
of an Indian IT industry; the cost was that the industry was backward despite the excellence of its
personnel. Due to this lack of foreign investment and despite the presence of skilled Indian
personnel, India was a technological backwater even while East Asia progressed rapidly. In terms
of experience, India contrasted favorably with most developing countries, which had small,
inefficient stock markets listing only established firms. However, although these stock markets
provided an exit opportunity, they did not provide the capital for firm establishment. Put
differently, accessible stock markets did not create venture capital for startups; they merely
provided an opportunity for raising follow-on capital or an exit opportunity. Other institutional
sources of funds .India has a strong mutual fund sector that began in 1964 with the formation of
the Unit Trust of India (UTI), an open-ended mutual fund, promoted by a group of public sector
financial institutions. Because UTIs investment portfolio was to consist of longer-term loans, it
was meant to offer savers a return superior to bank rates. In keeping with the risk-averse Indian
environment, initially UTI invested primarily in long-term corporate debt. 20
However, UTI eventually became the countrys largest public equity owner as well. This was
because the government controlled interest rates in order to reduce the borrowing costs of the
large manufacturing firms that it owned. These rates were usually set well below market rates,
yet UTI and other institutional lenders were forced to lend at these rates. In response, firms
started issuing debt that was partially convertible into equity in order to attract institutional
funds. The largest single source of funds for U.S. venture capital funds since the 1980s has been
public and private sector pension funds. In India, there are large pension funds but they are
prohibited from investing in either equity or venture capital vehicles, thus closing off this source
of capital. In summation, prior to the late 1980s, though India did have a vibrant stock market,

19 http://faculty.chicagobooth.edu/steven.kaplan/research/kaplanlerner.pdf as acessed on 2nd April 2015.

20 http://zoo.cs.yale.edu/classes/cs155/fall01/kearns.pdf as acessed on 2nd April 2015.

Project for Corporate Regulation (HONS I): VENTURE CAPITAL FUNDS

the rigid and numerous regulations made it nearly impossible for the existing financial
institutions to invest in venture capital firms or in startups.
Nearly all of these institutions were politicized, and the government bureaucrats operating them
were risk-adverse. On the positive side, there was a stock market with investors amenable to
purchasing equity in fairly early-stage companies. It was also possible to bootstrap a firm and/or
secure funds from friends and family if one was well connected. However, no financial
intermediaries comfortable with backing small technology-based firms existed prior to the mid
1980s. It is safe to say that little capital was available for any entrepreneurial initiatives. An
entrepreneur aiming to create a firm would have to draw upon familial capital or bootstrap their
firm. An Indian venture capital industry is struggling to emerge and given the general global
downturn, the handicaps existing in the Indian environment are threatening. As we have seen,
many of the preconditions do exist, but the obstacles are many.21
Some of these can be addressed directly without affecting other aspects of the Indian political
economy. Others are more deeply rooted in the legal, political, and economic structure and will
be much more difficult to overcome without having a significant impact on other parts of the
economy. A number of these issues were addressed in a report submitted to SEBI in January
2000 from its Committee on Venture Capital. 22
SEBI then recommended that the Ministry of Finance adopt many of its suggestions. In June
2000, the Ministry of Finance adopted a number of the Committees proposals. For example, it
accepted that only SEBI should regulate and register venture capital firms. The only criterion
was to be the technical qualifications of their promoters, whether domestic or offshore. Such
registration would not impose any capital requirements or legal structure this is very important,
because it would allow India to develop a legal structure suitable to its environment, while
offering tax pass-through for all firms registered as venture capital firms with SEBI. This was an
important achievement of the Committees report. However, the proposed guidelines continued
to prohibit finance and real estate investments. Whether this type of micromanagement is good
policy seems dubious. Also, registered venture capital funds must invest 70 percent of their paid21 http://www.cemfi.es/~suarez/repullo-suarez.pdf as acessed on 2nd April 2015.
22 https://www.india-financing.com/Venture_Capital_Fund_in_India.pdf as acessed on 2nd April 2015

Project for Corporate Regulation (HONS I): VENTURE CAPITAL FUNDS

in capital in unlisted equity or equity-related, fully convertible instruments. Similarly, relatedcompany transactions would Role of Venture Capital in Indian Economy e be prohibited, and not
more than 25 percent of a funds capital could be invested in a single firm. In the U.S. most of
these provisions are not law, but are codified in the limited partnership contracts and accepted as
common sense. Rather than letting the market decide which venture capital firms are operating
responsibly, the Indian government continues to specify a variety of conditions.23
A number of suggestions were not accepted even though they would assist in the growth of
venture capital. Many were related to the much larger general issues of corporate governance.
For example, there was no change in the regulations regarding restrictions on currency no
convertibility, providing employees more flexible stock-option plans, allowing domestic venture
capital firms to hold equity in overseas startups, and regulations allowing greater flexibility in
voting and dividend rights. Reluctance to adopt these measures is understandable, because they
would strike at some of the fundamental issues of corporate governance in India. Thus they were
seen as policy decisions that might set in motion a larger chain of events.
At the end of 2001, the Indian venture capital environment contained several unresolved issues.
One important obstacle was the inability to pass through unrealized gains or losses through to the
venture capital fund's investors through a direct distribution of stock or other securities unless the
fund is organized as a trust. In the US, these "in-kind distributions" are the most common method
of compensating investors.24
This method increases the return for socially beneficial tax-exempt organizations such as
foundations and pension funds. Private individuals, of course, pay taxes. Allowing legal
structures, such as limited partnerships, will enable such pass-through and encourage investment
in venture capital funds India has a large, sophisticated financial system including private and
public, formal and informal actors. In addition to formal financial institutions, informal
institutions such as family and moneylenders are important sources of capital. India has
23http://www.angelcapitalassociation.org/data/Documents/Resources/McKaskill__Raising_Angel_and_VC_Finance.pdf as accessed on 2nd April 2015.
24 http://www.thebhc.org/sites/default/files/beh/BEHprint/v023n2/p0001-p0026.pdf as accessed on 3rd
April 2015.

Project for Corporate Regulation (HONS I): VENTURE CAPITAL FUNDS

substantial capital resources, but as Table 1 indicates, the bulk of this capital resides in the
banking system.
In the formal financial system, lending is dominated by retail banks rather than the wholesale
banks or the capital markets for debt. The primary method for firms to raise capital is through the
public equity markets, rather than through private placements
CHAPTER V: CRITICAL FACTORS FOR SUCCESS OF VENTURE CAPITAL
INDUSTRY
While making the recommendations the Committee felt that the following factors are critical for
the success of the VC industry in India: (
A) The regulatory, tax and legal environment should play an enabling role. Internationally,
venture funds have evolved in an atmosphere of structural flexibility, fiscal neutrality and
operational adaptability.
(B) Resource raising, investment, management and exit should be as simple and flexible as
needed and driven by global trends
(C) Venture capital should become an institutionalized industry that protects investors and
investee firms, operating in an environment suitable for raising the large amounts of risk capital
needed and for spurring innovation through startup firms in a wide range of high growth areas.
(D) In view of increasing global integration and mobility of capital it is important that Indian
venture capital funds as well as venture finance enterprises are able to have global exposure and
investment opportunities. 25
(E) Infrastructure in the form of incubators and R&D need to be promoted using Government
support and private management as has successfully been done by countries such as the US,
Israel and Taiwan. This is necessary for faster conversion of R & D and technological innovation
into commercial products. 26

25 http://www.kauffman.org/~/media/kauffman_org/research%20reports%20and%20covers/2012/05/we
%20have%20met%20the%20enemy%20and%20he%20is%20us(1).pdf as accessed on 2nd April 2015.

Project for Corporate Regulation (HONS I): VENTURE CAPITAL FUNDS

The hassle free entry of such Foreign Venture Capitalists in the pattern of FIIs is even more
necessary because of the following factors:
(i)

Venture capital is a high risk area. In out of 10 projects, 8 either fails or yield
negligible returns. It is therefore in the interest of the country that FVCIs bear such a

(ii)

risk.27
For venture capital activity, high capitalization of venture capital companies is
essential to withstand the losses in 80% of the projects. In India, we do not have such

(iii)

strong companies.
The FVCIs are also more experienced in providing the needed managerial expertise
and other supports.28

Recommendations made by K B Chandrasekhar Committee:

(1) Multiplicity of regulations need for harmonization and nodal Regulator
(2) Double taxation for Venture Capital Funds need to be avoided
(3) Mobilization of Global and Domestic resources
(4) Flexibility in Investment and Exit of Venture Capitalists:
(5) Flexibility in the matter of investment ceiling and sectoral restrictions:
(6)Relaxation in IPO norms:29
(7) Issue of Shares with Differential Right with regard to voting and dividend:

26http://www.majmudarindia.com/pdf/Venture%20capital%20funds-%20a%20legal%20and
%20structural%20overview.pdf as accessed on 2nd April 2015.
27 http://www.sebi.gov.in/cms/sebi_data/commondocs/vcfnew_p.pdf as acessed on 12th March 2015.
28 http://www.evca.eu/media/78722/guide-on-private-equity-and-venture-capital-2007.pdf as accessed
on 2nd April 2015.
29 http://www.eib.org/attachments/pj/vencap.pdf as accessed on 2nd April 2015.

Project for Corporate Regulation (HONS I): VENTURE CAPITAL FUNDS

(8) Global integration and opportunities: (A) Incentives for Employees: (B) Incentives for
Shareholders (C) Global investment opportunity for Domestic Venture Capital Funds (DVCF):
Role of Venture Capital in Indian Economy
(9) Development in Infrastructure and R&D (10)Self Regulatory Organization (SRO)
Implementation of these recommendations would lead to creation of an enabling regulatory and
institutional environment to facilitate faster growth of venture capital industry in the country.
Apart from increasing the domestic pool of venture capital, around US$ 10 billion are expected
to be brought in by offshore investors over 3/5 years on conservative estimates. This would in
turn lead to increase in the value of products and services adding up to US$100 billion to GDP
by 2005. 30
Venture supported enterprises would convert into quality IPOs providing over all benefit and
protection to the investors. Additionally, judging from the global experience, this will result into
substantial and sustainable employment generation of around 3 million jobs in skilled sector
alone over next five years. Spin off effect of such activity would create other support services
and further employment. This can put India on a path of rapid economic growth and a position of
strength in global economy.

CONCLUSION
Venture capital in the India. is significantly larger and more active than in any other country. The control
mechanisms and tight monitoring of high risk/ high reward projects and the information generating
activities of venture capitalists are clearly valuable. Venture capitalists are a long-run competitive
advantage for the American economy. Present and future world leading finns have been, are, and will
continue to be financed by venture capital. Promoting an efficient venture capital sector should be a goal
of any administration. Will venture capital thrive in the 1990s? The question cannot be easily answered
because many policies the Clinton administration has proposed have yet to be implemented. We do not
30 http://madisonparkgrp.com/pdf/gtvc.pdf as acessed on 12th March 2015.

Project for Corporate Regulation (HONS I): VENTURE CAPITAL FUNDS

know if they will succeed in stimulating small business formation in general and venture capital in
particular. Health care reform could curtail investment in promising areas like biotechnology and
medical-related fields. The experiences of the 1980s and the political debate of the early 1990s have
focused attention on small firms as the engine for economic development in the United States for the next
decade. New initiatives and regulations can aid in the growth of venture capital.

REFERENCES
BOOKS

"Grandstanding inthe Venture Capital Industry," University of Chicago, mimeo (1993).

Gompers, P., "Optimal Investment, Monitoring, and the Staging of Venture Capital,"

University of Chicago, mimeo (1993).

. Bygrave, William and Jeffxy Timmons, Venture Capital at the Crossroads (Boston,
1992). The Rise and Fall Venture Capital / 25 Gompers, P.,

Project for Corporate Regulation (HONS I): VENTURE CAPITAL FUNDS

Austin, S., 2009, Majority of VCs in Survey Call Industry Broken, Wall Street

Journal Blog, June 29.

Birch, D., "Sources of Job Growth and Some Implications," in J. Kasarda, ed., Jobs,
Earnings, and Employment Growth Policies in the United States (Norwell, MA, 1990),

71-76
Chesbrough, H., 2003, Open Innovation: The New Imperative for Creating and Profiting

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Gottschalg, O., and L. Phalippou, 2009, The Performance of Private Equity Funds,

Review of Financial Studies 22, 1747-1776.

Gupta, Udayan, "Venture Capital Dims for Start-Ups, but not to worry," Wall Street
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Journal, February 1992, 39.

Hellmann, T. and Puri, M., 2002, Venture Capital and the Professionalization of StartUp

Firms: Empirical Evidence Journal of Finance 57, 169-197.

Hochberg, Y., A. Ljungqvist ,and A. Vissing-Jrgensen, 2009, Informational Hold-up and

Performance Persistence in Venture Capital,

Jansson, Solveig, "The Leap of Faith into Venture Capital," Institutional Investor,

September 1984, 117-121.

Journal of Finance 48, 831-880. Kaplan, S., F. Martel, and P. Strmberg, 2007, How Do

Legal Differences and Learning Affect Financial Contracts?

Journal of Financial Intermediation 16, 273-311. Kaplan, S., and A. Schoar, 2005,

Private Equity Performance: Returns, Persistence and Capital Flows,

Kaplan, S., "The Staying Power of Leveraged Buyouts," Journal of Financial
Economics, 29 (1991), 287-314. Kotkin, Joel, "Why Smart Companies are Saying NO to

Venture Capital," INC, August 1984, 65-75.

Working paper, Northwestern University. Jensen, M., 1993, The Modern Industrial
Revolution, Exit, and the Failure of Internal Control Systems,

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Project for Corporate Regulation (HONS I): VENTURE CAPITAL FUNDS

http://www.majmudarindia.com/pdf/Venture%20capital%20funds-%20a%20legal%20and

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