CHAPTER II

CONCEPTUAL AND LEGAL FRAMEWORK OF

VENTURE CAPITAL INVESTMENT

2.1.

THE CONCEPT OF VENTURE CAPITAL

The concept of venture capital is new. Venture capitalists often relate the

concept to the story of Christopher Columbus. In the fifteenth century,

Christopher Columbus sought to travel westwards instead of eastwards from
Europe and so planned to reach India. His far-fetched idea did not find favor with
the king of Portugal, who refused to finance him. Finally, Queen Isabella of Spain
decided to fund him and the voyages of Christopher Columbus are not empanelled
in history. And thus evolved the concept of venture capital. The modern venture
capital industry began taking shape, however, in the post-world war II years.
Venture capital is an equity investment in a high-risk project related to
some innovations or new technological developments contemplated by a
company. Venture capital also means a combination of capital and management
expertise provided for the initial risks of a new and emerging company, which has
a good growth prospect in terms of products, technologies, business concepts or
services with the objective of retrieving the investment with a handsome reward at
a future date.63
63

K.J. Taori, Venture Capital Funding, The Journal of Indian Institute of

Bankers, Vol.72, No.2, April-June 2001, p.13.
38

In the classical sense, venture capital financing or venturing simply means

investing in privately-owned technology based companies with a view to securing
the highest possible returns in the shortest possible time, notwithstanding the high
risk element involved.64
The concept of venture capital fund was born with the fundamental
objective to provide initial capital and support in building capital base to the
entrepreneurs having a sound background of professional education and expertise,
who take initiatives to launch the business, based on fast changing technology.65
Financial institutions and bankers primarily cater to projects with minimum
investment risk, maximum security of lending and uniform return from an early
stage investment. Conventional financing schemes are basically security-oriented
and are meant for projects based on proven technology.
Venture capital is providing long-term finance in the form of equity/quasi
equity to companies having high potential to grow. A venture capitalist is a
stakeholder in the companys equity. The investment by the venture capitalist
generally has the high risk- high return profile.66
Venture capital broadly implies an investment made in a business or
industrial enterprise which carries elements of risk and insecurity and the

64

p.18.

Will They Be Truly Venturesome?, Fortune India, December, 1-15, 1989,

65

Sanjeev Sharma, Venture Capital Key Source of Industrial Finance,

Financial Express, Madras, June 21, 1992, p.4.
66

P.D. Shedde, Venture Capital, Touchdown India, May 1999, p.5.

39

probability of business hazards. To connote the risk and adventure the generic
name of Venture Capital was coined.
Venture capital is a high risk high return business. The high risk is due to
the facts that projects are untested and are undertaken by the novices. The targeted
long-term returns from venture capital investment are naturally high. The seeking
of such potentially high returns had some analysts to term venture capital as
Vulture Capital.
There are many entrepreneurs with good product ideas, but lack the
necessary funds to commercialize them. Venture capital can open new avenues for
each entrepreneur. It plays an important role in financing high technology projects
and helps to turn research and development into commercial production. Besides
financing technology, venture capitalist is also involved in fostering the growth
and development of enterprises.
Venture capital is a significant financial innovation in the twentieth
century. As a new technique of financing to inject long term capital into the small
and medium sector, it has made notable contributions to its growth in the
developed countries. For some small firms for which a public issue is out of
question, a good alternative is venture capital. Venture capital in the sense is not
only an injection of funds into new firms but also an input of the skills needed to
set the firm up, design its marketing strategy, organize and manage it.

40

Definition of venture capital

According to Dominguez, Venture Capital Financing is generally the first
capital invested by sources outside the firm, and the last to exit. In the parlance of
the market, it is the front money or funds that are normally subordinated to all
other financial commitments of the enterprise. Aside from common stock
financing, the most common forms of alternative equity instruments issued in
venture capital investments are convertible debentures, warrants and letter stock
options.67
Venture capital can be defined as equity or equity-linked investments in
young, privately held companies, where the investor is a financial intermediary
who is typically active as a director, an advisor, or even a manager of the firm.68
Venture capital financing, generally implying long-term investment in
high risk industrial projects with high reward possibilities, may be at any stage of
implementation of the project or its production cycle, viz. to start up an economic
activity or an industrial or commercial project or to improve a process or a
product in an enterprise associated with both risk and reward.69

67

P.C.K. Rao, Project Management and Control, Sultan Chand and Sons, New
Delhi, 1997, pp.11-30.
68

Samuel Kortum and Josh Lerner, National Bureau of Economic Research,

Working Paper, 6846, December, 1998, p.1.
69

J.C. Verma, Manual Merchant Banking, 3rd Edition, Bharat Law House, New
Delhi, 1994, p.1062.

41

Venture capital is the organized financing of relatively new enterprises to

achieve substantial capital gains. Such young companies are chosen because of
their potential for considerable growth due to advanced technology, new products
or services, or other valued innovations. A high level of risk is implied by the
term Venture Capital and is implicit in this type of investment, since certain
ingredients necessary for success are missing and must be added later.70
Venture capital is the provision of risk-bearing capital, usually in the form
of a participation in equity, to companies with high growth potential. In addition,
the venture capital company provides some value-added in the form of
management advice and contribution to overall strategy. The relatively high risks
for the venture capitalists are compensated by the possibility of high return,
usually through substantial capital gains in the medium term.71
Venture capital is an investment in small or medium-sized unlisted
companies, with the investors participating, in some degree, in the management
process. 72

70

Kenneth W. Ruid, Venture Capital Investment, in Leo Barkers and Stephen

Feldman, Hand Book of Wealth Management, McGraw Hill Book Company, 1990,
Totonto, p.46-I.
71
Neil Cross, Introduction to Venture Capital Finance, Chris Bovaid, Pitman,
London, 1990, p.3.
72

Asian Venture Capital Journal, Guide to Venture Capital in Asia, Hong

Kong, 1992-93, p.7.
42

Venture capital is the investment in long term, risk equity finance where
the primary reward for the providers is an eventual capital gain, rather than
interest income or dividend yield.73
Venture capital investment is an activity by which investors support
entrepreneurial talent with finance and business skills to exploit market
opportunities and thus obtain long term capital gains.74
Venture capital is a separate asset class, often labeled as private equity.
Private equity investment sits at the furthest end of the risk-reward spectrum from
government bonds and can broadly describe equity investment in private
companies not quoted on the stock market.75
Venture capital as equity or equity featured capital seeking investment in
new ideas, new companies, new products, new processes or new services that
offer the potential of high returns on investment. It may also include investment in
turnaround situations.76

73

T. Lorenz, Venture Capital Today, 2nd Edition, Woodkead Faulkener, 1989,

quoted in Gordon C. Murray, The Changing Nature of Competition in the UK Venture
Capital Industry, National West Minister Bank Quarterly Review, November 1991,
p.65.
74

Journal of Central Bank, The Bank of England Quarterly Bulletin, 1984.

75

G. Anson, Venture Capital in Europe, Europe Venture Capital Association

Year Book (London), 1992, quoted in S. Ramesh and Arun Gupta, Venture Capital and
the Indian Financial Sector, Oxford University Press, New Delhi, 1995, p.49.
76

J.S. Saini and B.S. Rathore, Entrepreneurship Theory and Practice, Wheeler
Publishing, New Delhi, 2001, pp.483-484.
43

Venture capital is providing seed, start-up and first stage financing and
also funding the expansion of companies that have already demonstrated their
business potential but do not yet have access to the public securities market or to
credit-oriented institutional funding sources. Venture

capital also provides

management/ leveraged buyout financing.77

Venture capital is equity to fund new concepts that involves a high risk
and at the same time has high growth and profit potential.78
The Bank of England, which was the major promoter of the company
Investors in Industry, Britain, has defined venture capital as an activity by which
investors support entrepreneurial talent with finance and business skills to exploit
capital gain.79
The significant aspects of venture capital, as brought out in the definitions
are, first, the stress on equity rather than other forms of financial support and
secondly, the risk bearing nature of the assistance. The emphasis is on capital gain
rather than interest or dividend income as the return on the money invested by the
venture capitalist in the enterprise.

77

Jane Kolorki Morris, Editor, Venture Economics, quoted in Ibid., p.297.

78

Vasant Desai, Dynamics of Entrepreneurial Development and Management,

Himalaya Publishing House, Mumbai, 2000, p.458.
79

J.S. Saini and B.S. Rathore, Entrepreneurship Theory and Practice, Wheeler
Publishing, New Delhi, 2001, pp.483-484.
44

The Venture Capitalists

Every business and every product was funded by someone who stepped up
to the plate and invested, for better or for worse. The term venture capitalists
denotes institutional investors that provide equity financing to new projects and
play an active role in advising the management.
Venture capitalists are part riverboat gambler, part security analyst, and
part entrepreneurial voyeur. They are skeptics and business romantics; skeptics in
that their realism must often temper the optimistic fervor of the entrepreneur and
romantics, in that often they have little real control over operations, so must
suspend disbelief. This is a business of ambiguity and adversity- ambiguity in that
often the venture capitalist must read between the lines, based on his general
knowledge and experience, to derive the real state of affairs for an investment,
ambiguity in that the investments are often highly illiquid and must be held
through good times and bad-ambiguity in that most entrepreneurs have a love/hate
relationship with the venture capitalists. They want the money of venture
capitalists, and at times, their counsel, but want to be free of limitations and
controls. They, in most investments in this risky business go through the valley of
death at least once. Prior to becoming successful, venture capital investments go
many places most reasonable men would rather not. Creative business
development often depends on unreasonable men.80

80

I.M. Pandey, Venture Capital in the Indian Experience, Prentice Hall of India
Private Limited, New Delhi, 1999, p.3.
45

For entrepreneurs the attractions of venture capital inevitably go beyond

the money. More than finance, the venture capitalist gives his marketing and
management skills for the development of the new firm. But the venture capitalist
takes a big risk. If a new venture fails, all the money poured into the enterprise is
lost. There are rarely any assets of inventory to be sold off. A venture capitalist is
not a lender, but an equity partner. He cannot survive on minimalism but he is
driven by wealth maximization.
Venture Capital Vs Seed Capital and Risk Capital
It is difficult to make a distinction between venture capital, seed capital and
risk capital as the latter two form part of a broader meaning of venture capital.
Difference between them arises on account of application of funds and terms and
conditions applicable. The seed capital and risk funds in India are being provided
basically to arrange promoters contribution to the project. The objective is to
provide finance and encourage professionals to become promoters of industrial
projects. The seed capital is provided to conventional projects on the
consideration of low risk and security and the use of conventional techniques for
appraisal. Seed capital is normally in the form of low interest-deferred loan as
against equity investment by venture capital. Unlike venture capital, seed capital
providers neither provide any value addition nor participate in the management of
the project.

46

Risk capital is also provided to established companies for adapting new

technologies. Herein the approach is not business-oriented but developmental. As
a result on one hand the success rate of units assisted by seed capital/risk finance
has been lower than those provided with venture capital; on the other hand the
return to the seed/risk capital financier had been very low as compared to the
venture capitalist. The difference between the seed capital scheme and venture
capital scheme is given in the following Table 2.1

47

TABLE 2.1
SEED CAPITAL SCHEME Vs VENTURE CAPITAL SCHEME
Scheme

Seed Capital Scheme Venture Capital Scheme

Basis

Incentive or aid

Commercial viability

Beneficiaries

Very small
entrepreneurs

Medium and large entrepreneurs are

also covered

Size of
Assistance

Restricted to

Up to 40 per cent promoters equity

Appraisal

Normal

Skilled and specialized

Estimated
returns

20 per cent

30 per cent internal rate of return

Flexibility

Nil

Highly flexible

Value addition

Nil

Multiple ways

Exit option

Sell
back
promoters

Rs.1.Million

to Several, including public offer

Funding Sources Owner funds

Outside contribution allowed

Syndication

Not done

Possible

Tax concession

Nil

Fully exempted

Success rate

Not good

Very satisfactory

Source: Verma, J.C. Venture Capital Financing in India, Response Books, New
Delhi, 1997, p.23.

48

The Venture Capital Funds

A venture capital company and its venture funds are generally
different entities. The company usually floats a number of venture funds,
normally time-bound (close-ended), partly from its resources and partly with
major contributions from large corporations, pension funds, etc. The money is
then invested in a judicious mix of select high as well as low risk projects.
Venture capital companies do not invest in the firms where the credential
of the management appears to be doubtful. The most important investment
determinant of a venture capital fund is the quality of the management. George
Doriot, the most successful venture capital funds expert in the USA says, we can
back a first rate management team with a second rate product and have success,
but if we back a first rate product with a second rate management team, we can
seldom achieve our objectives.
In the developed countries, fund is mainly provided by private sector,
pension funds, insurance companies and banks, along with subscriptions from
private individuals and some industrial companies. The availability of large pools
of private capital is fundamental to the development of venture capital industry.
The following figure depicts the source of venture capital funds in the developed
countries.

49

SOURCES OF VENTURE CAPITAL FUNDS

Venture Capital

Short-term

Organizations

Investments

Contributory Funds

Venture Capital
Investments
a. Pension Funds
b. Individual & Families
c. Insurance / Investment
Companies
d. Foreign sources
e. Corporate Sector
f. Trust Endowments
And Foundations
Source: Fortune India, July, 1986.

50

2.2.

STAGES IN VENTURE CAPITAL FINANCING

Several distinct stages of a companys (project) development are

recognized by the venture capital industry for investment purposes. Venture

capital firms all over the world follow more or less similar practices of financing.
The venture capital financing covers a wide range of investment opportunities. An
entrepreneur needs venture capital at different stages of his companys growth.
Conceptually, there are three different stages at which a venture capital firm can
make investments.
Early Stage Financing
Ventures that seek finance for developing a new concept or exploiting a
new technology fall under this category. The management team is often
incomplete and does not have any proven track record. Finance may be provided
at seed stage, start-up stage or at the first stage.
Seed Finance
In the initial stage there is only an idea. The venture capitalist provides the
finance to the entrepreneurs to prove the concept. Seed capital is required to meet
the primary expenditures in respect of rent of the space, service charges of the
professionals and installation of requisite productive facilities. The seed capital
stage is essentially an applied research phase associated with research and
development.

51

Financing in this stage involves serious risk as the technology or

innovation being attempted may succeed or fail, after repeated investment.
Chances of success in high technology projects are meager. Seed capital finance is
warranted when there is enough evidence to show that the entrepreneur has used
up his own resources in carrying his idea to the point of acceptance and initiating
research.
At this stage, the venture capital firm has to see that the technology skill of
the entrepreneur is matched with market opportunities. The key risk at this stage is
marketing-related. The venture capital firm has to evaluate the commercial
acumen of the entrepreneur to take advantage of the market opportunity,
awareness of competition, the correct timing of launching the product and the
ability to motivate the staff to stay with the project rather than defect to rival
companies. The risk perception of investment at this stage is extremely high and
the investment may be realized in about 7 to 10 years.
Start-up Capital
Start-up capital is provided for financing product development and initial
marketing activities to launch a business. 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. In fact in the public eye,
the term start-up appears t be synonymous with venture capital in that the

52

product/service is being commercialized for the first time in association with

venture capital firm.
At this stage some indication of the potential market for the new
product/service is available. There are certain inherent problems in start-up
investments, especially related to the structuring of the deal. The natural desire of
the entrepreneur is to exercise control over the business he is starting with
inadequate resources of his own.
Although the start-up stage is exposed to high risk, and the investment may
take 5 to 10 years to realize, venture capital firms, however, assess the managerial
ability and capacity of the entrepreneur before making any financial commitment
at this stage and if needed, supply managerial skills and supervise the
implementation.
First Stage Financing
In this stage the firm starts producing the product, but the prospects are still
uncertain as to whether the market will accept the product or reject it outright. The
venture capitalist who finances a firm at this stage has a very high risk and may
take 5 to 7 years to realize the investment.
Expansion Financing
An enterprise established in a given market increases its profits
exponentially by achieving the economies of scale. This expansion can be
achieved either through an organic growth, that is by expanding production

53

capacity and setting up proper distribution system or by way of acquisitions.

Anyhow, expansion needs finance and venture capitalists support both organic
growth as well as acquisitions for expansion.
Second Stage Financing
Financing is done when the firm has the product or the service but it has
yet to develop the marketing infrastructure to reach the consumer. During this
period, additional finance is required because the project faces competition and
the firms own profits are normally meager to help it to penetrate the market.
The entrepreneur has invested his own funds but further infusion of funds
by the venture capital firm is necessary. The venture capital firms provide larger
funds at this stage than at other early stage financing, because the time scale for
the investment is obviously shorter than in the start-up case and the second round
financing is partly in the form of debt instrument which will provide some income
to the venture capital firm.
Third Stage Financing/Mezzanine Financing/ Development Capital
Finance may be required by established and profitable companies for
development or expansion of plant/equipment, expanding marketing and
distribution capabilities, refinancing existing debt, penetrating new geographic
regions, induction of new management, and so on. Venture finance provided at
this stage has medium risk and can be realized in one to three years. It constitutes
a significant part of the activities of many venture capital firms.

54

Bridge Finance
Bridge finance may be provided when a company is expecting to go to the
public shortly or any other sanctioned financial assistance from the commercial
banks, financial institutions and the like. When the finance remains undisbursed
due to some bureaucratic reasons, venture capital firms come forward to finance
the projects of the ventures under such critical juncture. This is the last round of
financing before going public, hence it involves low risk and the investment may
be realized in one to three years. Often bridge financing is structured so that it can
be repaid from the proceeds of an initial public offering.
Turnaround/ Acquisition/Buy-out Financing
Ventures that seek finance for turning around or acquiring or buying out a
existing company fall under this category.
Turnaround Financing
Finance may be given to a specialized group to bring about a turnaround of
an ailing (sick) company. Two kinds of inputs are required in turn-around, namely
money and management. The company may face mounting debt burden and
slowing down of cash inflows and may need more funds from all sources. The
enterprise may seek a moratorium from creditors for unpaid liabilities. The
original entrepreneur may be compelled to relinquish the enterprise to a new
management.

55

The venture capital firms play an active role in such a situation by

providing more equity investments and deploying managerial experts. Risk here is
medium to high and the investment can take three to five years to realize. It is
gaining widespread acceptance and increasingly becoming the focus of attention
of venture capital firms.
Acquisition Finance
Funds may be given to one company to finance its acquisition of another
company. Risk is medium to high and the investment may be realized in three to
five years in this case.
Management / Leveraged Buy-out Financing
The funds provided to the current operating management to acquire or
purchase a significant share holding in the business they manage are called
management buy-out. Management buy-in refers to the funds provided to enable a
manager or a group of managers from outside the company to buy into it. Buy-out
financed by other venture capitalists is known as leveraged buy-out.
Each of these stages in the life cycle has an inherent risk and time scale for
realization of the investment. However, the different stages of investment are
analytically distinct and vary as regards the time-scale, risk perceptions and other
related characteristics of the investment decision process. An overview of the
venture capital spectrum is given in table.

56

TABLE 2.2
VENTURE CAPITAL SPECTRUM
Stages
of
Investment
by
Venture Capital
Firm

1. Early Stage
(i)
Seed capital
(usually prototype
development)
(ii)
Start-up (to
commence
commercial)
(iii) Second round
(not yet profitable
enough for public
offering)
2. Later Stage
(i)
Mezzanine
development
capital
(established,
but
needs, expansion
finance)
(ii) Bridge (last
round
before
planned exit)
(iii)
Buy-out
(MBOs and MBIs)
(iv) Turnaround

Time-Scale
Risk
in
years Perception
(From
Investment
to
Public
Offering)

Finance for Expected

the Activity Return
Involved
(Indicative)

7 10

Extremely High

5 10

Very High

Manufacturing 60%
and research
based
Business
40 60%
Commitment

37

High

Marginal
Progress

30 40%

13

Medium

Expansion
Finance

25 35%

13

Low

Planned Exit

20 30%

13

Low

New
20 30%
Management
35
Medium to High Rescue
30 40%
Finance
Source: S. Ramesh and Arun Gupta, Venture Capital and the Indian Financial
Sector, Oxford University Press, New Delhi, 1995, p.66.

57

2.3. VENTURE CAPITAL INVESTMENT PROCESS

Investment Procedure
In generating a deal flow, the venture capital investor creates a pipeline
of deals or investment opportunities that he would consider investing in. This is
achieved primarily through plugging into an appropriate network. The most
popular network obviously is the network of venture capital funds/investors. It is
also common for venture capitals to develop working relationships with R&D
institutions, academia, etc, which could potentially lead to business opportunities.
Understandably the composition of the network would depend on the investment
focus of the venture capital funds/company. Thus venture capital funds focusing
on early stage technology based deals would develop a network of R&D centers
working in those areas.
The network is crucial to the success of the venture capital investor. It is
almost imperative for the venture capital investor to receive a large number of
investment proposals from which he can select a few good investment candidates
finally. Before making any investment, the goal as venture capitalists is to
understand virtually every aspect of the target company: the experience and
capabilities of the management team, the business plan, the nature of its
operations, its products and/or services, the methods by which sales are made, the
market for the products and/or services, the competitive landscape, and other
factors that may affect the outcome of the investment.

58

While due diligence investigations are viewed by many as mundane and

irritating tasks, the process enables venture capitalists to address areas of concern,
is an important tool in determining a fair pre-investment valuation, and may help
to avoid significant and otherwise unexpected liability following the investment.
The venture capitalists view the due diligence process as a means of identifying
and becoming comfortable with the risks to which their capital will be exposed.
The due diligence process involves an assessment of both the
microeconomic and macroeconomic factors that can affect the earnings growth of
the target company. The due diligence process also includes a review of the
corporate and legal records, including the documentation supporting any previous
issuances of the company's securities. Only one or two business plans in 100
result in successful financing. And of every 10 investments made, only one or two
are successful. But this is enough to recover investments made by the venture
capital (VC) in all 10 start-ups in addition to an average 40-50% return! Securing
an investment from an institutional venture capital fund is extremely difficult. It is
estimated that only five business plans in 100 are viable investment opportunities
and only three in 100 results in successful financing.
In fact, the odds could be as low as one in 100. More than half of the
proposals to venture capitalists are usually rejected after a 20-30 minute scanning,
and 25 per cent are discarded after a lengthier review. The remaining 15 per cent
are looked at in more detail, but at least 10 per cent of these are dismissed due to

59

irreconcilable flaws in the management team or the business plan. A Venture

Capitalist looks at various aspects before investing in any venture. First, you need
to work out a business plan. The business plan is a document that outlines the
management team, product, marketing plan, capital costs and means of financing
and profitability statements.
1. Initial Evaluation: This involves the initial process of assessing the feasibility
of the project.
2. Due diligence: In this stage an in-depth study is conducted to analyze the
feasibility of the project.
3. Deal structuring and negotiation: Having established the feasibility, the
instruments that give the required return are structured.
4. Investment valuation: In this stage, final amount for deal is decided.
5. Documentation: This is the process of creating and executing legal documents
to protect the interest of the venture.
6. 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.
7. Exit Policies: There are mainly 3 exit policies followed by VCFs in general.
1. Initial Evaluation:
Before any in depth analysis is done on a project, an initial screening is carried
out to satisfy the venture capitalist of certain aspects of the project. These include

60


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 .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
2. Due diligence
Due diligence is term used that includes all the activities that are associated
with investigating an investment proposal to assess feasibility. It includes carrying

61

out in depth reference checks on the proposal related aspects such as management
team, products, technology and market. Additional studies and collection of
project-based data are done during this stage. The important feature to note is that
venture capital due diligence focuses on the qualitative aspects of an investment
opportunity.
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 labour

Recruitment process

Products/services, technology and process

62

In this category the type of questions asked will depend on 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

Market
The questions asked under this head also vary depending on the type of
product. Some of the main questions asked are
 main customers
 future demand for the product
 competitors in the market for the same product category and their strategy
 pricing strategy
 supplier and buyer bargaining power
 channels of distribution

63

 marketing plan to be followed

 future sales forecast.
Market survey could be conducted to gather further more accurate and relevant
data.

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.

64

3. Structuring a deal
Structuring refers to putting together the financial aspects of the deal and
negotiating with the entrepreneurs to accept a venture capitals proposal and
finally closing the deal. Also the structure should take into consideration the
various commercial issues (i.e. what the entrepreneur wants and what the venture
capital would require to protect the investment). The instruments to be used in
structuring deals are many and varied. The objective in selecting the instrument
would be to maximize (or optimize) venture capitals returns/protection and yet
satisfy the entrepreneurs requirements. The instruments could be as follows:

65

INSTRUMENT

ISSUE

Equity shares

new or vendor shares par value partially-paid shares

Preference shares

redeemable (conditions under Company Act)

participating par value
nominal shares

Loan

clean Vs secured
Interest bearing Vs noninterest bearing
convertible Vs one with features (warrants)
1st Charge, 2nd Charge,
loan Vs loan stock maturity

Warrants

exercise price, expiry period

In India, straight equity and convertibles are popular and commonly used.
Nowadays, warrants are issued as a tool to bring down pricing. A variation that
was first used by PACT and TDICI was "royalty on sales". Under this, the
company was given a conditional loan. If the project was successful, the company
had to pay a percentage of sales as royalty and if it failed then the amount was
written off. In structuring a deal, it is important to listen to what the entrepreneur
wants, but the venture capital comes up with his own solution. Even for the
proposed investment amount, the venture capital decides whether or not the
amount requested, is appropriate and consistent with the risk level of the

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investment. The risks should be analyzed, taking into consideration the stage at
which the company is in and other factors relating to the project. (e.g. exit
problems, etc).
A typical proposal may include a combination of several different
instruments listed above. Under normal circumstances, entrepreneurs would prefer
venture capitals to invest in equity as this would be the lowest risk option for the
company. However from the venture capitals point of view, the safest instrument,
but with the least return, would be a secured loan. Hence, ultimately, what you
end up with would be some instruments in between which are sold to the
entrepreneur. A number of factors affect
the choice of instruments, such as
Categories

Factors influencing the choice of Instrument

Company specific

Risk, current stage of operation, , expected profitability, future

cash flows, investment liquidity options

Promoter specific

Current financial position of promoters, performance track-record,

willingness of promoters to dilute stake

Product/Project

Future market potential, product life-cycle, gestation period

specific
Macro environment

Tax options on different instruments, legal framework, policies

adopted by competition

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4. Investment valuation
The investment valuation process is an exercise aimed at arriving at an
acceptable price for the deal. Typically in countries where free pricing regimes
exist, the valuation process goes through the following steps:
1. Evaluate future revenue and profitability
2. Forecast likely future value of the firm based on experienced market
capitalization or expected acquisition proceeds depending upon the anticipated
exit from the investment.
3. Target ownership positions in the investee firm so as to achieve desired
appreciation on the proposed investment. The appreciation desired should yield a
hurdle rate of return on a Discounted Cash Flow basis.
In certainty the valuation of the firm is driven by a number of factors. The
more significant among these are:

Overall economic conditions: A buoyant economy produces an optimistic
long- term outlook for new products/services and therefore results in more
liberal pre-money valuations.

Demand and supply of capital: when there is a surplus of venture capital of
venture capital chasing a relatively limited number of venture capital deals,
valuations go up.
This can result in unhealthy levels of low returns for venture capital investors.

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Specific rates of deals: such as the founders/management teams track

record, innovation/ unique selling propositions (USPs), the product/service
size of the potential market, etc affects valuations in an obvious manner.

The degree of popularity of the industry/technology in question also
influences the pre-money. Computer Aided Skills Software Engineering
(CASE) tools and Artificial Intelligence were one time darlings of the
venture capital community that have now given place to biotech and
retailing.

The standing of the individual venture capital Well established venture
capitals who are sought after by entrepreneurs for a number of reasons
could get away with tighter valuations than their less known counterparts.

Investors considerations could vary significantly. A study by an American
venture capital, Venture One, revealed the following trend. Large
corporations who invest for strategic advantages such as access to
technologies, products or markets pay twice as much as a professional
venture capital investor, for a given ownership position in a company but
only half as much as investors in a public offering.

Valuation offered on comparable deals around the time of investing in the
deal.

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5. Documentation
It is the process of creating and executing legal agreements that are needed
by the venture fund for guarding of investment.
Based on the type of instrument used the different types of agreements are
 Equity Agreement
 Income Note Agreement
 Conditional Loan Agreement
 Optionally Convertible Debenture Agreement etc.
There are also different agreements based on whether the agreement is with
the promoters or the company. The different legal documents that are to be
created and executed by the venture firm are

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

Capital structure.

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.

Appointment of Board of Directors

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

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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

Number of shares to be subscribed by the venture capitalist

Purpose of the subscription

Pre-disbursement conditions that need to be met

Submission of reports to the venture capitalist

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

71

Guarantee Power of Attorney etc.

Whenever there is a modification in any of the agreements, then a
Supplementary Agreement is created for the same.
6. 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.

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Various styles
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 on a regular
basis information about the assisted projects. Venture capital target companies
with superior products or services focused at fast-growing or untapped markets.
Venture capitalists must be confident that the firm has the quality and depth in the
management team to achieve its aspirations. They will want to ensure that the
investee company has the willingness to adopt modern corporate governance
standards. Firms strong in factors relating to patents, management, idea, and
potential are more likely to obtain VC financing and willing partners to support
commercialization activities.
7. EXIT strategies adopted by VCFs:
A venture capital firm enters a relationship with a company with the
expectation that a significant return of investment will result when the firm exits

73

the investment. The firm plans for that exit to take place within a certain amount
of time, usually from three to six years, depending on the development stage of
the company in which it is investing. Depending on the investment focus and
strategy of the venture firm, it will seek to exit the investment in the portfolio
company. While the initial public offering may be the most glamorous and
heralded type of exit for the venture capitalist and owners of the company, most
successful exits of venture investments occur through a merger or acquisition of
the company by either the original founders or another company. Again, the
expertise of the venture firm in successfully exiting its investment will dictate the
success of the exit for themselves and the owner of the company.
There are several common exit strategies:
o IPO
o Mergers and Acquisitions
o Redemption
IPO
The initial public offering is the most glamorous and visible type of exit for
a venture investment. In recent years technology IPOs have been in the limelight
during the IPO boom of the last six years. At public offering, the venture firm is
considered an insider and will receive stock in the company, but the firm is
regulated and restricted in how that stock can be sold or liquidated for several
years. Once this stock is freely tradable, usually after about two years, the venture

74

fund will distribute this stock or cash to its limited partner investor who may then
manage the public stock as a regular stock holding or may liquidate it upon
receipt. Over the last twenty-five years, almost 3000 companies financed by
venture funds have gone public.
Mergers and Acquisitions
Mergers and acquisitions represent the most common type of successful
exit for venture investments. In an era of large companies dominating industry
landscapes, acquisition is often the targeted and most common exit strategy.
Smaller companies have, in essence, become the research and development arm of
larger companies who often look to buy them once their innovations can
contribute to their own profitability. In the case of a merger or acquisition, the
venture firm will receive stock or cash from the acquiring company and the
venture investor will distribute the proceeds from the sale to its limited partners.
Redemption
Another alternative is that the company may be required to buy back a
venture capital firm's stock at cost plus a certain premium. Often a venture capital
firm will put a redemption clause (sometimes referred to as a "buy-back clause")
in the investment terms which allows them to exit their investment in your
company in the event that an IPO or acquisition does not happen within a
designated time period.

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2.4. LEGAL FRAMEWORK FOR VENTURE CAPITAL INVESTMENT

SEBI GUIDELINES AND REGULATIONS
Incentives
Recognizing the importance of venture capital, the government introduced
major liberilisation of tax treatment for venture capital funds and simplification of
procedures. These included the following:
SEBI was recognized as the single nodal agency.
A new clause (23FB) in Section 10 of Income Tax Act was introduced with
effect from 1st March 2000. This clause stated that any income, of a
venture capital company or a venture capital fund, from any investments
made in venture capital undertaking, would not be included in computing
the total income.
Section 115U was also introduced in the Income Tax Act with effect from
the assessment year 2001-02 to establish a VC pass through. This means
that the VC profits will not be taxed twice. The regulated VC Fund (with
SEBI) would be exempted from tax (subject to certain conditions) but the
VC investor will have to pay tax.
Earlier on, if a VCF wished to avail certain tax benefits, the VCF had to
exit from investments made in a venture capital undertaking (VCU) within
twelve months of the VCU obtaining a listing. However, this requirement
was done away around November 2000. The Finance Bill 2001, proposes

76

to amend section 10 (23 FB) so as to provide that a VCC / VCF will

continue to be eligible for exemption under section 10 (23 FB), even if the
shares of the VCU, in which the VCC / VCF has made the initial
investment, are subsequently listed in a recognized stock exchange in
India.
Initiatives
There have been a number of initiatives by the Government as well as the
industry to pave way for a business and regulatory environment that is conducive
to new venture development and to innovation at the user end. Some of the
initiatives in the past have included those by the Ministry of Finance, the
Securities, Exchange Board of India (SEBI), Ministry of Information Technology
(formerly Department of Electronics), State Governments, Financial Institutions,
the Indian Venture Capital Association. These initiatives resulted in the
availability of more than US$ 500 million of venture funds for Indian ventures
during 1999-2000. With the growing realization of the immense potential offered
by Indian technology companies, funding opportunities are rapidly increasing.
The Government of India has already taken laudable steps to facilitate the creation
of an environment that is conducive for venture capital funds and start-ups in
India.
These include:
introduction of sweat equity,

77

 allowing venture capital funds to offset losses incurred in one company

against profits from another and establishment of government facilitated
venture capital funds.
However, the present regulatory framework is still not enough to provide for an
environment that lays stress on
encouraging the flow of venture funds,
easy exit options (for either party),
mentoring,
non-qualified availability of funds,
and flow of public funds for enterprise building in India.
India needs to encourage the growth of risk capital by acting on three fronts:
The Government of India and Indian financial institutions should catalyze
the process by creating Israel's Yozma-like funds. This will stimulate
competition but also protect entrepreneurs from inevitable risks.
India should amend its regulatory framework so that the VC funds can earn
a reasonable return on their risk capital.
India should actively promote the infusion of VC skills and capabilities,
either by attracting global VC funds or attracting managers from these
funds.

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However, the above moves need to be substantiated with the earliest

implementation of the recommendations of the SEBI Committee on Venture
Capital.
SEBI VENTURE CAPITAL FUNDS (VCFs) REGULATIONS,1996
According to this regulations, a VCF means a fund established in the form
of a trust/company; including a body corporate, and registered with SEBI which
(i) has a dedicated pool of capital raised in a manner specified in the regulations
and (ii) invests in venture capital undertakings(VCUs) in accordance with these
regulations a VCU means a domestic company (i) whose shares are not listed on a
recognized stock exchange in India and (ii) which is engaged in the business of
providing services/production/manufacture of articles/things but doesnt include
such activities/sectors as are specified in the negative list by SEBI with
governmental

approval-namely,

real

estate,

non-banking

financial

companies(NBFCs),gold financing, activities not permitted under the industrial

policy of the Government and any other activity which may be specified by SEBI
in consultation with the Government from time to time. The main elements of the
SEBI regulation are briefly outlined:
REGISTRATION
All VCFs must be registered with SEBI and pay Rs 25,000 as application
fee and Rs 5,00,000 as registration fee for grant of certificate. The eligibility
criteria for registration is:

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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.

Any company or a body corporate], who on the date of commencement of
these regulations 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 from the date of such commencement:
Provided that the Board, in special cases, may extend the staid period up to
a maximum of six months from the date of such commencement.

An application for grant of certificate under sub-regulation or subregulation shall be made to the Board in Form A and shall be accompanied
by a nonrefundable application fee as specified in Part A of the Second
Schedule to be paid in the manner specified in Part B thereof.

Any company or trust 3[or a body corporate] referred to in sub-regulation
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.

The Board may in the interest of the investors issue directions with regard
to the transfer of records, documents or securities or disposal of
investments relating to its activities as a venture capital fund.

80


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:
if the application is made by a company memorandum of association as has
its main objective, the carrying on of the activity of a venture capital
fund;
it is prohibited by its memorandum and articles of association from making
an invitation to the public to subscribe to its securities;
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;
its director, principal officer or employee has not at any time been
convicted of any offence involving moral turpitude or any economic
offence;
it is a fit and proper person
if the application is made by a trust

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);
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the main object of the trust is to carry on the activity of a venture capital
fund;

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 inserted by the SEBI
(Venture Capital Funds) Amendment Regulations, 1998

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 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
INVESTMENT CONDITIONS AND RESTRICTIONS
Minimum investment in a Venture Capital Fund.

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A venture capital fund may raise monies from any investor whether Indian,
Foreign or non-resident Indian. 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 lakhs rupees provided that nothing
contained in sub-regulation shall apply to investors who are,
(a) 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.
(b) the employees of the fund manager or asset management company;
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.
Restrictions on investment by VCF .
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 for the purpose,
one venture capital undertaking 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.

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Restrictions on investment by a venture capital fund-All investments made

or to be made by a venture capital fund shall be subject to the following
restrictions:
(a) the venture capital fund shall not invest in the equity shares of any company or
institution providing financial services;
(b) at least 80 percent of funds raised by a venture capital fund shall be invested in
the equity shares or equity related securities issued by a company whose securities
are not listed on any recognized stock exchange: Provided that a venture capital
fund may invest in equity shares or equity related securities of a company whose
securities are to be listed or are listed where the venture capital fund has made
these investments through private placements prior to the listing of the securities.
The equity shares or equity related securities of a financially weak
company or a sick industrial company, whose securities may or may not be listed
on any recognized stock-exchange.
Explanation: For the purposes of this regulation, a "financially weak company"
means 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 network as at the beginning of the previous financial year.
Providing financial assistance in any other manner to companies in whose
equity shares the venture capital fund has invested under sub-clause.

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As For the purposes of this regulation, "funds raised" means the actual
monies raised from investors for subscribing to the securities of the venture
capital fund and includes monies raised from the author of the trust in case the
venture capital fund has been established as a trust but shall not include the paid
up capital of the trustee company.
(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 4[33.33%] of the investible funds may be invested.
Prohibition on listing
No VCF would be entitled to get its units listed on any recognized stock
exchange till the expiry of three years from the date of issuance of units by it.
GENERAL OBLIGATIONS AND RESPONSIBILITIES
A VCF is not permitted to issue any document /advertisement inviting
offers from public for subscription/purchase of any of its units. It may receive
money from investment in the VCF through only private placement of its units.
Placement memorandum/subscription agreement.
The venture capital fund should
(a) issue a placement memorandum which shall contain details of the terms and
conditions subject to which monies are proposed to be raised from investor or

85

(b) 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.
(c) 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.
(d) 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.
Winding-up.
A scheme of a venture capital fund set up as a trust shall be wound up,
(a) when the period of the scheme, if any, mentioned in the placement
memorandum is over;
(b) 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;
(c) 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 (d) if the Board so directs
in the interests of investors.

A venture capital fund set up as a company shall be wound up in
accordance with the provisions of the Companies Act, 1956 (1 of 1956).

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A venture capital fund set up as a body corporate shall be wound up in

accordance with the provisions of the statute under which it is constituted.
As per the preference of investors, after obtaining approval of at least 75% of the
investors of the scheme.
INSPECTION AND INVESTIGATION
SEBI may, suomoto, or upon receipt of information/complaint appoint
one/more person(s) as inspecting /investigating officer(s) to undertake
inspection/investigation of the books of accounts/records/documents relating to a
VCF for any of the following reasons:

To ensure that the book of accounts, records and documents were being
maintained by it in the specified manner.

To inspect or investigate into complaints received from investors, clients or
any other person, on any matter having a bearing on its activities.

To ascertain whether it is complying with the provisions of the SEBI acts
and its regulations.

To inspect or investigate suomoto, into the affairs of the venture capital
fund, in the interest of the securities market/investors.
Obligations of VCFs
Obligations of venture capital fund on inspection or investigation by the
Board.-(1) It shall be the duty of the venture capital fund whose affairs are being
inspected or investigated, and of every director, officer and employee thereof, of
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its asset management company, if any, and of its trustees or directors or the
directors of the trustee company, if any, to produce before the inspecting or
investigating officer such books, securities, accounts, records and other
documents in its custody or control and furnish him with such statements and
information relating to the venture capital fund, as the inspecting or investigating
officer may require, within such reasonable period as the inspecting officer may
specify.
It shall be the duty of every officer of the Venture Capital Fund in respect
of whom an inspection or investigation has been ordered under regulation 25 and
any other associate person who is in possession of relevant information pertaining
to conduct and affairs of such Venture Capital Fund including Fund Manager or
asset management company, if any, to produce to the Investigating or Inspecting
Officer such books, accounts and other documents in his custody or control and
furnish him with such statements and information as the said officer may require
for the purposes of the investigation or inspection.
It shall be the duty of every officer of the Venture Capital Fund and any
other associate person who is in possession of relevant information pertaining to
conduct and affairs of the Venture Capital Fund to give to the Inspecting or
Investigating officer all such assistance and shall extend all such co-operation as
may be required in sought by the Inspecting or Investigating Officer in connection
with the inspection or investigation.

88

The Investigating or Inspecting Officer shall, for the purposes of inspection

or investigation, have power to examine on oath and record the statement of any
employees, directors or person responsible for or connected with the activities of
venture capital fund or any other associate person having relevant information
pertaining to such Venture Capital Fund.
The Inspecting or Investigating Officer shall, for the purposes of inspection or
investigation, have power to obtain authenticated copies of documents, books,
accounts of Venture Capital Fund, from any person having control or custody of
such documents, books or accounts. documents and computer data in the
possession of the venture capital fund or such other person and also provide
copies of documents or other materials which, in the opinion of the inspecting or
investigating officer are relevant for the purposes of the inspection or
investigation, as the case may be.
The inspecting or investigating officer, in the course of inspection or
investigation shall be entitled to examine or to record the statements of any
director, officer or employee of the venture capital fund.
It shall be the duty of every director, officer or employee, trustee or
director of the trustee company of the venture capital fund to give to the
inspecting or investigating officer all assistance in connection with the inspection
or investigation, which the inspecting or investigating officer may reasonably
require.

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Action in case of default

SEBI can suspend/cancel the registration of a VCF on the basis of the due
procedure.
Suspension of registration
The certificate of registration granted to a VCF can be suspended by SEBI,
in addition to issuing of direction/measures specified above in the following
circumstances:

Contravention of any of the provisions of the SEBI Act or these
regulations.

Failure to furnish any information relating to its activity as a VCF as
required by SEBI.

Furnishing to SEBI information which is false/misleading in any material
particular.

Non-submission of periodic returns/reports as required by SEBI

Non-cooperation in any enquiry, inspection/investigation conducted by
SEBI

Failure to resolve the complaints of investors/to give a satisfactory reply to
SEBI in this behalf.
Cancellation of registration
The registration of a VCF can be cancelled by SEBI when it:
Is guilty of fraud or is convicted of an offence involving moral turpitude;

90

 Has been guilty of repeated defaults which may result in suspension of the
registration;
Contravenes any of the provisions of the SEBI Act or these regulations.
The order of suspension/cancellation of certificate of registration would
be published by SEBI in two newspapers. On and from the date of
suspension/cancellation, the VCF would cease to carry on any activity as a VCF
and would be subject to directions from concerning SEBI the transfer of records,
documents/securities that may be in its custody/control as it may specify.
Action Against Intermediaries
SEBI may initiate action for suspension/cancellation of registration of an
intermediary (registered with it) who fails to exercise due diligence in the
performance of its functions or fails to comply with its obligations under these
regulations.
Any person aggrieved by an order of SEBI under these regulations may
prefer an appeal to the securities appellate Tribunal (SAT).

Regulatory Reforms and Framework

SEBI (Venture Capital Funds) (Amendment) Regulations, 2000 and the SEBI
(Foreign Venture Capital Investors) Regulations, 2000.
1. Following are the salient features of SEBI (Venture Capital Funds)
(Amendment) Regulations, 2000:

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Definition of venture capital fund:

The venture capital fund is now defined as a fund established in the form of
a Trust, a company including a body corporate and registered with SEBI
which:

has a dedicated pool of capital;

raised in the manner specified under the Regulations; and

to invest in venture capital undertakings in accordance with the
Regulations.
Definition of venture capital undertaking:
Venture capital undertaking means a domestic company:

Whose shares are not listed on a recognized stock exchange in India.

Which is engaged in business including providing services, production or
manufacture of articles 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. The negative list includes real estate, non-banking financial
services, gold financing, activities not permitted under the Industrial Policy
of the Government of India.

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Minimum contribution and fund size:

The minimum investment in a Venture Capital Fund from any investor will
not be less than Rs.5 lacks and the minimum corpus of the fund before the fund
can start activities shall be at least Rs.5 crores.
Investment criteria:
The earlier investment criteria has been substituted by a new investment
criteria which has the following requirements:

Disclosure of investment strategy;

Maximum investment in single venture capital undertaking not to
exceed 25% of the corpus of the fund;

Investment in the associated companies not permitted;

At least 75% of the investible funds to be invested equity shares or
equity linked instruments.

Not more than25% of the investible funds may be invested by way of:
(a) 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;
(b) Debt or debt instrument of a venture capital fund has already made an
investment by way of equity.
It has also been provided that venture capital fund seeking to avail
benefit under the relevant provisions of the Income Tax Act will be

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required to divest from the investment within a period of one year from the
listing of the venture capital undertaking.
Disclosure and information to investors:
In order to simplify and expedite the process of fund raising, the
requirement of filing the Placement memorandum with SEBI is dispensed with
and instead the fund will be required to submit a copy of Placement
Memorandum/copy of contribution agreement entered with the investors along
with the details of the fund raiser for information to SEBI. Further, the contents of
the Placement Memorandum are strengthened to provide adequate disclosure and
information to investors. SEBI will also prescribe suitable reporting requirement
from the fund on their investment activity.
2. QIB status for venture capital funds:
The venture capital funds will be eligible to participate in the IPO through
book building route as Qualified Institutional Buyer subject to compliance with
the SEBI (Venture Capital Fund) Regulations.
3. Relaxation in takeover code:
The acquisition of shares by the company or any of the promoters from the
Venture Capital Fund under the terms of agreement shall be treated on the same
footing as that of acquisition of shares by promoters/companies from the state
level financial institutions and shall be exempt from making an open offer to other
shareholders.

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4. Investments by mutual funds in venture capital funds:

In order to increase the resources for domestic venture capital funds,
mutual funds are permitted to invest up to 5% of its corpus in the case of openended schemes and up to 10% of its corpus in the case of close-ended schemes.
Apart from raising the resources for venture capital funds this would provide an
opportunity to small investors to participate in venture capital activities through
mutual funds.
5. Government of India guidelines:
The government of India (MOF) guidelines for overseas venture capital
investment in India dated September 20, 1995 will be repealed by the MOF on
notification of SEBI

Venture Capital Fund Regulations.

6. The following will be the salient features of SEBI (Foreign Venture Capital
investors) Regulations, 2000:
Definition of foreign venture capital investor:
Any entity incorporated and established outside India and proposes to
make investment in venture capital fund or venture capital undertaking and
registered with SEBI.
Eligibility criteria:
Entity incorporated and established outside India in the form of investment
company, trust, partnership, pension fund, mutual fund, university fund,
endowment fund, asset management company, investment manager, investment

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management company or other investment vehicle incorporated outside India

would be eligible for seeking registration from SEBI. SEBI for the purpose of
registration shall consider 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 promoters track record where the applicant is neither
a regulated entity nor an income tax payer.
Investment criteria:

Disclosure of investment strategy;

Maximum investment in single venture capital undertaking not to exceed
25% of the funds committed for investment of India. However it can invest
its total fund committed in one venture capital fund;

At least 75% of the investible funds to be invested in unlisted equity shares
or equity linked instruments.

Not more than 25% of the investible funds may be invested by way of:
(a) 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;
(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.
The foreign venture capital investors proposing to make venture capital
investment under the Regulations would be granted registration by SEBI. SEBI

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registered foreign venture capital investors shall be permitted to make investment

on an automatic route within the overall sect oral ceiling of foreign investment
under Annexure III of statement of Industrial Policy without any approval from
FIPB.
Further, SEBI registered FVCIs shall be granted a general permission from
the exchange control angle for inflow and outflow of funds and no prior approval
of RBI would be required foe pricing, however, there would be ex-post reporting
requirement for the amount transacted.
8. Trading in unlisted equity:
The board also approved the proposal to permit OTCEI to develop a
trading window for unlisted securities where Qualified Institutional Buyers (QIB)
would be permitted to participate.
Some of the members of the Board felt that the mandated post listing exit
time frame of one year for availing tax pass through by a domestic venture capital
fund could be reconsidered by the Government in the light of international
experience and the need to avoid operational restrictions and optimize inflow of
venture capital in the country. The Board also desired that a small Group within
SEBI could be set up to codify the experience of the existing players, international
experience including tax treatment and potential areas for venture capital funding.
There have been tremendous legal and regulatory reforms in the Venture
Capital and Private Equity sectors, which have led to the present state of boom in

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the Private Equity scenario in India. Some of the major reforms impacting this
industry can be summarized as under:

Government if India issued guidelines in September 1995 for overseas
Venture Capital investment in India.

SEBI framed SEBI (Venture Capital Funds) Regulations, 1996.

In 1999-the companies (Amendment) Act, 1999, dispensed with prior
approval of Central Government for investment by a company exceeding
60 percent (paid-up share capital +free reserves) or 100 percent free
reserve, whichever is more, and enabled the company to make investment
by way of special resolution at general meeting.

In 2000-SEBI introduced an-other regulation for SEBI (Foreign Venture
Capital Investors) Regulations, 2000, enabling foreign Venture Capital and
Private Equity investors to register with SEBI and avail certain benefits
provided there under.

In 2000-amendments were made in SEBI (Substantial Acquisition of
Shares and Takeovers) Regulation, 1997; as a result, these regulations were
not to apply to the shares transferred from VCF or FVCI to the promoters
or to the company itself, if effected as per pre-existing agreement between
VCF or FVCI and the promoters of the company . If promoters buy back
the shares from FVCI, then there is no requirement of public offering.

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In 2000-as per FEMA, FVCI can acquire or sell any investment held by it
at a mutually acceptable price.

In 2001-The companies (Amendment) Act, 2001, reduced the period of
issue of fresh shares from 24 months to 6 months, from when the company
completes the buyback of its shares.

In 2001-The companies (Issue of share capital with differential voting
rights) Rules, 2001, allowed every company limited by shares to issue
shares with differential rights (voting or dividend).

In 2003-Qualified Institutional Buyer QIB status granted to VCF/FVCI,
as per SEBI (DIP) guidelines. VCF/FVCI can subscribe securities at IPO of
a VCU through book-building process.

In 2004-VCF/FVCI permitted to invest in NBFC registered with RBI and
engaged in equipment leasing or Hire Purchase. It permitted to invest in
companies engaged in gold financing for jeweler. FVCI allowed to invest
100 percent in one VCU, as compared to the 25 percent earlier.

In 2005-in the press note 1 of 2005, exemption was granted from prior
government approval under press note 18 of 1998.
Indias Security markets regulator SEBI (Securities Exchange Board of
India) has approved the SEBI (Alternative Investment Funds) Regulations, 2012
to bring unregulated funds under its purview, ensure systemic stability, increase
market efficiency and enable the formation of new capital. These regulations will

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be applicable to all pooled investment vehicles apart from Mutual Funds, CIS
Schemes, Family Trusts, ESOP Trusts, Employee Welfare Trusts, holding
companies, funds managed by Asset Reconstruction Companies, Securitization
Trust or funds directly regulated by any other regulator in India.
Some of the regulations approved by the board include:
Registration:
All Alternative Investment Funds (AIFs), whether operating as Private
Equity Funds, Real Estate Funds or Hedge Funds should be registered with SEBI.
Withdrawal of old VC Fund Regulations:
The SEBI (Venture Capital Funds) Regulations of 1996 will be officially
withdrawn, however existing venture capital funds will continue to be regulated
by the regulations until the fund winds down its operations and they will not be
allowed to raise any fresh funds, except for the previous investor commitments.
That being said, Venture Capital funds can also opt to re-register themselves
under the new AIF regulations, provided they receive the approval to do so from
66.67% of their investors and can seek exemption from the board from strictly
adhering to these regulations, in case they are not able to comply with all the new
regulations.
Unregistered funds will not be allowed to launch new schemes without
registering with SEBI under the new AIF regulations. The existing schemes which
were launched by funds prior to the AIF regulation announcement, will however

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continue to be governed till it matures by contractual terms, with no room for a

rollover or an extension.
Corpus:
AIFs should have a minimum corpus of Rs 20 crores and they shall not
accept any investment less than Rs 1 crores from an investor. The fund should not
have more than 1000 investors and the fund manager should have continuing
interest of minimum 2.5% of the initial corpus or Rs 5 crores, whichever is lower.
The fund manager is not allowed to continue the interest through the waiver of
management fees.
Filings:
Funds can launch schemes, following the filing of

information

memorandum with the Board along with applicable fees, and fund units can be
listed on the stock exchange subject to a minimum tradable lot of Rs one crores,
however they are forbidden to raise funds through the exchange.
Limits To Investment:
AIFs are not allowed to invest more than 25% of the funds in one
Company and are forbidden to invest in associate companies. They should also
provide investors with financial information of portfolio companies as also
material risks and how these are managed on an annual basis.
All AIFs will have a Qualified Institutional Buyer (QIB) status as per
SEBIs (Issue of Capital and Disclosure Requirements) Regulations of 2009.

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SEBI will work with the Government of India to extend the tax passthrough status to these AIFs. Currently, the tax pass-through status is only enjoyed
by investors who invest in select sectors such as bio-technology, nana-technology,
hardware and software development and many more. The regulator also has the
right to inspect or investigate any AIFs and take necessary action.
What Funds Are Under This New Regulation?
SEBI stated that the new regulations will broadly cover all types of funds
under three categories. All AIFs can apply for registration under one of the
categories below:
Category I AIFs:
These funds will be close ended, adhere to the investment restrictions as
instructed for each category and shall not engage in leverage i.e. any activity to
multiply gains and losses like borrowing money, buying fixed assets and using
derivatives. SEBI stated that they or Government of India or other Indian
regulators may consider certain incentives or concessions for these funds,
depending upon the specific need of each type of funds. Among the funds
included in this category are Venture Capital Funds, SME Funds, Social Venture
Funds and Infrastructure Funds and the minimum tenure of these funds should be
3 years.

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Category II AIFs:
These funds shall be close ended with no investment restrictions. However
these funds are not allowed to engage in leverage other than meeting day-to-day
operational requirements, as per the regulations and they will not attract any
specific incentives or concessions from SEBI, Government of India or any other
regulator. Among the funds included in this category include Private Equity
Funds, Debt Funds, Fund of Funds and unclassified funds that dont fall under
either category I or category III and have a minimum tenure of 3 years.
Category III AIFs:
These funds can be open ended or closed ended and are allowed to engage
in leverage within the prescribed board limits. Among the funds included are
Hedge Funds which, according to SEBI, have negative externalities i.e. these
funds make decisions which may impose a negative effect on other funds, thereby
leading to inefficiencies in the market. These funds will be regulated through
Boards directions in areas such as operational standards, conduct of business
rules, prudential requirements, restrictions on redemption, and conflict of interest.

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