An Introduction to Venture Capital

Venture Capital/Private Equity is medium to long-term finance provided in return for a shareholding in unquoted companies. For the purposes of this guide Private Equity refers to Venture Capital and Business Angel investments at stages in a companys development, from the seed to expansion stages, as well as management buy-outs and buy-ins. The terms Venture Capital and Private Equity should therefore be regarded as interchangeable phrases. The purpose of this booklet is to encourage you to start planning early when seeking finance to accelerate the growth of your business. It will explain how a Venture Capitalist approaches the process of investing equity in a business and what you need to do to improve your chances of raising equity. It gives guidance on what should be included in your business plan, the most important document you will produce when searching for a private equity investor. The guide also demonstrates the positive advantages that venture capital/private equity will bring to your business. The main sources of private equity on the island are Venture Capital Funds, Business Angels (private individuals who provide smaller amounts of finance at

an earlier stage than many private equity firms are able to invest at), Government Agencies (depending upon the sector your business operates in, the presence of other investors and where the business is in its development cycle) and Corporate Venturers. Corporate Venturers can be product related or service companies that provide funds and/or a partnering relationship between mature and early stage companies which may operate in the same industry sector. This Guide's principal focus is upon Venture Capital Funds. However, the investment criteria that both Venture Capital Funds and Business Angels apply when assessing potential investee companies is often very similar - therefore the guide will benefit entrepreneurs and their advisers looking for private equity from both these sources. In short, the aim is to help you understand what Venture Capital Funds are looking for in a potential business investment and how to approach them.

What is venture capital/private equity?

Venture Capital/Private Equity; provides long-term, committed share capital, to help unquoted companies grow and succeed. If you are looking to start up, expand, buy into a business, buy out a division of your parent company, turnaround or revitalise a company, Private Equity could help.

Obtaining private equity is very different from raising debt or a loan from a lender, such as a bank. Lenders, who usually seek security such as a charge over the assets of the company, will charge interest on a loan and seek repayment of the capital. Private equity is invested in exchange for a stake in your company and, as shareholders, the investors' returns are dependent on the growth and profitability of your business. The investment is unsecured, fully at risk and usually does not have defined repayment terms. It is this flexibility which makes private equity an attractive and appropriate form of finance for early stage and knowledge-based projects in particular.
Brief History of the Venture Capital Industry The idea of investing capital in risky ventures with a tremendous upside is not new. The explorers who sailed the globe in the fifteenth and six-teenth centuries looking for fabulous treasure in exotic lands had to get their financing from somewhere. The lucky ones had access to the king or queen and the royal treasurer. Even if you had a great reputation as a seagoing adventurer, it wasnt easy to get an audience with the crowns money men, unless you had someone on the inside to make the contact for you. The more things change . . . With the Industrial Revolution, funding technology ventures eventually became an interesting diversion for the very rich. In the late nineteenth century, a prolific

inventor sought $30,000 in research and development (R&D) funding for a device he claimed would replace the universally popular gas lamp, although attempts to commercialize other similar devices had failed for several decadesthey generated an unsafe amount of heat, and the materials used to manufacture the alternative devices were too expensive. A syndicate of financiers, including J. P. Morgan and the Vanderbilts, decided to go ahead and fund the development of the new technology. Potential financial partners might have been concerned about the inventors lack of formal scientific training or his weak financial management skills. But the inventor was Thomas Edison, and he produced the incandescent electric light bulb. This shows us that if you notice J. P. Morgan is the lead investor in a deal, go ahead and jump in. Prior to the Second World War, companies seeking start-up capital often relied on wealthy individuals or wealthy industrial families as backers angels, as we call them today. These were old-money type of investors, and deals were often consummated in the quiet dining rooms of country clubs. These were careful investors who knew how long it took to accumulate wealth. The first true venture fund, in that it raised institutional capital and invested in early-stage ventures, is said to have begun in 1946. The first letter to an entrepreneur declining investment went out that same year, and the phrase Sorry, your venture does not fit our investment parameters was coined.

The first business plan is thought to have been written in 1954, revised throughout 1955, and read by an investor for 12 minutes sometime in early 1956. The U.S. Government passed the Small Business Investment Act in 1958, which created incentives for the development of Small Business Investment Companies (SBICs) that would provide financing for small companies that did not have ready access to the capital markets. The country was founded in 1776. Thus it only took the government 182 years to figure out that the small business person needs capital. Silicon Valley emerged in the 1960s, when a company there, south of San Francisco, became the first to make computer chips completely out of silicon. Developments related to this technological breakthrough required venture capital, and a community of engineers and scientists, investors, and managerial talent sprang up. This pattern would later be repeated in other areas of the United States: Plant a seed of technology, fertilize with management talent, water with abundant amounts of venture money, grow companies, and hope for a bountiful harvest three to seven years later. Over the next 20 years the number of venture capital companies and investment groups in the United States swelled to several thousand and the amount of venture investment grew steadily to the tens of billions of dollars. The investment concentration of these companies changed with major technological innovation:

biotech, computer hardware and software, semiconductors, communications, and the Internet have all had their day in the sun. Entrepreneurs have an innate sense of what investment area is currently hot because its the area completely unrelated to whatever company they are seeking capital for at the time. In the mid- to late 1990s, a tremendous upsurge in stock prices created thousands of new millionaires in the United States, many of whom began to seek out investments in entrepreneurial ventures. These new angel investors are quite different from the angels of old. With nearly unlimited access to information, they have the ability to make much better informed decisions than their predecessors. After all, it cant be that hard to be a venture capitalist, can it? Who Are the Venture Capitalists? They are commonly called the VCs, as if they are a completely homogenous group with uniform background, experience, attitudes and business philosophy. The popular image of the venture capitalist is a middle-age person with a finance background, probably from one of the nations premier universities. A kind of pinstripe suit person. Very focused on rate of return. A bottom-line guy. The truth is very different. Some VCs are quite young. It is not unusual these days for partners in venture capital firms to be in their early 30s. Increasing numbers of women are entering this once very maledominated profession. They are not all finance gurus, either. If you examine the background of venture capitalists that are posted on their

web sites, you will see that many have an engineering or technical background, some are marketing experts, and quite a few have general business experience related to starting and growing small companies into large ones. In medicaloriented venture capital funds, a number of the partners are physicians or scientists. Not all venture capitalists are even from the United States. Because business is increasingly conducted on a global basis, you will see partners in venture capital firms from Europe, Asia, and other parts of the world.

How do I make my company attractive to a Venture Capitalist or an investor in general?

Many small companies on the island do not grow and so do not provide 'upside potential' for the owners other than to provide a good standard of living and job satisfaction. These businesses are not generally suitable for private equity investment, as they are unlikely to provide sufficient financial returns to make them of interest to an external investor. High potential businesses can be distinguished from others by their aspirations and potential for growth, rather than by their current size. Such businesses are aiming to grow rapidly to a significant size. As a rule of thumb, unless a business can

offer the prospect of significant turnover growth within three to five years, it is unlikely to be of interest to a private equity investor. This usually means that the market for the product and service will not solely be on the island. Private equity investors are interested in companies with high growth prospects, enjoy barriers to entry from competitors, are managed by experienced and ambitious teams and have an exit opportunity for investors which will provide returns commensurate with the risk taken. Venture Capital Funds normally agree their investment criteria with those who have invested in the fund, for example, preferred sectors and stages of development. Business Angels also usually prefer to invest in projects which reflect their own skill sets or investment history. When approaching a Venture Capitalist or a Business Angel, it is important to understand if their investment criteria or preferences match your project. Earlier stage projects normally reflect a higher level of risk for equity investors, so it's important that entrepreneurs explore all possible sources of finance when fundraising.
Benefits of Venture Capital In the current economic climate on the island, most fast growth start-ups are knowledge based. Given that these projects cannot offer tangible security to traditional

debt financiers or predictable cash flows to service loans, private equity is the obvious source of finance to fill the financing gap. Investment executives working with Venture Capital Funds attempt to identify the best projects in order to minimize their investment risk. Research has shown that Venture Capital backed companies grow faster than other types of companies, employ more people and are more profitable when benchmarked against their peers. This is made possible by a combination of capital, Venture Capitalists identifying and investing in the best investment opportunities and input from Non-Executive and Executive Directors introduced by the VC investor (a key differentiator from other forms of finance) WHY DO VENTURE CAPITALISTS SEEM SO FOCUSED ON CERTAIN GEOGRAPHICAL AREAS? A significant number of venture capital firms will consider investing in companies throughout the United States. Many others, however, limit their interest to certain regions, or even certain states. The main reason for this is simply that it is easier to visit companies and attend meetings with management after funding if the company is within driving distance or at most a short plane trip away from the venture capitalists office. Another reason is that the venture capital firms tend to locate their offices in areas that are particularly fertile regarding the number of good companies to invest in. They

dont see a need to spend time looking outside this area. The reverse is also true: Entrepreneurs are attracted to areas with an infrastructure of venture capital firms and professional service providers that work with start-up or emerging companies. And then the best managerial talent is attracted to these same areas because there are many challenging job opportunities with the potential for lucrative stock options. So you end up with pockets of the country that have all the ingredients investors, the hottest technologies, the best management talent, a complete service infrastructure. Its almost as if It takes a village to build a company. Hmmm. Kind of a catchy phrase. Entrepreneurs puzzle over venture capitalists who say, We invest primarily in Southern California but are willing to look at excellent opportunities in other parts of the country. Should I contact that venture capital firm or not? asks the entrepreneur in the Midwest, who of course believes that his company represents an excellent opportunity. Why Is Finding Capital So Difficult for Entrepreneurs? There are a number of reasons why entrepreneurs have so much trouble finding capital. Entrepreneurs dont understand how the process works and do not understand the thought processes of investors. Investors end up seeming more elusive than they really are.

 Entrepreneurs dont know where to look for capital, and do not have the contacts necessary to be introduced to investors. Different capital sources fit different stages of investment and type of companies. Raising money takes a certain flair for salesmanship that not everyone has. Some individuals are better at doing than talking. Entrepreneurs underestimate how long it will take to find investors. Raising money is a time-intensive process that takes time away from what the entrepreneur really wants to do: build a successful enterprise. And the most important reason: The funding of private enterprises is not an efficient market. It is getting more efficient, but it has a long way to go. Its certainly not an efficient market when willing buyers and willing sellers of a commodity (equity in emerging enterprises) have such an incredibly difficult time finding each other. You would never say the market is efficient when the pricing for the commodity is established by guesswork and the opinions of a handful of potential buyers. And it is not an efficient market when the seller is allowed to Meet the buyer only if the seller has met the good friend of a good friend of the buyer at some cocktail party sometime, somewhere. Fortunately, we will see in later chapters that the Internet is bringing down some of these barriers that keep the entrepreneurs from having access to the investors. But the market inefficiencies

show why entrepreneurs should not be too hard on themselves when it takes more time to find capital than they imagined it would. A free and open marketplace would be the ideal; its not here yet. What Entrepreneurs Dont Know About Venture Capitalists Venture capitalists have to go out and raise money, too. Wealthy individuals, or angels, may use their own funds to invest, but professionally managed venture capital firms get the majority of their funds from outside the partners in the firm. They raise the money from corporate pension funds, corporations, public pension funds, foundations, endowment funds, wealthy individuals, and insurance companies. Venture capitalists have people watching them, too. The funds are often organized as limited partnerships, with the venture capital firm serving as a general partner. The other institutional investors are the limited partners. They may talk like financiers, but they are actually employees of a financial institution much like your local commercial banker. Venture capitalists will tell you they are much smarter than most commercial bankers, however. Venture capitalists are under a certain amount of pressure to find good investments for the fund within a reasonable length of time, just as commercial loan officers in banks are charged with going out and finding companies that will make good loan prospects. Venture capitalists have to go out periodically and raise money themselves. This is why they have a keen understanding of what the entrepreneur goes through trying to

find money. Venture capitalists will meet with the managers of the large pension funds and the other funding sources mentioned above and describe what the investment focus of the new venture fund is planned to be, and why the venture capitalists believe the partners of their firm are uniquely qualified to find great investments and build portfolio companies. This is why we see venture funds that are extremely focused on a narrow range of investmentssome wont do seed stage ventures, for example; some only invest in telecommunications, or medical technology. They have secured funding for the venture fund based on the understanding that they will stick close to these criteria. That is why, as a general rule, no amount of discussion or sales effort on the part of an entrepreneur, no matter how persuasive, will get a venture capitalist to deviate very far from the Established investment focus of the firm. The institutions that place money in venture capital funds do so because of the historically superior investment returns venture capital funds have been able to achieve relative to other classes of equity investment. Lets say that in the long run you are able to achieve a return of 10 percent by investing in publicly traded securities. The historical returns venture capital funds have been able to achieve have been closer to 25 percenta substantially better performanceand even higher in recent years. Some top-performing funds

achieve average annual returns of 100 percent or more. Institutional investors typically allocate only a very small percentage of their total investment capital in venture capital funds because there is a great deal of risk in this type of investment. The 25 percent rate of return just mentioned comes about by averaging the widely varying performance of the individual investments, or companies funded, in the venture capitalists portfolio. It is often said that venture capitalists seek an annual return of 30 to 40 percent or higher on each investment. The 25 percent average return comes about because some companies are complete busts and the investment has to be written off. Some companies fail and the investment has to be written off. Others will not reach growth expectations but are still viable enterprises. There will be solid companies that perform as expected in their business plans. It is hoped that there will be superstars that become phenomenal initial public offerings (IPOs) or will be acquired by other companies for large multiples on revenues or earnings. LOOKING BEYOND THE FUNDING Money is only part of the contribution venture capitalists make to growing businesses. They offer knowledge about how to grow companies, the challenges all entrepreneurial companies face, how to build a distribution network, and how to attract top-flight management. They understand the entire life cycle of a company, from getting started to going public or being acquired. Venture capitalists manage

a portfolio of investments, much as mutual fund managers do with public companies. They consider diversification by stage of company and industry. They hold onto investments longer than mutual fund managers. An entrepreneur may get turned down by a venture capitalist not because the company does not have investment merit, but because the company does not fit into the overall strategy of the fund. Perhaps the fund already has several other investments in similar companies. Capital availability is not distributed evenly across the United States. Northern California and the Northeast states dominate in terms of the number of companies being funded and the total capital committed to companies there. The pace of investment is picking up significantly in the Midwest and Southeast, however. Companies located in places outside the venture capital hotbeds have a more difficult time finding investors. Entrepreneurs still think venture capital is available only to high- technology companies. The majority of companies funded have a technology component, yes, but its not the whole picture. Many entrepreneurs are surprised to find out there are venture capital funds that focus solely on retail enterprises, for example. THE CONFLICT BETWEEN THE ENTREPRENEUR AND THE

INVESTORS

How would you characterize the relationship between an investor and an entrepreneuras predator/prey? As father/offspring? As partner/partner? As boss/employee? Or as benefactor/beggar? If you ask investors how the relationship is supposed to work, they would uniformly respond that it should be partner/partner. Does it work that way in real life? It can, but not necessarily. And its not all the investors fault. POINTS OF CONFLICT Many Entrepreneurs Dont Really Want Partners, They Want Money. At the heart of the entrepreneurial desire is the need to be in control, in command. Many talk a good game about wanting to have the investor involved, but they dont really want to. Forming a partnership with an investor inherently creates the potential conflict over who is in control, but theres no way around doing it that way. It can be far too expensive for a small company to go public on its own. And small companies need expertise investors have to offer. The partnership with the investor results in the entrepreneurs strategies or decisions being questioned, not an easy thing for some people to take. Entrepreneurs can get excessively stuck on certain ideas and resent input from investors. They can have a kind of arrogance regarding the benefits or what they perceive as the true perfection of their products or services.

Wow, How Long Does It Take to Grow an Ego That Large? The meeting between the investor and the entrepreneur amounts to the clash of two (or more) tremendous egos. Anyone who has met a venture capital-ist at a trade show, a venture capital conference, or any other event can attest that many of them cant wait to tell you how much they know about every aspect of every industry and every enterprise. They always know more than you doeven if you have worked in the industry for a number of yearsand they will gladly tell you so. The more successful they are and the more money they have made, the larger the ego grows. It is an interesting facet of capitalism in general that the people who reach the top and acquire the most wealth eventually, conveniently, forget the sheer luck, the being-in-the-right-place-at-the-right-time phenomena, that was greatly responsible for their success, and recall only the strokes of individual genius that led to their (inevitable) victory. When dealing with venture capitalists, theres no getting around this ego factor. It is a state of nature with them. Ah, but the entrepreneur is not so innocent in this regard, either. Several years ago we arranged a meeting for an entrepreneur with a venture capital group that specializes in expansion capital for industry consolidation deals, putting several companies together to create a larger, more competitive entity. The partner of this group is a very pleasant, fair, easygoing individual, whose firm has done extremely well; and his family had done well for generations. The entrepreneur was, at best, a guy with a spotty track

record and a tiny company with big dreams. The entrepreneur shook hands with the venture capitalist, sat down in the mans office, and the first thing out of his mouth was Im here to see if youre good enough to be my venture capital partner. You probably already can guess this meeting only lasted about two minutes longer. Back in the 1960s there was a wonderful episode of a science fiction TV series about an older, vastly wealthy businessman who grew tired of not having any challenges any more and longed to go back to the beginning of his career and do it all again. He visited a rather sinister travel agency that accommodated his dream of going back in time. He returned to the small town where he started, a young man again. But this time he missed some of the key connections, the seemingly small incidents of good fortune, that actually caused him to succeed in such a big way. This time things went sour for him, and he learned an important lesson: Business is a team sport.

Questions to ask before approaching a Venture Capitalist Does my company have high growth prospects and is my team ambitious to grow the company rapidly?

Does my company have a product or service with a competitive edge or unique selling point? Can it be protected by Intellectual Property Rights? Can I demonstrate relevant industry sector experience? Does my team have the relevant skills to deliver the business plan fully? Am I willing to sell some of the company's shares to a private equity investor? Is there a realistic exit opportunity for all shareholders in order to realise their investment? Am I prepared to accept that my exiting this business may be in the best interest of all shareholders? If your answers are 'yes', external equity is worth considering. If 'no', it may be that your proposal is not suitable for venture capitalists and it may take additional work on your behalf to make the proposal 'investor ready'. When seeking to raise capital to accelerate the development of a business idea, promoters must explore all possible sources of funds. It is likely that an equity investor will usually help the promoters secure other sources of funds. This usually includes debt finance from banks to finance working capital and asset purchases, grant aid from development agencies and, indeed, an equity investment from the promoters. Such an investment from the promoters/management team can help demonstrate commitment to a project and may attract fiscal incentives in the

form of the Business Expansion Scheme, Enterprise Investment Scheme or Enterprise Management Incentives, depending upon the jurisdiction the company is based in and other criteria. Professional help should be sought to confirm eligibility and benefits of these schemes at an early opportunity. The end result is likely to be a funding package which includes a cocktail of funders secured with the assistance of the Venture Capitalist. It is this flexibility and value-added input From a private equity investor which differentiates them from other funders. Venture Capitalists look for capital gains from their investments. They adopt a portfolio approach to their investments which reflects their strategy to mitigate the risk of investing unsecured funds in early stage companies. Before they invest, VC executives will consider the likelihood of realising their investment. After all, they are responsible for returning the cash invested in their fund with interest to their investors. The promoters ability to implement their business plan in full is the obvious question, but just as importantly, can the company in question be sold to another trade player or find another way to redeem the venture capitalist's investment within a reasonable time frame (usually between three and Seven years)?ITAL The Business Plan The business plan is the most important document for a company seeking to raise finance from private equity investors. It should demonstrate what the business

opportunity is, the amount of funds required to deliver the business plan and a management team capable of implementing it. Venture Capitalists read numerous business plans from a wide range of sources and they must invest in the best projects. Their first impression of your business plan will determine whether they take their interest any further. It is absolutely essential that your business plan demonstrates an 'investor ready' project. The following section is intended to give you a summary of what the business plan should include: Executive Summary This is the key part of the document which must immediately and clearly articulate the investment opportunity for the reader. The Executive Summary should make a potential investor believe that your unique proposition has the potential to make a good return on their investment and that you and your team have the ability to deliver what the plan says. If this part of the Business Plan is not presented with conviction and in clear language, you may miss the opportunity of ensuring that a potential investor takes the time to read your entire plan. The detailed plan should give full details under the following headings: 1. The Product / Service 2. The Market 3. Management Team 4. Business Process / Operations

5. Financial Projections 6. Proposed Investment Opportunity 1. The Product / Service In simple language, this should explain what exactly the product / service offering is. This will clearly demonstrate the unique selling point of your offering, differentiation from other products, barriers to entry etc and how your product / Service will add value to the purchaser. 2. The Market A common mistake that entrepreneurs make is to express their market in terms of a global figure representing all activity within their sector. The private investor requires comfort that there is a commercial opportunity for your product/service and that the management team has the ability to exploit this opportunity. The marketing section should demonstrate who the customer base is likely to be, how the product / service will be priced, how it will be distributed to customers, an analysis of competitors and how you will deal with competing goods and services. It is unlikely that there will be no rivals in your market sector and you should avoid comments like 'there is no competition' or, 'our product is totally new'. If no one has thought of offering a similar or competing product, is it conceivable that there is no demand for your product or that customers do not realise that they need it? 3. Management Team

Most venture capitalists will tell you that they invest in people not ideas. The management team must sell their experience to investors as well as their understanding of the market which they are targeting. This section must convey the message that the team has the full complement of skills required to deliver the plan. Indeed, it is prudent to identify skill gaps which must be addressed in order to deliver the plan as new investors in a business can utilise their networks to fill the gaps. NonExecutive Directors (NEDs) are an obvious source of expertise for early stage companies to address this issue and and Venture Capital Fund managers usually appoint a NED to investor companies to help them avoid the pitfalls of growing a business. Further details on NEDs can be found in the next section of the guide. 4. Business Processes / Operations This section explains how the business operates, be that manufacturing products, delivering a service, or both. It should demonstrate that any necessary R&D can be fully undertaken and that an appropriately skilled workforce is available. The location of the business and the physical infrastructure will also be detailed. Care should be taken to demonstrate that there is sufficient flexibility within systems, facilities and human resources to expand the business in line with its projected growth. Whilst there may be a market for the product/service being offered, you must ensure that the proposed location, process and utilisation of resources (human and physical) are the best available to exploit this opportunity.

5. Financial Projections An investor will always wish to review a detailed set of integrated financial projections which encompasses profit and loss accounts, balance sheets and cashflow statements. These figures will be supported by detailed assumptions Which reflect the content of the business plan The projections must be realistically achieveable, but they must also be sufficiently ambitious to demonstrate that there is an attractive investment opportunity. These projections will form the basis of any term sheet which an equity investor may issue. Negotiation with the Venture Capitalist over valuation, future milestones and ultimate exit opportunities will be influenced by the delivery of the financial projections. Much consideration should be given to this section to produce realistic projections and indicate an openness to work with the investor in the future to deliver a common goal the maximising of value. 6. Proposed Investment Opportunity / Exit This is the opportunity to identify the level of funds required, how and when they will be spent, and an outline showing how investors will receive a return on their investment. As with the financial projections the exit opportunity should be realistic and take account of current market conditions. It cannot be stressed too much that the Business Plan is the single most important document that you will provide for

potential private equity investors. It must be coherent, well presented and of a length which maintains the interest of the reader. It is essential that you strike a balance between providing the investor with sufficient information to evaluate the investment opportunity while not overloading them with technical information.

The Role of theNon-Executive Director The considerable amount of media attention on the issue of corporate governance has highlighted the role of Non-Executive Directors. It is well documented that Non-Executive Directors can make a significant contribution to company performance regardless of size. The use of Non-Executive Directors is one way of accelerating the development and growth of SMEs and whether it is a longstanding traditional business or a start-up seeking equity finance, non-executives can bring added value with objectivity drawn from their own experience and skills. It is normal for Venture Capital investors to place a Non-Executive Director on the Board of the investee company to represent their interests. This can either be one of its own fund managers or an individual who has sectoral, market, or management expertise which will help delivery of the corporate plan. Most Venture Capitalists, however, recognise that the chemistry and teamwork between the non-executive and the existing management team is crucial. As a result,

the VC's Non-Executive Director is there to play an integral role in the development of the company rather than act as a watchdog for their investment. This availability of outside expertise to the management team represents a valuable asset for most companies, particularly start-ups, and is one reason why Venture Capital is regarded as a value-added source of finance for SMEs.

Glossary of Terms ACQUISITION The act of one company taking over a controlling interest in another company. Investors often look for companies that are likely acquisition candidates, because the acquiring firms are usually willing to pay a premium on the market price for the shares. This may be the most likely exit route for a VC investor. ANGEL FINANCIERS The first individuals to invest money in your company. For example, friends, family. They do not belong to a professional venture capital firm and do not have similar monitoring processes. They often believe in the Entrepreneur more than the actual product. This capital is generally used as seed financing. ANTI-DILUTION PROTECTION In the event a company sells shares in the future at a price lower than what the VC paid, an adjustment will be made to the % of shares held by the VCs.

BOOTSTRAPPING A means of finding creative ways to support a start-up business until it turns profitable. This method may include negotiating delayed payment to suppliers and advances from potential partners and customers. BRIDGING FINANCE Type of financing used to fill an anticipated gap between more permanent rounds of capital investments. Usually structured to enable them to become part of future rounds if successfully raised. BURN RATE The rate at which your company is consuming cash, usually expressed on a monthly basis. CAPITAL GAINS The difference between an assets purchase price and selling price when the selling price is greater. Capital gains are usually subject to tax which may be mitigated by careful tax planning. CARRIED INTEREST The portion of any gains realised by a Venture Capital Fund to which the fund managers are entitled, generally without having to contribute capital to the fund. Carried interest payments are customary in the venture capital industry to create a significant economic incentive for venture capital fund managers to achieve capital gains. CONVERTIBLE SECURITY A financial security (usually preference shares) that is exchangeable for another type of security (usually ordinary shares) at a pre-stated price. Convertibles are appropriate for investors who want higher income, or

liquidation preference protection, than is available from ordinary shares, together with greater appreciation potential than regular bonds offer. DILUTION The process by which an investor's ownership percentage in a company is reduced by the issue of new shares. DUE DILIGENCE The process by which VCs conduct research on the market potential, competition, reference interviews, financial analysis, and technology assessment. Usually divided into commercial, financial, legal and commercial due diligence. EARLY STAGE A fund investment strategy involving investments in companies to enable product development and initial marketing, manufacturing and sales activities. Early stage investors can be influential in building a companys management team and direction. While early stage venture capital investing involves more risk at the individual deal level than later stage venture investing, investors are able to buy company stock at very low prices and these investments may have the ability to produce high returns. EXIT STRATEGY A funds intended method for liquidating its holdings while achieving the maximum possible return. These strategies depend on the exit climates including market conditions and industry trends. Exit strategies can include selling or distributing the portfolio companys shares after an initial public offering (IPO), a sale

of the portfolio company or a recapitalisation. (See Acquisition, Initial Public Offering) FUND FOCUS (OR INVESTMENT STAGE) The indicated area of specialization of a venture capital fund usually expressed as Balanced, Seed and Early Stage, Later Stage, Mezzanine or Leveraged Buyout (LBO). (See all of the stated fund types for further information) FUND SIZE The total amount of capital committed by the investors of a venture capital fund. HOCKEY STICK Refers to a financial projection which starts modestly for a number of months and rapidly accelerates. How much of a hockey stick is in the plan? INVESTMENT PHILOSOPHY The stated investment approach or focus of a fund manager. INITIAL PUBLIC OFFERING (IPO) The sale or distribution of a stock of a portfolio company to the public for the first time. IPOs are often an opportunity for the existing investors (often venture capitalists) to receive significant returns on their original investment. During periods of market downturns or corrections the opposite is true. LATER STAGE A fund investment strategy involving financing for the expansion of a company that is producing, shipping and increasing its sales volume. Later stage

funds often provide the financing to help a company achieve critical mass in order to position itself for an IPO. Later stage investing can have less risk than early stage financing because these companies have already established themselves in their market and generally have a management team in place. Later stage and Mezzanine level financing are often used interchangeably. LEAD INVESTOR Each round of Venture Capital has a lead investor who negotiates the terms of the deal and usually commits to at least 50% of the round. LEVERAGED BUYOUT (LBO) A takeover of a company using a combination of equity and borrowed funds (or loans). Generally, the target companys assets act as the collateral for the loans taken out by the acquiring group. The acquiring group then repays the loan from the cash flow of the acquired company. For example, a group of investors may borrow funds using the assets of the company as collateral in order to take over a company. Or the management of the company may use this vehicle as a means to regain control of the company by converting a company from public to private. In most LBOs, public shareholders receive a premium to the market price of the shares. LIMITED PARTNERSHIPS An organization comprised of a general partner, who manages a fund, and limited partners, who invest money but have limited liability and are not involved with the day-to-day management of the fund. In the typical venture capital fund, the general partner receives a management fee and a percentage of the

profits or carried interest). The limited partners may receive both income and capital gains as a return on their investment. MANAGEMENT FEE Compensation for the management of a venture funds activities, paid from the fund to the general partner or investment advisor. This compensation generally includes an annual management fee. MANAGEMENT TEAM The persons who oversee the activities of a venture capital fund. MEZZANINE FINANCING Refers to the stage of venture financing for a company immediately prior to its IPO. Investors entering in this round have lower risk of loss than those investors who have invested in an earlier round. Mezzanine level financing can take the structure of preference shares, convertible bonds or subordinated debt (the level of financing senior to equity and below senior debt). NEW ISSUE A stock or bond offered to the public for the first time. New issues may be initial public offerings by previously private companies or additional stock or bond issues by companies already public. New public offerings are registered with the Securities and Exchange Commission. (See Securities and Exchange Commission and Registration) OPTION POOL The number of shares set aside for future issuance to employees of a private company.

PORTFOLIO COMPANIES Portfolio companies are companies in which a given fund has invested. POST-MONEY VALUATION The valuation of a company immediately after the most recent round of financing. This value is calculated by multiplying the companys total number of shares by the share price of the latest financing. PREFERENCE SHARES Form of equity which has rights superior to ordinary shares. Most VC deals use preference shares which may convert to ordinary shares upon an IPO or Acquisition. PRE-MONEY VALUATION The value of the company before VCs cash goes into the business. VCs use the Pre-Money Valuation to determine what % ownership they will have in your company. PRIVATE EQUITY Private equities are equity securities of companies that have not gone public (in other words, companies that have not listed their stock on a public exchange). Private equities are generally illiquid and thought of as a long-term investment. As they are not listed on an exchange, any investor wishing to sell securities in private companies must find a buyer in the absence of a marketplace. PROPRIETARY INFORMATION Any information uniquely possessed by a company which is not generally available to the public. PROSPECTUS A formal written offer to sell securities that provides an investor with the necessary information to make an informed decision. A prospectus explains a

proposed or existing business enterprise and must disclose any material risks and information according to the securities laws. A prospectus must be filed with the SEC and be given to all potential investors. Companies offering securities, mutual funds, and offerings of other investment companies (including Business Development Companies) are required to issue prospectuses describing their history, investment philosophy or objectives, risk factors and financial statements. Investors should carefully read them prior to investing. SECONDARY SALE The sale of private or restricted holdings in a portfolio company to other investors. SEED MONEY The first round of capital for a start-up business. Seed money usually takes the structure of a loan or an investment in preferred stock or convertible bonds, although sometimes it is common stock. Seed money provides start-up companies with the capital required for their initial development and growth. Business Angels and early-stage venture capital funds often provide seed money. STOCK OPTIONS There are two definitions of stock options. The right to purchase or sell a stock at a specified price within a stated period. Options are a popular investment medium, offering an opportunity to hedge positions in other securities, to speculate on stocks with relatively little investment, and to capitalize on changes in the market value of options contracts themselves through a variety of options strategies. A widely used form of employee incentive and compensation.

The employee is given an option to purchase its shares at a certain price (at or below the market price at the time the option is granted) for a specified period of years. TERM SHEET Typically a 3-5 page document which outlines the fundamental business terms of a Venture Investment. This document serves to drive at the final business agreement of closing the deal. If you receive a term sheet from a VC there is a high probability of closing and funding the deal. VENTURE CAPITAL Money provided by investors to privately held companies with perceived long-term growth potential. Professionally managed venture capital firms generally are limited partnerships funded by private and public pension funds, endowment funds, foundations, corporations, wealthy individuals, foreign investors, and the venture capitalists themselves. WRITE-OFF The act of changing the value of an asset to an expense or a loss. A write-off is used to reduce or eliminate the value an asset and reduce profits. WRITE-UP/WRITE-DOWN An upward or downward adjustment of the value of an asset. Usually based on events affecting the investee company or its securities beneficially or detrimentally. Venture Capital Regulations in India

"There is a tide in the affairs of men, which taken at the flood, leads on to fortune...And we must take the current when it serves, or lose our ventures." - William Shakespeare

Growth is the process that only happens when the untread is tried and the undone is materialized. For any new venture we undertake there is always apprehension of missesthan hitting the bulls eye and this apprehension for years has curbed the entrepreneurs from innovating and growing. Venture Capital is the conduit for giving the entrepreneurs wings to fly when they are willing to jump of the cliff. Simply put, Venture Capital is a term coined for the capital required by an entrepreneur to venture into something new, promising and unconventional. Investing in a budding company has always been a risky proportion for any financier. The risk of the business failure and the apprehensions of an all together new project clicking weighed down the small entrepreneurs to get the start-up fund. The Venture Capitalists or the angel investors then came to the forefront with an appetite for risk and willingness to fund the ventures. How does it work? Venture Capital financing is a process whereby funds are pooled in for a period of around 10 years and investing it in venture capital undertakings for a period of 3 to 5 years with an expectation of high returns. To protect the funds of the investors against the risk of losses, venture capital fund provides its expertise, undertake advisory function and invest in the patient capital of the undertaking equities. Venture Capital financing had been a popular source of funding in many countries and served as a lucrative bait to create a similar industry in India as well. Regulations of Venture Capital:

VCF are regulated by the SEBI (Venture Capital Fund) Regulations, 1996. The regulation clearly states that any company or trust proposing to carry on activity of a VCF shall get a grant of certificate from SEBI. Section 12 (1B) of the SEBI Act also makes it mandatory for every domestic VCF to obtain certificate of registration from SEBI in accordance with the regulations. Hence there is no way that an Indian Venture Capital Fund can exist outside SEBI Regulations. However registration of Foreign Venture Capital Investors (FVCI) is not mandatory under the FVCI regulations. A VCF and registered FVCI enjoy several benefits: No prior approval required from the Foreign Investment Promotion Board (FIPB) for making investments into Indian Venture Capital Undertakings (VCUs). As per the Reserve Bank of India Notification No. FEMA 32 /2000-RB dated December 26, 2000, an FVCI can purchase/ sell securities/ investments at a price that is mutually acceptable to the parties and there is no ceiling or floor restriction applicable to them. A registered FVCI has been granted the status of Qualified Institutional Buyer (QIB), so they can subscribe to the share capital of a VCU at the time of intial public offer. A lock-in of one year is applicable to the shares subscribed in an IPO. The lock-in period applicable for the pre-issue share capital from the date of allotment, under the SEBI (Disclosure and Investor Protection) Guidelines, 2000

is not applicable in case of a registered FVCI and VCF. Under the SEBI (Substantial Acquisition of Shares and Takeover) Regulations, 1997 if the promoters want to buy back the shares from FVCIs, it would not come under the public offer requirements. Structure of a VCF: The regulations in India have been carefully drafted but then have left ambiguity in understanding to many. Though the laws relating are not complex but then they do not lay down clear cut laws; susceptible to interpretations and discussions. Section 2(m) defines a VCF is a corpus of funds created by raising funds in a specific manner to be invested in a manner as specified in the regulations. This means any activity beyond the periphery of what is laid in the charter is prohibited. A VCF can be created in a form of a 1) trust, 2) company including 3) a body corporate. This means that no matter what the form of a VCF is the core substance shall remain the same. The VCF is segregated into schemes in which the funds are invested. The scheme relates to investing the money into venture capital undertakings as defined under sec 2 (n) of the regulations. A VCF raises money from the investors in the form of units (discussed below) to be invested in these schemes. Chapter III and IV lay down the restrictions and prohibitions on raising and investment of funds by a VCF. From the above laid structure the following few key features of a VCF have emerged: A VCF raises funds in the form of units. Section 2(l) defines units as

beneficial interest of the investors in the scheme or funds floated by a trust or issued by a company including a body corporate. Chapter III says that these funds can be raised from Indian, foreign or non-resident investors by the way of issuance of units. Chapter VI prohibits public offers for inviting subscription or purchase of units from the public. The above elucidated two things 1) the units are the beneficial interest of the investors and that the VCF holds only legal interest and 2) that the VCF is a channel of investing the investors money in various schemes. The regulations have crisply laid down the core substance of the VCF. The regulations lay down that the VCF can be constituted in form of a trust or company including a body corporate but have rested in the beneficial interest in the hands of the investors and legal interest in the hands of the managers of the fund. In case of a trust form of VCF, it is evident that the funds pooled are held by the trustees and that they have only legal interest in the raised funds, so this raises no confusions. However, in case of a company/ body corporate also the company holds only legal interest in the fund. Unlike a company, fund is raised scheme specific and cannot be used by the company in any other manner or for any other purpose and that the unit holders are the beneficiaries, reducing the status of the company to having only fiduciary interest in the fund. Thus, no matter what form a VCF is constituted in the essence would be that of a trust. This further raises question as to what is the interest of the trust or company (including body corporate) in managing the schemes. Section 2 (hh) of the regulation

defines investible funds ascorpus of the fund net of expenditure for administration and management of fund. So the managers of the fund receive fees for the management of the VCF business. The regulations expressly do not specify the permissible or prohibited quantum of the fees. This clears the sham, surfacing the clear cut view that the VCF may be dressed in any form raising doubts on interpretations, the conclusion is that the core substance prevails.

Accessing Venture Capital in India

The Human Capital Supply: Quality, Quantity, Mobility, and Risk-Taking Attitudes

In the 1970s, IT exports from India began with body-shopping, also known as contract programming. In such contracts, the amount of code was specified in the contract and there was relatively little risk. Until 1991, this was the main form of IT exports, and it was performed exclusively by Indian firms. Foreign firms were deliberately excluded as a matter of government policy. It was a difficult business environment. Indian firms that were exporting bodies, as well as firms that operated only in the domestic market, found themselves operating in a closed economy, featuring high tariffs on hardware imports and non-tariff barriers on software imports. Quite by accident, this situation led to a growth of skills that would be of great value to India a few years later. Indias UNIX talents, now

globally in demand due to the growth of the Internet, developed because the countrys closed economy forced Indian computer makers to develop their own hardware and software design skills. Sridhar Mitta noted that, in 1983, the United States used an Intel 386 microprocessor as the base for a simple personal computer, whereas India employed the same microprocessor with the UNIX operating system to power mainframes that controlled large enterprises. Indias closed environment also spurred the countrys IT industry to develop advanced skills in system design, architecture, protocol stacks, compilers, device drivers, and boards. When India began to export its IT labor in the 1970s, most workers came from one city: Bangalore. The emergence of Bangalore as a suitable site for high technology work rests on two key factors. The first is the presence of several academic institutions and government sponsored high technology enterprises, such as the Indian Institute of Sciences and Hindustan Aeronautics Limited. The ongoing strength of the four southern statesTamil Nadu, Andhra Pradesh (AP), Karnataka (which includes Bangalore), and Keralain supplying labor is helped by the fact that four hundred of Indias six hundred technical colleges are located within them. In a recent presentation at Stanford University, the director of the Indian Institute of Technology (IIT) at Kanpur (one of Indias five prestigious IITs) noted that Bangalores Indian Institute of Science, as a research center for IT, has in fact overtaken the IITs as a center of technology research.2 The second

group of factors contributing to Bangalores current IT dominance springs from its lower real estate costs, good weather, and the development of an international airport. Together, these attributes led an important high technology firm, Wipro, as well as several multinationals, to relocate from Mumbai to Bangalore in the 1980s. Bangalore offers many advantages, but even these may not be eternal. Recent visits to its IT Park, a private venture funded by the Tatas, Indias largest industrial group, and the Government of Singapore, suggest that Bangalore is losing out to Hyderabad. To be sure, Bangalore possesses a much stronger labor pool, but its severe power and water shortages, along with incentives from APs state government to firms setting up in Hyderabad, are conspiring to make it a less popular choice than previously. A recent, prominent example of this phenomenon occurred when General Electrics finance division, after rejecting an initial decision to go with Bangalore, chose to take advantage of the AP Government incentives. From 1991 onwards, the Indian economy was opened to foreign investment. Almost immediately, U.S. high technology firms began outsourcing software development in India, leveraging local knowledge of English and lower labor costs, and adding value without risk. Indian firms which had until then focused on hardware and software design, and on products and services for the local market, were unable to compete with U.S. firms for labor. They shifted their focus to the export market. Meanwhile, those Indian firms which had become

leaders in on-site body-shopping shifted into off-site work in India. Since then, several Indian exporters have successfully entered the software support business. In some cases, their current revenues exceed those of many mid-tier, U.S.-based, public IT service companies. These companies continue to lead the Indian industry today. Interestingly, the domestic market for IT products and services has grown very slowly (less than 10 percent per year through the past decade), while the export market, by contrast, has done very well. In addition, though low valueadded services still dominate the export market, the balance has shifted in the past two years from on-shore services to off-site services. According to the Pune-based Maratha Chamber of Commerces IT group, about 50 percent of Indias exports come from on-site body-shopping and 30 percent from off-site contract work. High value-added next-stage businesses, such as turnkey projects, consultancy, and transformational outsourcing, remain small, and branded product development for the export market is negligible. Nor is India yet a player in technology development or hardware products. Though generally thought to be very high, the quality of labor is still a matter of debate within India. The head of training at Satyam Computers, a large IT firm with Level training facilities (a European designation awarded to fewer than a dozen firms worldwide), stated that his firm found the quality of graduates from the software training institutes to be inadequate. He noted that the best students of the IITs (the top 10-15 percent)

possessed outstanding ability, but most of them went abroad (primarily to the United States) after graduating. The remainder, in his view, were of poorer quality and needed substantial additional study to improve their skill-sets. At the middle levels of the IITs, similar perceived quality problems, combined with the inability to recruit top level candidates, have dented IIT enrollment numbers. The proportion of IIT students at the Indian Institute of Management, Ahmedabad, the premier management institute in India, has decreased from 70 percent in 1990 to less than 30 percent today. Holding aside for the moment the question of whether India has the talent and overall quality of labor for product development, it clearly possesses the quantity. Each year, 61,000 computer engineering graduates come out of Indian universities, as compared with the 30,000 graduates who complete the same degree in the United States. An even larger number of Indian students 215,000 per yeargraduate in other engineering fields. Many of these graduates promptly shift to computer engineering because of the earning differential, or join the 200,000 people who annually enroll in private software training institutes. Still other Indian IT workers are trained in post-recruitment, in-house institutes, at firms such as Wipro and Satyam. This generally youthful population is also mobile, willing to move anywhere in India or abroad to pursue their jobs. Indeed, 50 percent of the H1-B visas issued by the United States in 1998 went to Indians.

The Indian IT industry now boasts a much more open environment, yet its production of high value-added business capabilities lags behind that of Israel and Taiwan. In his conference presentation, Mitta argued that software work remains limited to low-level programming jobs. He attributed this to an inability to understand market and technology trends from a distance, which in turn leads to problems in arriving at the desired product and engineering specifications. Gaps exist in user interfaces that prevent ease of use or quality of back-up documentation and technical support, and ultimately lower Indian software companies ability to address investor demand and changing market scenarios. In contrast, while discussing the Israeli IT industry, David Blumberg noted that Israeli companies tend to pay particular attention to user interface. They recognize that, for companies based outside the United States, customer care and technical support procedures must maintain a quality as high or higher than that available in the American market. The problems noted above relate more to smaller-scale structure and interface adjustments than to large-scale, innate problems of the Indian labor force. Nevertheless, in many quarters there exist concerns about software specialists willingness to risk starting or joining a new company. Multinationals and large Indian firms remain the employments of choice. This may reflect the financially insecure background from which Indians come, or the countrys longstanding culture of bureaucratic control. Either way, it has led to what Som Das

and Sudhir Sethi called in their remarks the 51 percent ownership syndrome. Indian entrepreneurs are reluctant to allow a venture firm to supply capital that will reduce their personal ownership to below 51 percent at any stage of the financing process. This reluctance leads to the peculiar problem of project investments often being too small at the start-up stage to justify venture capitalists attention. This may be why financing focuses on later-stage projects, which in turn accounts for the general shortage of seed capital for start-ups in India. These concerns about risk aversion are transitional issues likely to disappear soon. As Blumberg noted, Israel went through the same experience in its venture capital industry. Once the low hanging fruit of late-stage firms is plucked and venture capitalists have shored up a reservoir of talent to advise start-ups, the situation changes quickly. This has been borne out by Indian entrepreneurs in Silicon Valley. Having started as shopped-bodies, these workers rapidly became risktakers. In her conference remarks, Anna Lee Saxenian noted that between 1980 and 1997, Indian entrepreneurs started 565 firms in Silicon Valley, or 6 percent of the total number of firms established in that time frame. The figure has likely risen since then. By 1997, Indian start-ups in Silicon Valley were generating annual sales of $3.25 billion and employment for 13,664 people. Das and Sethi noted that in India, the typical risk-averse mindset shows signs of positive change. Recently, they observed, the supply of young, technically qualified entrepreneurs

has been increasing. At the same time, increasing numbers of internationally savvy, senior management have been leaving established multinationals and large Indian firms to start new companies. In addition to risk aversion, K. Ramachandran pointed out another kind of human capital deficiencyone that operates within its domestic venture capital firmswith which Indian IT must contend. For reasons that will be covered more fully later in this summary, most Indian venture capital firms are staffed by personnel seconded or transferred from public sector banks, or recruited fresh from management institutes. Their income is unrelated to performance, and they bring with them the baggage of undeveloped management skills and high risk aversion. Firms employing such personnel typically do not possess the industry knowledge that can help a start-up, particularly in the high tech field. While this, too, may be a transitional problem, it has led to inefficient outcomes. Ramachandran reported a typical example of inefficient board strategy. The CEO of one of the largest venture capital firms in India sits on the board of six companies belonging to six different industries, including firms from the pharmaceutical, textile, and IT industries. Similarly, Indias largest venture capital firm, ICICI Ventures, has a portfolio of two hundred and fifty companies, in a wide range of industries located in different parts of the country, managed by fourteen managers. Many of the ICICI Ventures-financed firms are not in the high technology field, and a risks they often carry is that of finding a market in a

competitive industry. Examples include Gum India, a manufacturer of bubble and chewing gum, and Asian Peroxides, a manufacturer of hydrogen peroxide. In summary, the conference concluded that change in human resources for IT, though underway, is too slow. Indias software and services exports are unlikely to meet the governments expectations for a ten-year annual growth rate of 33 percent in the absence of an environment more conducive to skill development. The Financial Capital Supply: Quality, Quantity, Mobility, and Risk-Taking Attitudes The private venture capital industry in India started in 1990, on the recommendation of the World Bank (WB), when four funds, all promoted by public sector undertakings, were begun. Overseas and truly private domestic funds only began investing in India in 1996, after the venture capital regulator, the Securities and Exchange Board of India (SEBI), announced the first guidelines for registration and investment by venture capital firms. The venture capital supplied to India remains small and dominated by foreign investors. Domestic pension funds, insurance firms, and mutual funds are not permitted to invest in venture capital firms. International Finance Corporation (IFC) data supplied at the conference show that of the twenty private equity funds in India classified as very active, three are subsidiaries of development financial institutions (DFIs), or long-term debt suppliers. Seventeen are foreign funds. There

are no domestic funds in this category. Of the seventeen funds classified as moderately active, four come from the DFI group, four from domestic private funds, and nine from off-shore funds. Data presented by L.K. Singhvi for SEBI, and corroborated by IFC data show that about $1 billion has been committed from off-shore funds, of which less than half has been invested to date. The fourteen registered domestic funds have committed 3.8 billion rupees, of which 1 billion rupees (U.S. $23 million) have been invested across 108 projects. While these figures are very low, Singhvi estimated that the total pool will grow very quickly to 200 billion rupees (U.S. $4.6 billion). Data from the Indian Venture Capital Association (IVCA) for 1998 show that, among the domestic funds, 64.3 percent was invested in equity shares, 19.8 percent in convertible debt and 7.6 percent in preference shares. Of the 719 start-ups financed, only 166 were late-stage financings; the rest were start-ups, seed stage, and other early-stage financings. Interestingly, the software industry took 19.9 percent of the money disbursed, second only to industrial products machinery at 23.5 percent. The Financial Capital Supply: Legal and Regulatory Issues Indian law does not allow for the formation of limited partnerships, which are the common international method of organizing venture capital firms. Since the limited partnership law does not exist in India, SEBI has laid down special

guidelines permitting the tax department to provide incentives, for venture capital firms registered with SEBI, that mimic the tax passthrough available to U.S. limited partnerships. For this to be possible, venture capital firms must be organized as limited companies or trusts, and may create, if they desire, separate asset management companies. All long-term capital gains earned (defined as capital gains on investments held for more than one year) are exempted from tax. Since dividend receipts in India are tax-exempt in the hands of all recipients, the combination of the two rules effectively means almost complete tax exemption for venture capital firms and their investors. Venture firms have to pay tax only on two occasions: if their gains are short-term or in the form of interest receipts (38.5 percent for companies and 33 percent for trusts), or if they organized as companies rather than trusts, thus requiring them to pay dividends (10 percent withholding tax). This structure for venture capital firms has the following advantages and disadvantages: 1) The trust form of the venture capital firm is more tax-advantageous than the company form. In fact, in the typical case, it allows for complete tax exemption in the hands of both trust and investor. However, Nishith Desai noted in his conference remarks that the kinds of securities a venture capital trust firm may acquire are limited mainly to equity securities under the Indian Trusts Act. This means that investing in equity-linked securities, such as convertible preference

shares, would cause the trust to lose its tax-exempt status. Further, an important aspect of equity-linked securities their voting rights, the essential mechanism through which a venture capitalist controls an investee firms managementis not available. 2) While the tax status of dividend payouts in India is more advantageous than in most other countries, including the United States, the Indian tax code does not recognize marking-to-market of either unrealized capital gains or losses as taxable income or loss. Likewise, capital distributions to investors are not allowed, except in the event of the venture capital firms termination. This is particularly important for new funds that may lose money in the initial years. Such losses cannot be passed on to investors to realize potentially advantageous personal tax losses. 3) When the tax rules were first announced, their chief featurea tax passthrough, not available in any other corporate formmeant that investors had a strong incentive to abuse them. For example, a finance company that specialized in providing finance to textile retailers could reorganize itself as a venture capital trust, thus avoiding income taxes completely. The venture capital guidelines stated that the funds were to be used for new or untried technology, but the words untried technology lent themselves to wide interpretation. In an effort to limit the tax pass-through benefit to socially desirable activities only, the tax department restated the law in 1999, making tax pass-through available only for funds

investing in software, information technology, production of basic drugs, biotechnology and agriculture, or the production of patented items from governmentapproved research laboratories. Obviously, this list of industries is meant to be a dynamic one, but it creates a new (and as yet untested) bureaucratic filter, discussed later in this summary. Other restrictions on Indian tax pass-through include: At least 80 percent of the funds must be invested in equity shares or equityrelated securities of unlisted or financially weak companies. A venture capital firm may not own more than 40 percent of an investee company and may not invest more than 5 percent of its externally raised funds or 20 percent of its total paid-up capital in a single company. To protect small investors, a high net-worth restriction requires a minimum investment of half a million rupees per investor. All permitted listed investments are subject to tax at normal corporate rates for venture capital companies, and at normal trust rates for venture capital trusts. 4) Conflicts between the edicts of SEBI, the Ministry of Finance, and the Income Tax Department (ITD) remain unresolved. In order to claim tax exemption, the Income Tax Department only requires investment in unlisted equity shares, whereas SEBI permits limited investment (up to 20 percent) in listed equity, and in the listed equity of financially weak or sick companies. Another point of

disagreement arises over quasi-equity securities within a trust: the ITD does not recognize them and will disqualify a firm that invests through convertible preference and other quasi-equity securities from tax pass-through. But SEBI will continue to recognize such firms as registered venture capital firms. 5) Since most venture capital funds call up capital as needed from investors, they initially have high proportions invested in the first few investee firms, making the 20 percent restriction untenable. Further, in the event of foreign shareholdings in divested firms, the central bank must approve the price of divestment. The Reserve Bank of Indias (RBI) guidelines are the same as for listed equity and could be restrictive. They require a price that is the higher of 60 percent of the Bombay Stock Exchange P/E multiple or 60 percent of the firms Net Asset Value (NAV). For companies developing intellectual property that have yet to make profits, neither guideline makes much sense. 6) For the on-shore investor, the above restrictions have led to the peculiar situation of not a single registered venture capital firm claiming the tax passthrough. For offshore investors permitted to invest in domestic firms, these restrictions have led to a preference for direct investment in investee companies via tax havens such as Mauritius. This requires a simple bureaucratic filter in that each investment must be approved by the Foreign Investment Promotion Board, but there are no other significant restrictions.

The tax haven treaty also guarantees complete tax exemption from Indian taxes, thus allowing foreign investors to create exactly the kind of capital structure they want off-shore. The result is an uneven playing field favoring off-shore venture capital firms over domestic ones. Policy Options Allowing Limited Partnerships. In his conference remarks, Ravindra Gupta stated that permitting limited partnerships is a major goal of the Department of Electronics, and that the government has approved a limited partnership law in principle. S. Vardachary also noted that legislation to provide for limited partnership is one of the Centre for Technology Developments key policy objectives. Amending Trusts. An alternative argument put forward by Desai proposed that trusts be given tax exemptions as above; that the tax department recognize marking- to-market, capital, and interest distributions; and that restrictions on venture capital portfolios and the kinds of securities they may hold be lifted. Using General Partnerships. India currently allows partnerships only as general partnerships, where partnership income is taxed once at the level of the partnership (the current rate is 38.5 percent), and the income distributed to the partners is tax-free. Losses can be carried forward only by the partnership and are not distributed to the partners. Clearly, a general partnership with unlimited liability

would not work for venture capital firm structuring. The primary tax advantage of the limited partnership structure is that income and losses are taxed in the partners hands (as capital gains/losses, interest payments, or dividends) and not in the partnership. The partners liability, excluding that of the general partner, is limited to the amount subscribed, and the partnership can have a limited tenure. Non-tax distributions of stock and other securities are also permissible. The primary nontax advantage of limited partnerships is that the liability of general partners is unlimited, thus allowing active risk managers to assume more risk than passive investors. Nevertheless, though such a risk-sharing arrangement may be desirable for passive investors, it is not an important factor for the success of venture capital firms. This is borne out by the fact that most venture capital firms general partners are themselves structured as firms with limited liability, thus rendering the unlimited liability clause ineffective. From the venture capital firms perspective, the corporate form in which it operates should permit control of investee firms through an adequate number of seats on the board, regardless of the proportion of the investee company it holds. This arrangement can be negotiated independently of the venture capital firms corporate structure, and does not require a limited partnership structure. From the investee firms perspective, its financial structure should allow venture capital firms to invest at a higher price than the founders and employees, in recognition of their socalled sweat equity (the typical ratio is

10:1). This scenario requires that the venture capital firm hold quasi-equity, such as voting, and preference shares convertible at prices different from shares issued to employees, without losing its tax pass-through status. In summary, the key elements for venture capital are tax pass-through, capital distributions, recognition of marking-to-market, the ability to invest in an unrestricted variety of financial instruments, and the ability to disinvest without special approvals. According to Desai, allowing different risk-sharing arrangements between general and limited partners is not important for venture capital firms since the trust structure, duly amended as discussed, will do the job. The Financial Capital Supply: Governance and Exit Issues As discussed earlier in this summary, the only active domestic venture capital funds in India are subsidiaries of government-related, long-term lending institutions. As the experience of the United States, Japan, and several other countries has demonstrated, such firms make poor venture capitalists. Problems arise from the risk aversion parameters they set and the quality of the human capital, described earlier in these proceedings, working within them. In examining governance and exit issues in Indian venture capital, Ramachandran pointed out what he calls a god to dog phenomenon. After being treated like gods during the borrowing process, the venture capital firm is thereafter treated as

a pariah dog, and tends to have no ongoing relationship with the investee firm once it has handed out the money. In most cases, Indian entrepreneurs, as in the United States, would prefer bank loans to venture capital, but do not have the collateral to secure them. They must, therefore, accept the venture capitalists onerous terms. Since they receive no other support from the venture capitalist, they tend to view the cost of the money as unnecessarily heavy. Typically, the domestic venture capital firm imposes loans on a contingent basis: the venture capitalist will purchase equity-linked, unsecured debt that specifies a high interest rate (usually over 25 percent), provided the investee firm achieves certain turnover targets, with further upside depending on performance. Although board seats are allotted to venture capitalist, these are largely ceremonial posts. According to

Ramachandrans findings, investee firms believe the cost of venture capital is too high, and feel that it should be 8 to 10 percent, compared with bank loans, which cost 15 percent on average. While the basis for such expectations is not obvious, it helps to explain the high default rate. Though still in its nascent stages, and therefore untested, exit is likely to be a problem for venture capital firms. The record of government-promoted venture capital firms, which were established in 1990, is dismal. The private venture capital industry only began supplying finance in 1997, after SEBI issued guidelines. Similarly, the industrys performance record is unknownbearing in mind that these are early daysbut it is believed to be

poor. All divestments so far have taken the acquisition route; none passed through the stock markets. This is due in part to Indias sluggish economy since 1996, and a generally poor market for IPOs, but also to the restrictive RBI guidelines, noted above, which create problems for divestment through IPOs. Indian Venture Capital and the Business Environment As summarized above, the conference participants addressed the legal, regulatory, and governance structures of Indian venture capital firms in some detail. The discussion then shifted to issues associated with the business environment for venture capital in India. For Indian entrepreneurs, the costs of starting up a new venture are modest. Companies may be bought off the shelf and business begun relatively cheaply and quickly. However, the availability of infrastructure is weak as compared to developed countries. Gokul Agarwalla states that there are seven software technology parks (STPs), each with an average investment of $3 million. The quality of habitat in these parks is considered to be poor, but entrepreneurs are attracted by good global communications infrastructure, which is made available at cost. The only STP that rises to an international standard is the International Technology Park in Bangalore, promoted by the Tatas and the Government of Singapore. Oddly, it has constructed less than half of its projected office space because it remains unable, as yet, to compete with downtown space in Bangalore (where there exists a prolonged recession in office space). Generally,

the poor quality of STPs could contribute to the IT brain drain in Indiaa subject that conference participants discussed later in the session. Further, though the Indian business environment is open and encourages entrepreneurship, there is very little interaction between universities and other research centers and business. Government Policy for Developing IT The Indian governments policy towards IT is captured in its 108 Point IT Program, approved in 1998. The key features are: 1) Infrastructure Enhancing Internet access by opening access nodes countrywide, through the government-owned Department of Telecom Bandwidth release as needed from both Intelsat and the Defence Ministry Allowance of ISP services through cable TV networks 2) Corporate IT development Duty-free access to imported software and hardware Licensing exemption for IT service firms from excise, labor, and pollution Service tax exemptions Introduction of personal tax incentives for computer and software purchases Accelerated depreciation for business purchases Changes from asset-based to contract-based lending in bank lending norms Priority sector status for accessing bank loans for the IT software and services

sectors Permission for banks to buy equity in venture capital funds, up to 5 percent of their incremental deposits Loss-carry backward allowed for venture capital firms Sweat equity allowed, including dollar-linked stock options Freedom to purchase overseas firms 3) National IT development Easy loans for buying computers and software Internet access for every educational institution by 2003 Compulsory IT course module for all degree courses IT literacy for all government employees This is an impressive list of policies. Since the program was announced in July 1998, the following initiatives have been implemented: Creation of a 1 billion rupee fund to finance venture capital, to be administered through the Small Industries Development Bank, a government-promoted undertaking. Bank investments in new high technology ventures are now recognized as priority sector loans, on par with loans to agriculture and small industries.

 Banks may now invest up to 5 percent of their incremental deposits in high technology ventures in any year. Before discussing the implications of and gaps in the governments new 108 Point Program, the conference participants considered the IT and venture capital experiences and regulations that prevail in other countries. The Venture Capital Business Environment: Americas SBIC Program In his presentation on the U.S. venture capital experience, Robert Stillman noted that the Small Business Investment Corporation (SBIC) programs basic objective is to induce private capital to invest in small companies that could not otherwise raise capital from purely private sources. In most cases, the Small Business Administration (SBA) that administers the SBIC program for the U.S. government agrees to provide two-thirds of the total capital, at a cost linked to the central bank lending rate, thus reducing the cost of borrowing while providing easy credit access to the private investor. For example, equity lenders can put in their own capital of $10 million, and the SBA will provide $20 million, for a total investment pool of $30 million. These arrangements can be structured in any way allowed under the law, though typically as limited partnerships. For SBICs that specialize as equity lenders, the SBA invests by way of participating securities that provide

some small equity upside, along with a moratorium on interest payments until the SBIC is ready to make cash distributions to its investors. The SBIC does not distinguish between types of businesses, although investments in buyouts, real estate, and oil exploration are prohibited. In 1998, the SBIC invested $3.4 billion in 3,470 ventures, approximately 40 percent by number and 20 percent by dollar value of all venture capital financings. Over half that amount was given over to businesses three years old or younger. Companies such as Apple, America Online, Intel, and Sun stand as some of the SBICs more famous past financings, but the lesson of its success lies in successfully financing thousands of small, unknown firms. The SBIC program enjoys great popularity with politicians. Because the SBA guarantees loans and makes budget appropriations equal to the net present value of anticipated negative cash flow of the loans guaranteed, the budgetary implication of the program is small. In recent years, the budget appropriation has been about 1 percent of the loans guaranteed. In 1996, the budget appropriation was $20.6 million, or less than a tenth of the taxes paid by corporate SBICs ($242 million). Thus, the program makes money for the government even without considering the taxes paid by the businesses financed or by their employees. The SBIC program undoubtedly has relevance for India, and it is possible a structure could be implemented in which Indian venture capital firms registered

with SEBI could avail themselves of those funds. Were this to occur, the only major constraint would be the absence of an active capital market for debt. This obstacle could be overcome, however, by allowing such funds to be part of the banking systems statutory reserves. As discussed above, such a program would need to tie into overall reform of the venture capital environment. The Venture Capital Business Environment: Taiwans Experience In his presentation, Tzu-Hwa Hsu asserted that Taiwans high rate of economic development, along with deliberate government policy, has engineered a much desired reverse brain drain from U.S. high technology. In this effort, Hsinchu Science-based Industrial Park is the showpiece of Taiwans success. Forty percent of the firms established in this governmentpromoted park, which currently accommodates 3,000 expatriates, were begun by entrepreneurs from the United States. The revenue of firms located at Hsinchu Park was $14 billion in 1998. Facilities at Hsinchu include English language teaching for the children of its expatriate entrepreneurs. The Hsinchu experiment has benefited from the generally high quality of education in Taiwan, whose institutes produce 50,000 engineers annually. Taiwan has 74 technical schools, 36 colleges, and 24 universities, two of which are located near Hsinchu Park. The venture capital environment has also been a favorable factor.

There are 110 venture capital firms in Taiwan, including 38 begun in 1998. By the end of 1997, these firms had invested $1.32 billion in 1,839 ventures, mostly in high technology. Unlike Indias experience, these have earned good returns. Hsu reported that the Walden Group earned 200 percent on its initial capital between 1994 and 1998. Taiwans active stock exchange has also been a good avenue for exit opportunities. Moreover, its accounting system, which imitates that of the United States, allows for easy listing of several Taiwanese firms on the U.S. stock exchanges. Taiwans government has been particularly successful in promoting its hardware industry through tax incentives for returning expatriates, low tariff barriers, large amounts of credit at cheap rates, good infrastructure facilities, and the establishment of research institutes. The Industrial Research Institute, owned by the government, was started with semiconductor technology purchased from RCA Records. The technology subsequently developed at the Institute led to two very successful integrated chip firms, United Microland Corporation (UMC) and Taiwan Semiconductor Manufacturing Corporation (TSMC), which were initially promoted by the government and ultimately privatized. With a self-reliant, welldiversified industrial base in high technology, both in size and activity, future Taiwanese government policy is to facilitate rather than direct research. In particular, the government intends to focus more on infrastructure development, science, and engineering education. It has also set up a special fund to finance

research and development in electro-optical and biosciences, which are currently identified as key technologies. During the discussion of international venture capital environments, Saxenian argued that Taiwan has benefited from close ties with Silicon Valley. A transnational community of Taiwanese engineers has fostered a two-way flow of capital, skills, and information between Silicon Valley and Taiwan. The benefits that India derives from its expatriate community are, according to Saxenian, more limited. This is due partly to Indias more constrained business environment and partly to its lower stage of overall economic development, which discourages repatriation. Many Indian entrepreneurs in Silicon Valley have linked U.S. companies to low-cost software expertise in India, such as Kanwal Rekhi did by opening offices for Novell in Bangalore. Saxenian suggested, though, that expatriate Indians have played a more limited role than expatriate Taiwanese. Both Saxenian and Mitta noted an emerging trend: the meeting of Taiwanese and Indian high technology talents in Silicon Valley. Saxenian described the case of Ramp Networks, which was started by an Indian expatriate, Mahesh Veerina, in Silicon Valley in 1993. Ramp Networks develops low-cost devices that speed Internet access for small businesses. The firm set up software development operations in Hyderabad at costs that were one-fourth of Silicon Valleys. Although the firm was initially funded by an India-dedicated venture capitalist,

Draper International, the founder, Veerina, happened to meet the principals of a Taiwanese venture capital firm, InveStar Capital. InveStar invested in Ramp and then convinced Veerina to visit Taiwan, where he subsequently established Original Equipment Manufacturing (OEM) relationships to manufacture its routers there. The price to do so was half that of the United States, and included substantially faster new product development in the bargain. Given current trends in technology, which will be covered below, the Taiwanese experience of promoting high technology hardware industries within Taiwan may have limited relevance to India. However, India can learn important lessons from the Taiwanese governments focus on education and encouragement of small enterprises, via facilities such as Hsinchu Park, as well as a U.S.-style legal, regulatory, tax, and institutional environment. The Venture Capital Business Environment: Israels Experience Spurred by high levels of education, high technology expertise from Russian immigrants, and the peace process, Israel is undergoing a high technology boom. The Israeli venture capital industry has grown from one firm with a corpus of $30 million in 1991, to eighty firms with

$3 billion in investible funds by 1998. Further, Israels IT specialty is developing technology, rather than software or products. This focus has meant that new Israeli ventures are most typically acquired by larger technology firms, but the IPO route in the U.S. markets has also succeeded. Like Taiwan, Israel is another country in which government policy fostered a successful, highly diversified, self-reliant industry. In the early 1990s, Israel restructured its legal, accounting, and regulatory framework to mimic that of the United States. According to Blumbergs conference presentation, the new Israeli framework guarantees U.S. investors parity with U.S. tax rates. In 1984, the Israeli government passed a law to encourage industrial research and development (R&D) and created the Office of the Chief Scientist to implement government policy

related to this area. The laws strategy is to encourage private companies to invest in R&D projects with the government sharing the business risk. Under the law, a Research Committee appointed by the Chief Scientist approves proposals for anywhere from 30 to 66 percent of given projects funding (up to $250,000). These proposals, when funded, also receive tax exemptions for up to ten years. As an additional incentive to entrepreneurship, the Israeli government has created twentysix technology incubators designed to allow start-ups to convert their ideas into commercially viable products. These IT incubators currently house two hundred firms with nine hundred employees, and government administrative staff provide administrative assistance and business guidance. Israels government participates in international cooperation, seeking to match the nations

technical skills with global markets, and to share start-up risks up front with laterstage activities such as marketing. The most successful of these ventures has been the Bilateral Industrial Research and Development Foundation (BIRD). Begun in 1977 as an equal partnership with the U.S. government, the BIRD Foundation was seeded with $110 million to fund joint ventures between Israeli and U.S. firms. BIRD provides 50 percent of a companys R&D expenses, with equal amounts going to each partner. Its return comes from the royalties it charges on the companys revenue. In practice, only 25 percent of the funded projects have been successful, but this is a satisfactory rate even for private funds. The monies BIRD has earned on profitable projects more than offset losses made by the rest, thus allowing the Foundation to maintain the value of its corpus. BIRD approves about forty new projects a year, with average funding of $1.2 million

for a duration of twelve to fifteen months. It has so far funded five hundred such projects. Israel has also benefited from its close relationships with the United States. As Saxenian noted, the Israeli high technology industry enjoys the same kinds of transnational ties that have helped Taiwan. For example, Intels investments in Israel were motivated by American Jews working in the companys U.S. location. Similarly, the Israeli venture capital industry was set up by a well known Silicon Valley venture capitalist, Arthur Rock, an American Jew 20 who moved to Israel. Because of this link, as Blumberg pointed out in his remarks, almost all Israeli venture capital firms have strong U.S. connections. Blumberg Capital itself provides an interesting case study for the transnational Israeli community that Saxenian described. Blumberg characterized his company as half investment

bank, raising venture capital for start-ups, and half consulting firm that, for a fee, works on strategic alliances, legal and accounting support, analyst contacts, vendor relationships, marketing, and other business development work that his clients outsource. By creating a virtual office with a Silicon Valley address, the firm allows its clients to work as a seamless part of Silicon Valley. The conference participants determined that several of Israels experiences have relevance for India. Government policy on incubators, the funding of R&D projects, and the BIRD project provide useful object lessons for the Indian government and business alike. The nonresident Indian sector in Silicon Valley can also learn from the Blumberg approach. Summary of Trend Analyses Five trends emerged from the conference discussions. First, participants observed that Indias

most notable IT achievement to date has been the organic growth of a globally competitive software industry without any significant direct government support. Current government policy, as stated in the 108 Point Program, will affect positive change, yet it misses the mark on two counts: by failing to recognize emerging global IT trends, and by ignoring the needs of start-ups. Future growth is never entirely predictable. It is clear, though, that Indias IT development will be linked more closely with the growth of Silicon Valley than with other world centers. Many of the worlds developed countries, including Britain, France, and Japan, have partially insulated economies that lead to technical developments with local uses to which Indias IT growth cannot profitably be tied. For example, Deepak Satwalekar, in a presentation at

Stanford University in December 1998, asserted that the quality of British, French, and Japanese bank software currently under development lags well behind that of both the United States and India, employing fewer open standards, as well as less ATM accessibility and networking.6 If India succeeds, it will likely mirror the growth trajectories of Israel and Taiwan, countries which have also aligned themselves closely with Silicon Valley. Eric Schmidt elaborated on this second growth trend by observing that, as IT companies become larger, they globalize their work forces. There are several good reasons for this tendency: Cost. The United States is short-supplied (including foreign workers) by at least 350,000 knowledge workers at all skill levels. Diversification. Despite the strong overall growth in the industry, there have been rapid changes in firms market shares, leading to high firm-specific risk for employees. While strong growth in the IT sector ensures that employees can easily find other jobs, it also means that those firms in a downturn often lose employees rapidly. Novell faced this situation a few years ago, and overcame

it via operations in Bangalore and Utah, where job options were fewer and work forces, consequently, were more stable. 21 Quality. Although IT workers of all skills are available in the United States, the Internet has spurred particular demand for UNIX-related skills. India, for fortuitous reasons enumerated earlier, developed its UNIX capabilities several years ahead of the curve, and could thus capitalize on this growth in demand. Customization or individualization of the Internet, the third trend identified by conference participants, will play a significant role in its so-called next wave. Eric Schmidt noted three particular components of this trend. First, akin to Metcalfes law of networks, he hypothesized that the value of a network is the square of the number of identities managed on that network. The key to the network, however, is the identification of relationships within it. His second point stated that the productivity gains companies enjoy are directly proportional

to the number of secure identities on the network. Finally, he observed that the value of an identity increases in proportion to the number of platforms it can span. As customization on the Internet increases, transactions sites will become more ephemeral. Customers will migrate without cost (even in terms of search costs) to their most valued sites, which will themselves have limited stickiness. The growth of identity will allow advertising to be uniquely tailored, targeted, and effective, leading in turn to a resurgence in Internet advertising. Currently Web advertising is under question, given that click-through rates average less than one percent. The fourth trend that conference participants foresaw might be called the death of distance, resulting from the growth of the Internet. The Blumberg Capital case study cited earlier demonstrates how operations in Israel and Silicon Valley may be seamlessly integrated

to create a single operation spanning both countries. Saxenian presented evidence that suggests a similar phenomenon in Taiwan. Her case study of Ramp, summarized above, proves that the death of distance phenomenon can lead to multi-country integration, in this case, among India, Taiwan, and the United States. However, to the extent that the spreading of the Internet has been accompanied by an acceleration of the rate of change, participants such as Mitta and Blumberg argued that the problem of distance remains. The fifth and final trend, posited by Blumberg, suggests that the quality of research performed in start-ups now rivals that of much bigger research projects undertaken by large firms. Previously, start-ups had focused on niche or innovative ideas not covered by the large firms. Schmidt noted, for example, that when Cisco started making routers, they were considered a small, niche market, neglected by major players in the industry, such as Lucent and

Sun. Another example is Hotmail Corporation, described by Rafiq Dossani and Charles Holloway in their 1999 case study of Hotmail Corporation for the Graduate School of Business at Stanford University. At the time, Hotmails idea of a web-based email service was entirely new. Today, a start-up can successfully pursue an idea even if it already has currency in the public domain and is being researched by large firms. To illustrate this development, Blumberg presented the case of Checkpoint, the market leader in firewall systems. Checkpoint was founded by three Israeli scientists who had come out of the armys research group. They knew that Sun Microsystems was developing a competitive product, and since Sun was already the market leader in servers (on which firewalls reside), the success of their product

depended on Suns acceptance of it. Moreover, they needed cash to develop their product. One option, of course, would have been to approach a venture capital firm for funding and to develop, independently, a marketing strategy to tackle Suns considerable competitive threat. 22 Instead, Checkpoint negotiated a financing deal with Sun with the following elements: (1) Checkpoint agreed to sell their product at a deep discount to Sun to match the cost of Suns own internal development, and to offer Sun the right of first to market; (2) The deal was negotiated with Suns marketing department, which agreed to sign a non-disclosure agreement (NDA) that covered its own internal departments (including R&D), thus ensuring that Sun researchers working on the same product could not access Checkpoints intellectual property.

The Checkpoint case offers several interesting object lessons for India. First, it illustrates multinationals growing acceptance of their responsibility to support outside product development, even when the same products are being developed in-house. To close the deal with Checkpoint, Sun was forced to erect a corporate wall between its marketing and research departments. Second, although the deal meant that Suns own product might not be first-tomarket, they paid a fair price for their competitors product, matched their own product development costs, and got first-to-market rights in addition. Intellectual property that does not come with economies of scale in research made this win-win situation possible. Third, Checkpoint benefited hugely from the partnership. They protected their intellectual property through the Sun NDA (the alternative source of finance, venture capital firms, do not usually sign NDAs, as information from investee firms is a source of their competitive advantage)

and they retained a larger share of their company than if they approached venture capitalists. Their alliance with Sun gained them a good reputation in the market, which would not have been forthcoming from venture capitalists. They also signed their financing deal within eight weeks of the start of negotiations, on par with venture capital timetables. Although Checkpoint did award first-to-market rights to Sun, they later sold their product to other firms and thus retained their market leadership. What can India learn from Checkpoint? Multinationals already maintain a strong presence in India, far more so than the foreign venture capital community. As Blumberg put it: Strategic investors are a great opportunity for India. Multinationals are geographically insensitive whereas American venture capital firms are very provincial. Your typical Menlo Park venture capitalist will not invest in a firm if he cannot ride his bike to its headquarters.

Policy Options and Next Steps Based on the above discussion, conference participants mapped out several desirable policy options for governmental and private sector policy with respect to IT and venture capital financing. Broadly summarized, these next steps include the following elements: The government should enhance access to the Internet wherever it controls such access. The government has removed, or has agreed to remove, most tariff barriers, but it must still create the right regulatory, legal, tax, and institutional environment for innovative start-ups to flourish. The government can play a positive role in creating financing and research initiatives that replicate both the U.S. SBIC and the Israeli law on encouraging R&D. 23 To maximize Indias IT strengths, the private sector should consider multicountry approaches to IT development, as discussed by both Saxenian and Blumberg. The Indian governments 108 Point IT Program, as described above, contains several positive

components. Unfortunately, it also displays several important gaps which must be filled before the Program can reach its full potential. The first flaw in the 108 Point IT Program is that it benefits large companies while neglecting start-ups. Multinationals and large Indian firms supplying low value-added software services currently dominate the IT industry, whereas start-ups are relatively insignificant. The large playersparticularly those that fall into the corporate IT development classification will greatly benefit from the proposed reforms under the 108 Point Program.7 Startups will benefit less from the 108 Point Program than large organizations because they require greater university and research support and finance, elements that the program does not cover. Large companies already have access to finance and can undertake low valueadded activities that are not research-intensive.

The second gap in the 108 Point Program concerns potentially harmful expectations. These expectations will likely harm the IT sector because the government will seek greater and unnecessary control over IT processes and decisions. For instance, the Program dictates that the procedure of keeping records in paper form in public and private software technology parks shall be restricted to a maximum period of two months after which the records shall be Kept only in the electronic/magnetic/optical media. What is the purpose of imposing such a Condition on STPs? Who will monitor compliance? Why not allow the STPs themselves to decide such low-priority matters without government intervention? Another example stipulates that all employees in all companies, public or private, are to be given the option of telecommuting, where feasible and efficient. Conference participants suggested that the Indian government might profitably focus its attention on weightier matters.

A third difficulty of the Program is that it impels the government to spend unnecessary Money to establish, for example, a National Institute of Smart Government. This money Will have to be procured somehow. Conference participants argued that the 108 Point Program fails on certain critical issues Because Indian policymakers and large company practitioners remain largely ignorant of the real needs of IT development. The conference proposed the creation of a not-forprofit thinktank, independent of industry associations and government and headquartered in India, to Be funded by private interested entrepreneurs and NGOs around the world. Among its objectives Would be: To research and publish its findings on the IT sector with reference to global Trends, and regulatory, legal, tax, and institutional reform. To monitor government reform in the Indian states and the central government, Including reviewing teledensity benchmarks, Internet access nodes, etc.

 To propose changes in the enabling environment as it affects governance and access to capital. Such changes could include a study of possible financing and research initiatives that follow U.S. SBIC and Israeli laws for encouraging R&D.