Acknowledgement

This project was done as a part of our course curriculum of “Management of Financial

Services”.

We are highly grateful to our Department for sanctioning the grant to carry out this project.

We express our sincere thanks to Mr. Prem Sibbal, Faculty- Management of Financial

Services at Lal Bahadur Shastri Institute of Management, for his encouragement and support

in pursuing this project.

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Table of Contents

Serial Number Particulars Page Number

1 Acknowledgement

2 Concept of Venture Capital

3 The Venture Capital Spectrum

4 Current Industry Trends

5 VC Industry in India

6 Factors Affecting Venture Capital

7 Venture Capitalists: Scenario 2010

8 Case Study

2

Concept of Venture Capital

The term venture capital comprises of two words that is, “Venture” and “Capital”. Venture is

a course of processing, the outcome of which is uncertain but to which is attended the risk or

danger of “loss”. “Capital” means recourses to start an enterprise. To connote the risk and

adventure of such a fund, the generic name Venture Capital was coined.

Venture capital is considered as financing of high and new technology based enterprises. It is

said that Venture capital involves investment in new or relatively untried technology,

initiated by relatively new and professionally or technically qualified entrepreneurs with

inadequate funds. The conventional financiers, unlike Venture capitals, mainly finance

proven technologies and established markets. However, high technology need not be pre-

requisite for venture capital.

Venture capital has also been described as ‘unsecured risk financing’. The relatively high risk

of venture capital is compensated by the possibility of high returns usually through

substantial capital gains in the medium term. Venture capital in broader sense is not solely an

injection of funds into a new firm, it is also an input of skills needed to set up the firm, design

its marketing strategy, organize and manage it. Thus it is a long term association with

successive stages of company’s development under highly risk investment conditions, with

distinctive type of financing appropriate to each stage of development. Investors join the

entrepreneurs as co-partners and support the project with finance and business skills to

exploit the market opportunities.

Venture capital is not a passive finance. It may be at any stage of business/production cycle,

that is, start up, expansion or to improve a product or process, which are associated with both

risk and reward. The Venture capital makes higher capital gains through appreciation in the

value of such investments when the new technology succeeds. Thus the primary return sought

by the investor is essentially capital gain rather than steady interest income or dividend yield.

The most flexible definition of Venture capital is-

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“The support by investors of entrepreneurial talent with finance and business

skills to exploit market opportunities and thus obtain capital gains.”

Venture capital commonly describes not only the provision of start up finance or ‘seed corn’

capital but also development capital for later stages of business. A long term commitment of

funds is involved in the form of equity investments, with the aim of eventual capital gains

rather than income and active involvement in the management of customer’s business.

Features of Venture Capital

2.2.1 High Risk

By definition the Venture capital financing is highly risky and chances of failure are high as it

provides long term start up capital to high risk-high reward ventures. Venture capital assumes

four types of risks, these are:

Management risk - Inability of management teams to work together.

Market risk - Product may fail in the market.

Product risk - Product may not be commercially viable.

Operation risk - Operations may not be cost effective resulting in

increased cost decreased gross margins.

2.2.2 High Tech

As opportunities in the low technology area tend to be few of lower order, and hi-tech

projects generally offer higher returns than projects in more traditional areas, venture capital

investments are made in high tech. areas using new technologies or producing innovative

goods by using new technology. Not just high technology, any high risk ventures where the

entrepreneur has conviction but little capital gets venture finance. Venture capital is available

4

for expansion of existing business or diversification to a high risk area. Thus technology

financing had never been the primary objective but incidental to venture capital.

2.2.3 Equity Participation & Capital Gains

Investments are generally in equity and quasi equity participation through direct purchase of

shares, options, convertible debentures where the debt holder has the option to convert the

loan instruments into stock of the borrower or a debt with warrants to equity investment. The

funds in the form of equity help to raise term loans that are cheaper source of funds. In the

early stage of business, because dividends can be delayed, equity investment implies that

investors bear the risk of venture and would earn a return commensurate with success in the

form of capital gains.

2.2.4 Participation In Management

Venture capital provides value addition by managerial support, monitoring and follow up

assistance. It monitors physical and financial progress as well as market development

initiative. It helps by identifying key resource person. They want one seat on the company’s

board of directors and involvement, for better or worse, in the major decision affecting the

direction of company. This is a unique philosophy of “hands on management” where Venture

capitalist acts as complementary to the entrepreneurs. Based upon the experience other

companies, a venture capitalist advise the promoters on project planning, monitoring,

financial management, including working capital and public issue. Venture capital investor

cannot interfere in day today management of the enterprise but keeps a close contact with the

promoters or entrepreneurs to protect his investment.

2.2.5 Length of Investment

Venture capitalist help companies grow, but they eventually seek to exit the investment in

three to seven years. An early stage investment may take seven to ten years to mature, while

most of the later stage investment takes only a few years. The process of having significant

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returns takes several years and calls on the capacity and talent of venture capitalist and

entrepreneurs to reach fruition.

2.2.6 Illiquid Investment

Venture capital investments are illiquid, that is, not subject to repayment on demand or

following a repayment schedule. Investors seek return ultimately by means of capital gains

when the investment is sold at market place. The investment is realized only on enlistment of

security or it is lost if enterprise is liquidated for unsuccessful working. It may take several

years before the first investment starts to locked for seven to ten years. Venture capitalist

understands this illiquidity and factors this in his investment decisions.

Difference between Venture Capital & Other Funds

2.3.1 Venture Capital Vs Development Funds

Venture capital differs from Development funds as latter means putting up of industries

without much consideration of use of new technology or new entrepreneurial venture but

having a focus on underdeveloped areas (locations). In majority of cases it is in the form of

loan capital and proportion of equity is very thin. Development finance is security oriented

and liquidity prone. The criteria for investment are proven track record of company and its

promoters, and sufficient cash generation to provide for returns (principal and interest). The

development bank safeguards its interest through collateral.

They have no say in working of the enterprise except safeguarding their interest by having a

nominee director. They do not play any active role in the enterprise except ensuring flow of

information and proper management information system, regular board meetings, adherence

to statutory requirements for effective management control where as Venture capitalist

remain interested if the overall management of the project o account of high risk involved I

the project till its completion, entering into production and making available proper exit route

for liquidation of the investment. As against this fixed payments in the form of installment of

principal and interest are to be made to development banks.

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2.3.2 Venture Capital Vs Seed Capital & Risk Capital

It is difficult to make a distinction between venture capital, seed capital, and risk capital as

the latter two form part of broader meaning of Venture capital. Difference between them

arises on account of application of funds and terms and conditions applicable. The seed

capital and risk funds in India are being provided basically to arrange promoter’s contribution

to the project. The objective is to provide finance and encourage professionals to become

promoters of industrial projects. The seed capital is provided to conventional projects on the

consideration of low risk and security and use conventional techniques for appraisal. Seed

capital is normally in the form of low interest deferred loan as against equity investment by

Venture capital. Unlike Venture capital, Seed capital providers neither provide any value

addition nor participate in the management of the project. Unlike Venture capital Seed capital

provider is satisfied with low risk-normal returns and lacks any flexibility in its approach.

Risk capital is also provided to established companies for adapting new technologies. Herein

the approach is not business oriented but developmental. As a result on one hand the success

rate of units assisted by Seed capital/Risk

Finance has been lower than those provided with venture capital. On the other hand the return

to the seed/risk capital financier had been very low as compared to venture capitalist.

Seed Capital Scheme Venture capital Scheme

Basis Income or aid Commercial viability

Beneficiaries Very small entrepreneurs Medium and large

entrepreneurs are also

covered

Size of assistance Rs. 15 Lac (Max) Up to 40 percent of

promoters’ equity

Appraisal process Normal Skilled and specialized

Estimates returns 20 percent 30 percent plus

Flexibility Nil Highly flexible

Value addition Nil Multiple ways

Exit option Sell back to promoters Several ,including Public

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offer

Funding sources Owner funds Outside contribution

allowed

Syndication Not done Possible

Tax concession Nil Exempted

Success rate Not good Very satisfactory

Table 2.1: Difference between Seed Capital Scheme and Venture capital Scheme

2.3.3 Venture Capital Vs Bought Out Deals

The important difference between the Venture capital and bought out deals is that bought-

outs are not based upon high risk- high reward principal. Further unlike Venture capital they

do not provide equity finance at different stages of the enterprise. However both have a

common expectation of capital gains yet their objectives and intents are totally different.

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The Venture Capital Spectrum

The requirements of funds vary with the life cycle stage of the enterprise. Even before a

business plan is prepared the entrepreneur invests his time and resources in surveying the

market, finding and understanding the target customers and their needs. At the seed stage the

entrepreneur continue to fund the venture with his own or family funds. At this stage the

funds are needed to solicit the consultant’s services in formulation of business plans, meeting

potential customers and technology partners. Next the funds would be required for

development of the product/process and producing prototypes, hiring key people and building

up the managerial team. This is followed by funds for assembling the manufacturing and

marketing facilities in that order. Finally the funds are needed to expand the business and

attaint the critical mass for profit generation. Venture capitalists cater to the needs of the

entrepreneurs at different stages of their enterprises. Depending upon the stage they finance,

venture capitalists are called angel investors, venture capitalist or private equity

supplier/investor.

Venture capital was started as early stage financing of relatively small but rapidly growing

companies. However various reasons forced venture capitalists to be more and more involved

in expansion financing to support the development of existing portfolio companies. With

increasing demand of capital from newer business, Venture capitalists began to operate

across a broader spectrum of investment interest. This diversity of opportunities enabled

Venture capitalists to balance their activities in term of time involvement, risk acceptance and

reward potential, while providing on going assistance to developing business.

Different venture capital firms have different attributes and aptitudes for different types of

Venture capital investments. Hence there are different stages of entry for different Venture

capitalists and they can identify and differentiate between types of Venture capital

investments, each appropriate for the given stage of the investee company, These are:-

1. Early Stage Finance

Seed Capital

Start up Capital

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Early/First Stage Capital

Later/Third Stage Capital

2. Later Stage Finance

Expansion/Development Stage Capital

Replacement Finance

Management Buy Out and Buy ins

Turnarounds

Mezzanine/Bridge Finance

Not all business firms pass through each of these stages in a sequential manner. For instance

seed capital is normally not required by service based ventures. It applies largely to

manufacturing or research based activities. Similarly second round finance does not always

follow early stage finance. If the business grows successfully it is likely to develop sufficient

cash to fund its own growth, so does not require venture capital for growth.

The table below shows risk perception and time orientation for different stages of venture

capital financing.

Financing Stage Period (funds

locked in years)

Risk perception Activity to be financed

Early stage finance

Seed

7-10 Extreme For supporting a concept or

idea or R & D for product

development

Start up 5-9 Very high Initializing operations or

developing prototypes

First stage 3-7 High Start commercial production

and marketing

Second stage 3-5 Sufficiently

high

Expand market & growing

working capital need

Later stage finance 1-3 Medium Market expansion,

acquisition & product

10

development for profit

making company

Buy out-in 1-3 Medium Acquisition financing

Turnaround 3-5 Medium to high Turning around a sick

company

Mezzanine 1-3 Low Facilitating public issue

Table 2.2: Venture Capital- Financing Stages

2.4.1 Seed Capital

It is an idea or concept as opposed to a business. European Venture capital association

defines seed capital as “The financing of the initial product development or capital provided

to an entrepreneur to prove the feasibility of a project and to qualify for start up capital”.

The characteristics of the seed capital may be enumerated as follows:

Absence of ready product market

Absence of complete management team

Product/ process still in R & D stage

Initial period / licensing stage of technology transfer

Broadly speaking seed capital investment may take 7 to 10 years to achieve realization. It is

the earliest and therefore riskiest stage of Venture capital investment. The new technology

and innovations being attempted have equal chance of success and failure. Such projects,

particularly hi-tech, projects sink a lot of cash and need a strong financial support for their

adaptation, commencement and eventual success. However, while the earliest stage of

financing is fraught with risk, it also provides greater potential for realizing significant gains

in long term. Typically seed enterprises lack asset base or track record to obtain finance from

conventional sources and are largely dependent upon entrepreneur’s personal resources. Seed

capital is provided after being satisfied that the entrepreneur has used up his own resources

and carried out his idea to a stage of acceptance and has initiated research. The asset

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underlying the seed capital is often technology or an idea as opposed to human assets (a good

management team) so often sought by venture capitalists.

Volume of Investment Activity

It has been observed that Venture capitalist seldom make seed capital investment and these

are relatively small by comparison to other forms of venture finance. The absence of interest

in providing a significant amount of seed capital can be attributed to the following three

factors: -

a) Seed capital projects by their very nature require a relatively small amount of capital. The

success or failure of an individual seed capital investment will have little impact on the

performance of all but the smallest venture capitalist’s portfolio. Larger venture

capitalists avoid seed capital investments. This is because the small investments are seen

to be cost inefficient in terms of time required to analyze, structure and manage them.

b) The time horizon to realization for most seed capital investments is typically 7-10 years

which is longer than all but most long-term oriented investors will desire.

c) The risk of product and technology obsolescence increases as the time to realization is

extended. These types of obsolescence are particularly likely to occur with high

technology investments particularly in the fields related to Information Technology.

2.4.2 Start up Capital

It is stage 2 in the venture capital cycle and is distinguishable from seed capital investments.

An entrepreneur often needs finance when the business is just starting. The start up stage

involves starting a new business. Here in the entrepreneur has moved closer towards

establishment of a going concern. Here in the business concept has been fully investigated

and the business risk now becomes that of turning the concept into product.

Start up capital is defined as: “Capital needed to finance the product development, initial

marketing and establishment of product facility. “

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The characteristics of start-up capital are:-

i. Establishment of company or business. The company is either being organized or is

established recently. New business activity could be based on experts, experience or a spin-

off from R & D.

ii. Establishment of most but not all the members of the team. The skills and fitness to the

job and situation of the entrepreneur’s team is an important factor for start up finance.

iii. Development of business plan or idea. The business plan should be fully developed yet

the acceptability of the product by the market is uncertain. The company has not yet started

trading.

In the start up preposition venture capitalists’ investment criteria shifts from idea to people

involved in the venture and the market opportunity. Before committing any finance at this

stage, Venture capitalist however, assesses the managerial ability and the capacity of the

entrepreneur, besides the skills, suitability and competence of the managerial team are also

evaluated. If required they supply managerial skills and supervision for implementation. The

time horizon for start up capital will be typically 6 or 8 years. Failure rate for start up is 2 out

of 3. Start up needs funds by way of both first round investment and subsequent follow-up

investments. The risk tends t be lower relative to seed capital situation. The risk is controlled

by initially investing a smaller amount of capital in start-ups. The decision on additional

financing is based upon the successful performance of the company. However, the term to

realization of a start up investment remains longer than the term of finance normally provided

by the majority of financial institutions. Longer time scale for using exit route demands

continued watch on start up projects.

Volume of Investment Activity

Despite potential for specular returns most venture firms avoid investing in start-ups. One

reason for the paucity of start up financing may be high discount rate that venture capitalist

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applies to venture proposals at this level of risk and maturity. They often prefer to spread

their risk by sharing the financing. Thus syndicates of investor’s often participate in start up

finance.

2.4.3 Early Stage Finance

It is also called first stage capital is provided to entrepreneur who has a proven product, to

start commercial production and marketing, not covering market expansion, de-risking and

acquisition costs.

At this stage the company passed into early success stage of its life cycle. A proven

management team is put into this stage, a product is established and an identifiable market is

being targeted.

British Venture Capital Association has vividly defined early stage finance as: “Finance

provided to companies that have completed the product development stage and require

further funds to initiate commercial manufacturing and sales but may not be generating

profits.”

The characteristics of early stage finance may be: -

Little or no sales revenue.

Cash flow and profit still negative.

A small but enthusiastic management team which consists of people with technical and

specialist background and with little experience in the management of growing

business.

Short term prospective for dramatic growth in revenue and profits.

The early stage finance usually takes 4 to 6 years time horizon to realization. Early stage

finance is the earliest in which two of the fundamentals of business are in place i.e. fully

assembled management team and a marketable product. A company needs this round of

finance because of any of the following reasons: -

Project overruns on product development.

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Initial loss after start up phase.

The firm needs additional equity funds, which are not available from other sources thus

prompting venture capitalist that, have financed the start up stage to provide further

financing. The management risk is shifted from factors internal to the firm (lack of

management, lack of product etc.) to factors external to the firm (competitive pressures, in

sufficient will of financial institutions to provide adequate capital, risk of product

obsolescence etc.)

At this stage, capital needs, both fixed and working capital needs are greatest. Further, since

firms do not have foundation of a trading record, finance will be difficult to obtain and so

Venture capital particularly equity investment without associated debt burden is key to

survival of the business.

The following risks are normally associated to firms at this stage: -

a) The early stage firms may have drawn the attention of and

incurred the challenge of a larger competition.

b) There is a risk of product obsolescence. This is more so when the

firm is involved in high-tech business like computer,

information technology etc.

2.4.4 Second Stage Finance

It is the capital provided for marketing and meeting the growing working capital needs of an

enterprise that has commenced the production but does not have positive cash flows

sufficient to take care of its growing needs. Second stage finance, the second trench of Early

State Finance is also referred to as follow on finance and can be defined as the provision of

capital to the firm which has previously been in receipt of external capital but whose financial

needs have subsequently exploded. This may be second or even third injection of capital.

The characteristics of a second stage finance are:

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A developed product on the market

A full management team in place

Sales revenue being generated from one or more products

There are losses in the firm or at best there may be a break even but the surplus generated

is insufficient to meet the firm’s needs.

Second round financing typically comes in after start up and early stage funding and so have

shorter time to maturity, generally ranging from 3 to 7 years. This stage of financing has both

positive and negative reasons.

Negative reasons include:

I Cost overruns in market development.

II Failure of new product to live up to sales forecast.

III Need to re-position products through a new marketing campaign.

IV Need to re-define the product in the market place once the

product deficiency is revealed.

Positive reasons include:

I Sales appear to be exceeding forecasts and the enterprise needs to acquire assets to gear

up for production volumes greater than forecasts.

II High growth enterprises expand faster than their working capital permit, thus

needing additional finance. Aim is to provide working capital for initial expansion of an

enterprise to meet needs of increasing stocks and receivables.

It is additional injection of funds and is an acceptable part of venture capital. Often provision

for such additional finance can be included in the original financing package as an option,

subject to certain management performance targets.

2.4.5 Later Stage Finance

It is called third stage capital is provided to an enterprise that has established commercial

production and basic marketing set-up, typically for market expansion, acquisition, product

16

development etc. It is provided for market expansion of the enterprise. The enterprises

eligible for this round of finance have following characteristics.

I. Established business, having already passed the risky early stage.

II. Expanding high yield, capital growth and good profitability.

III. Reputed market position and an established formal organization structure.

“Funds are utilized for further plant expansion, marketing, working capital or development of

improved products.” Third stage financing is a mix of equity with debt or subordinate debt.

As it is half way between equity and debt in US it is called “mezzanine” finance. It is also

called last round of finance in run up to the trade sale or public offer.

Venture capitalist s prefer later stage investment vis a vis early stage investments, as the rate

of failure in later stage financing is low. It is because firms at this stage have a past

performance data, track record of management, established procedures of financial control.

The time horizon for realization is shorter, ranging from 3 to 5 years. This helps the venture

capitalists to balance their own portfolio of investment as it provides a running yield to

venture capitalists. Further the loan component in third stage finance provides tax advantage

and superior return to the investors.

There are four sub divisions of later stage finance.

Expansion / Development Finance

Replacement Finance

Buyout Financing

Turnaround Finance

Expansion / Development Finance

An enterprise established in a given market increases its profits exponentially by achieving

the economies of scale. This expansion can be achieved either through an organic growth,

that is by expanding production capacity and setting up proper distribution system or by way

of acquisitions. Anyhow, expansion needs finance and venture capitalists support both

organic growth as well as acquisitions for expansion.

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At this stage the real market feedback is used to analyze competition. It may be found that the

entrepreneur needs to develop his managerial team for handling growth and managing a

larger business.

Realization horizon for expansion / development investment is one to three years. It is

favored by venture capitalist as it offers higher rewards in shorter period with lower risk.

Funds are needed for new or larger factories and warehouses, production capacities,

developing improved or new products, developing new markets or entering exports by

enterprise with established business that has already achieved break even and has started

making profits.

Replacement Finance

It means substituting one shareholder for another, rather than raising new capital resulting in

the change of ownership pattern. Venture capitalist purchase shares from the entrepreneurs

and their associates enabling them to reduce their shareholding in unlisted companies. They

also buy ordinary shares from non-promoters and convert them to preference shares with

fixed dividend coupon. Later, on sale of the company or its listing on stock exchange, these

are re-converted to ordinary shares. Thus Venture capitalist makes a capital gain in a period

of 1 to 5 years.

Buy - out / Buy - in Financing

It is a recent development and a new form of investment by venture capitalist. The funds

provided to the current operating management to acquire or purchase a significant share

holding in the business they manage are called management buyout.

Management Buy-in refers to the funds provided to enable a manager or a group of managers

from outside the company to buy into it.

It is the most popular form of venture capital amongst later stage financing. It is less risky as

venture capitalist in invests in solid, ongoing and more mature business. The funds are

provided for acquiring and revitalizing an existing product line or division of a major

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business. MBO (Management buyout) has low risk as enterprise to be bought have existed for

some time besides having positive cash flow to provide regular returns to the venture

capitalist, who structure their investment by judicious combination of debt and equity. Of late

there has been a gradual shift away from start up and early finance to wards MBO

opportunities. This shift is because of lower risk than start up investments.

Turnaround Finance

It is rare form later stage finance which most of the venture capitalist avoid because of higher

degree of risk. When an established enterprise becomes sick, it needs finance as well as

management assistance foe a major restructuring to revitalize growth of profits. Unquoted

company at an early stage of development often has higher debt than equity; its cash flows

are slowing down due to lack of managerial skill and inability to exploit the market potential.

The sick companies at the later stages of development do not normally have high debt burden

but lack competent staff at various levels. Such enterprises are compelled to relinquish

control to new management. The venture capitalist has to carry out the recovery process

using hands on management in 2 to 5 years. The risk profile and anticipated rewards are akin

to early stage investment.

Bridge Finance

It is the pre-public offering or pre-merger/acquisition finance to a company. It is the last

round of financing before the planned exit. Venture capitalist help in building a stable and

experienced management team that will help the company in its initial public offer. Most of

the time bridge finance helps improves the valuation of the company. Bridge finance often

has a realization period of 6 months to one year and hence the risk involved is low. The

bridge finance is paid back from the proceeds of the public issue.

Venture Capital Investment Process

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Venture capital investment process is different from normal project financing. In order to

understand the investment process a review of the available literature on venture capital

finance is carried out. Tyebjee and Bruno in 1984 gave a model of venture capital investment

activity which with some variations is commonly used presently.

As per this model this activity is a five step process as follows:

1. Deal Organization

2. Screening

3. Evaluation or due Diligence

4. Deal Structuring

5. Post Investment Activity and Exit

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Figure 2.2: Venture Capital Investment Process

21

Deal origination:

In generating a deal flow, the VC investor creates a pipeline of deals or investment

opportunities that he would consider for investing in. Deal may originate in various ways.

referral system, active search system, and intermediaries. Referral system is an important

source of deals. Deals may be referred to VCFs by their parent organisaions, trade partners,

industry associations, friends etc. Another deal flow is active search through networks, trade

fairs, conferences, seminars, foreign visits etc. Intermediaries is used by venture capitalists in

developed countries like USA, is certain intermediaries who match VCFs and the potential

entrepreneurs.

Screening:

VCFs, before going for an in-depth analysis, carry out initial screening of all projects on the

basis of some broad criteria. For example, the screening process may limit projects to areas in

which the venture capitalist is familiar in terms of technology, or product, or market scope.

The size of investment, geographical location and stage of financing could also be used as the

broad screening criteria.

Due Diligence:

Due diligence is the industry jargon for all the activities that are associated with evaluating an

investment proposal. The venture capitalists evaluate the quality of entrepreneur before

appraising the characteristics of the product, market or technology. Most venture capitalists

ask for a business plan to make an assessment of the possible risk and return on the venture.

Business plan contains detailed information about the proposed venture. The evaluation of

ventures by VCFs in India includes;

Preliminary evaluation: The applicant required to provide a brief profile of the proposed

venture to establish prima facie eligibility.

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Detailed evaluation: Once the preliminary evaluation is over, the proposal is evaluated in

greater detail. VCFs in India expect the entrepreneur to have:-  Integrity, long-term vision,

urge to grow, managerial skills, commercial orientation.

VCFs in India also make the risk analysis of the proposed projects which includes: Product

risk, Market risk, Technological risk and Entrepreneurial risk. The final decision is taken in

terms of the expected risk-return trade-off as shown in Figure.

Deal Structuring:

In this process, the venture capitalist and the venture company negotiate the terms of the

deals, that is, the amount, form and price of the investment. This process is termed as deal

structuring. The agreement also include the venture capitalist's right to control the venture

company and to change its management if needed, buyback arrangements, acquisition,

making initial public offerings (IPOs), etc. Earned out arrangements specify the

entrepreneur's equity share and the objectives to be achieved.

Post Investment Activities:

Once the deal has been structured and agreement finalised, the venture capitalist generally

assumes the role of a partner and collaborator. He also gets involved in shaping of the

direction of the venture. The degree of the venture capitalist's involvement depends on his

policy. It may not, however, be desirable for a venture capitalist to get involved in the day-to-

day operation of the venture. If a financial or managerial crisis occurs, the venture capitalist

may intervene, and even install a new management team.

Exit:

Venture capitalists generally want to cash-out their gains in five to ten years after the initial

investment. They play a positive role in directing the company towards particular exit routes.

A venture may exit in one of the following ways:

There are four ways for a venture capitalist to exit its investment:

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Initial Public Offer (IPO)

Acquisition by another company

Re-purchase of venture capitalist’s share by the investee company

Purchase of venture capitalist’s share by a third party

Promoter’s Buy-back

The most popular disinvestments route in India is promoter’s buy-back. This route is suited to

Indian conditions because it keeps the ownership and control of the promoter intact. The

obvious limitation, however, is that in a majority of cases the market value of the shares of

the venture firm would have appreciated so much after some years that the promoter would

not be in a financial position to buy them back.

In India, the promoters are invariably given the first option to buy back equity of their

enterprises. For example, RCTC participates in the assisted firm’s equity with suitable

agreement for the promoter to repurchase it. Similarly, Canfina-VCF offers an opportunity to

the promoters to buy back the shares of the assisted firm within an agreed period at a

predetermined price. If the promoter fails to buy back the shares within the stipulated period,

Canfina-VCF would have the discretion to divest them in any manner it deemed appropriate.

SBI capital Markets ensures through examining the personal assets of the promoters and their

associates, which buy back, would be a feasible option. GVFL would make disinvestments,

in consultation with the promoter, usually after the project has settled down, to a profitable

level and the entrepreneur is in a position to avail of finance under conventional schemes of

assistance from banks or other financial institutions.

Initial Public Offers (IPOs)

The benefits of disinvestments via the public issue route are, improved marketability and

liquidity, better prospects for capital gains and widely known status of the venture as well as

market control through public share participation. This option has certain limitations in the

Indian context. The promotion of the public issue would be difficult and expensive since the

first generation entrepreneurs are not known in the capital markets. Further, difficulties will

be caused if the entrepreneur’s business is perceived to be an unattractive investment

proposition by investors. Also, the emphasis by the Indian investors on short-term profits and

24

dividends may tend to make the market price unattractive. Yet another difficulty in India until

recently was that the Controller of Capital Issues (CCI) guidelines for determining the

premium on shares took into account the book value and the cumulative average EPS till the

date of the new issue. This formula failed to give due weight age to the expected stream of

earning of the venture firm. Thus, the formula would underestimate the premium. The

Government has now abolished the Capital Issues Control Act, 1947 and consequently, the

office of the controller of Capital Issues. The existing companies are now free to fix the

premium on their shares. The initial public issue for disinvestments of VCFs’ holding can

involve high transaction costs because of the inefficiency of the secondary market in a

country like India. Also, this option has become far less feasible for small ventures on

account of the higher listing requirement of the stock exchanges. In February 1989, the

Government of India raised the minimum capital for listing on the stock exchanges from Rs

10 million to Rs 30 million and the minimum public offer from Rs 6 million to Rs 18 million.

Sale on the OTC Market

An active secondary capital market provides the necessary impetus to the success of the

venture capital. VCFs should be able to sell their holdings, and investors should be able to

trade shares conveniently and freely. In the USA, there exist well-developed OTC markets

where dealers trade in shares on telephone/terminal and not on an exchange floor. This

mechanism enables new, small companies which are not otherwise eligible to be listed on the

stock exchange, to enlist on the OTC markets and provides liquidity to investors. The

National Association of Securities Dealers Automated Quotation System (NASDAQ) in the

USA daily quotes over 8000 stock prices of companies backed by venture capital.

The OTC Exchange in India was established in June 1992. The Government of India had

approved the creation for the Exchange under the Securities Contracts (Regulations) Act in

1989. It has been promoted jointly by UTI, ICICI, SBI Capital Markets, Can bank Financial

Services, GIC, LIC and IDBI. Since this list of market-makers (who will decide daily prices

and appoint dealers for trading) includes most of the public sector venture financiers, it

should pick up fast, and it should be possible for investors to trade in the securities of new

small and medium size enterprises.

25

The other disinvestments mechanisms such as the management buyouts or sale to other

venture funds are not considered to be appropriate by VCFs in India.

The growth of an enterprise follows a life cycle as shown in the diagram below. The

requirements of funds vary with the life cycle stage of the enterprise. Even before a business

plan is prepared the entrepreneur invests his time and resources in surveying the market,

finding and understanding the target customers and their needs. At the seed stage the

entrepreneur continue to fund the venture with his own or family funds. At this stage the

funds are needed to solicit the consultant’s services in formulation of business plans, meeting

potential customers and technology partners. Next the funds would be required for

development of the product/process and producing prototypes, hiring key people and building

up the managerial team. This is followed by funds for assembling the manufacturing and

marketing facilities in that order. Finally the funds are needed to expand the business and

attaint the critical mass for profit generation. Venture capitalists cater to the needs of the

entrepreneurs at different stages of their enterprises. Depending upon the stage they finance,

venture capitalists are called angel investors, venture capitalist or private equity

supplier/investor.

The players

There are following groups of players:

· Angels and angel clubs

· Venture Capital funds

- Small

- Medium

- Large

· Corporate venture funds

· Financial service venture groups

26

Angels and angel clubs

Angels are wealthy individuals who invest directly into companies. They can form angel

clubs to coordinate and bundle their activities. Besides the money, angels often provide their

personal knowledge, experience and contacts to support their investees. With average deals

sizes from USD 100,000 to USD 500,000 they finance companies in their early stages.

Examples for angel clubs are · Media Club, Dinner Club ,· Angel's Forum

Small and Upstart Venture Capital Funds

These are smaller Venture Capital Companies that mostly provide seed and start-up capital.

The so called "Boutique firms" are often specialised in certain industries or market segments.

Their capitalization is about USD 20 to USD 50 million (is this deals size or total money

under management or money under management per fund?). As for the small and medium

Venture Capital funds strong competition will clear the marketplace. There will be mergers

and acquisitions leading to a concentration of capital. Funds specialised in different business

areas will form strategic partnerships. Only the more successful funds will be able to attract

new money. Examples are:

· Artemis Comaford

· Abbell Venture Fund

· Acacia Venture Partners

Medium Venture Funds

The medium venture funds finance all stages after seed stage and operate in all business

segments. They provide money for deals up to USD 250 million. Single funds have up to

USD 5 billion under management. An example is Accel Partners

Large Venture Funds

As the medium funds, large funds operate in all business sectors and provide all types of

capital for companies after seed stage. They often operate internationally and finance deals up

to USD 500 million The large funds will try to improve their position by mergers and

acquisitions with other funds to improve size, reputation and their financial muscle. In

27

addition they will to diversify. Possible areas to enter are other financial services by means of

M&As with financial services corporations and the consulting business. For the latter one the

funds have a rich resource of expertise and contacts in house. In a declining market for their

core activity and with lots of tumbling companies out there is no reason why Venture Capital

funds should offer advice and consulting only to their investees.

Examples are:

· AIG American International Group

· Cap Vest Man

· 3i

Corporate Venture Funds

These Venture Capital funds are set up and owned by technology companies. Their aim is to

widen the parent company's technology base in an win-win-situation for both, the investor

and the investee. In general, corporate funds invest in growing or maturing companies, often

when the investee wishes to make additional investments in echnology or product

development. The average deals size is between USD 2 million and USD 5 million. The

large funds will try to improve their position by mergers and acquisitions with other funds to

improve size, reputation and their financial muscle. In addition they will to diversify. Possible

areas to enter are other financial services by means of M&As with financial services

corporations and the consulting business. For the latter one the funds have a rich resource of

expertise and contacts in house. In a declining market for their core activity and with lots of

tumbling companies out there is no reason why Venture Capital funds should offer advice

and consulting only to their investees. Examples are:

· Oracle

· Adobe

· Dell

· Kyocera

As an example, Adobe systems launched a $40m venture fund in 1994 to invest in companies

strategic to its core business, such as Cascade Systems Inc and Lantana Research

28

Corporation.- has been successfully boosting demand for its core products, so that Adobe

recently launched a second $40m fund.

Financial funds:

A solution for financial funds could be a shift to a higher securisation of Venture Capital

activities. That means that the parent companies shift the risk to their customers by creating

new products such as stakes in an Venture Capital fund. However, the success of such

products will depend on the overall climate and expectations in the economy. As long as the

sownturn continues without any sign of recovery customers might prefer less risky

alternatives.

29

Current Industry Trends

Round Class Distribution

The distribution of financing rounds by round class in mature markets is typically 30-40% in

the early stage rounds, 20-25% in second round, and 35-40% in later rounds. In emerging

market like China, the round distribution is very different as 68% in early stage round and

25% in second round. In mature countries, the investments are made at early start up or

product development phase.

Industry shifts

It is perhaps no surprise that the contraction is mostly concentrated in information technology

and the business, consumer and retail industries, give the huge number of companies financed

in the technology and Internet boom of 1999-2000, and the subsequent downturn. The

healthcare pool, driven by investment in biopharmaceuticals and medical devices, has

actually grown to some degree in the different geographies .In United States, the healthcare

pool has grown consistently over the last several years, both in terms of number of companies

and cumulative dollars invested.

Key observations on the pool of private companies by industry:-

The information and technology pool has declined by just 6% since 2002; particularly

due to increasing Interest in WEB 2.0 innovations.

Since 2003, the IT pool has decreased by 27% in Europe and since 2004 17% in Israel.

Cumulative investment has declined in similar amounts.

The business, consumer and retail category has faced the steepest declines across the

board. In US the number had fallen 54% since 2002 and 54% in Europe since 2003 .In

Israel; it dropped 67% since 2004.

30

The number of healthcare companies has grown in U.S. since 2002 by 27% and the

capital risen 30% in last five years. Capital investment to the pool of healthcare

companies in Europe and Israel has also climbed, although the number of companies

dropped by 9%in Europe since 2003 and 9% in Israel since 2004.

Clean technology is a small but increasing element of the pool. There were 262 clean

technology companies with a cumulative invested venture capital of US $38 billion in

2007.

Mega trends

Several global mega trends will likely have an impact on venture capital in the next decade:-

Beyond the BRICs: - A new wave of fast growing economies is joining the global growth

leaders like Brazil, China, India, and Russia. The beginning of venture capital activity has

been seen in others countries such as Indonesia, Korea, Turkey and Vietnam.

The new multinationals: - A new breed of global company is emerging from developing

countries and redefining industries through low-cost advantage, modern infrastructure,

and vast customer databases in their home countries. These companies are potential

acquirers of developed market companies at all stages of growth.

Globalization of capital:- Changes in economic and financial landscape are creating a

significant regional shifts in IPO activity. These changes have also sparked global

consolidation alliances among stock exchanges.

Transformation of the CFO’s role and function:- With the globalization and increasingly

complex regulatory environment, CFOs have a wider range of responsibilities and finance

function has been transformed to face broader mandates.

Clean Technology: - Clean technology is poised to become the first break through sector

of 21st century. Encompassing energy, air and water treatment, industrial efficiency

31

improvements, new material and waste management etc are playing very vital role

globally because of which VC investors are enjoying rewards.

The 2007 Global Venture Capital Survey was sponsored by Deloitte & Touche LLP in

conjunction with the National Venture Capital Association and other venture capital

associations* throughout the world. It was administered in April and May 2007 to venture

capitalists (VCs) in the Americas, Asia Pacific, Europe, the Middle East, and Africa.

There were 528 responses from general partners, with 45 percent of respondents from the

United States and 31 percent from Europe. A complete geographic breakdown of respondents

is as follows:

Figure: 3.1 Primary focused location for investment (APAC) respondents

The breadth of assets under management by these respondents was varied. The highest

number of respondents—42 percent—had managed assets totaling less than $100 million; 35

percent managed assets between $100 million and $499 million; 12 percent managed assets

between $500 million to $1 billion; and 11 percent more than $1 billion in assets under

management

32

There are 13 % respondents from APAC in which China, India, Japan, South Korea, other

Asia. 45% respondents from Middle East include Israel and other area of Middle East.

Global VC investment increasing, but growth is slow and cautious.

We may live in a global economy, but the venture capital community is not broadly

embracing global investment. Rather, roughly half of the venture community has made a

commitment to a global investment strategy and those firms are implementing that strategy

slowly and cautiously. The intentions for growth of foreign investment, as demonstrated by

this year’s survey data, are modest at best.

4654

% OF VENTURE CAPITALISTCURRENTLY INVESTING OUTSIDE HOME COUNTRY(U.S. RESPONDENTS)

YES NO

Figure: 3.2 Percentage of venture capitalist currently investing outside home country

(U.S. respondents)

33

Figure: 3.3 Percentage of venture capitalist currently investing outside home country

(Non U.S. respondents)

Among U.S. investors, 54 percent indicated that they would be expanding their investment

focus outside of their home country or region in the next five years. Adequate deal flow in

their home country was the reason indicated most for not wanting to expand globally.

Some venture investors are certainly taking advantage of opportunities outside their home

countries, actual growth in terms of percentage of venture investors investing globally is

occurring much more slowly than is commonly believed. And, for a lot of firms, they’re not

diving deep into investing in other countries, but dipping a toe in with one or two deals. This

cautious approach allows the venture firms to further assess the investment environment,

evaluate how their strategy may need to be adjusted and how critical challenges, such as tax

and intellectual property issues impact overall performance.

3.5 Current strategies

Among those VCs who are currently investing abroad, 48 percent of them have developed

strategic alliances with a foreign-based firm and 51 percent invest only with other investors

who have a local presence. This underscores the need in venture capital to be physically close

to the portfolio companies in order to work with management. Firms also indicated that to

succeed, they need to understand local culture, and to do so they must have a local presence

in their target countries to take advantage of in-country expertise. To this end, they also are

34

hiring investment staff with expertise in target countries (41 percent) and requiring their

partners to travel more (58 percent).

China, India, Israel and Canada are primary target countries for

U.S. venture capitalists

There continues to be a consensus among U.S. venture capitalists regarding where the most

opportunities exists globally. Most of the U.S. firms who have invested globally are making

investments in China, India, Israel, and Canada. However, even in these countries, the

majority of U.S. respondents are essentially dabbling, making only one to two investments

thus far.

35

Current business practises used by venture capitalist to manage foreign investment focus

4851

11

58

7 8

33

4136

4440

7

63

812

40

52

41

50

58

14

55

6 6

2934 33

0

10

20

30

40

50

60

70

strategicalliances

with foreignfirms

invest onlywith otherinvestorsthat have a

localpresence

acquireforeign

based firms

requirepartners totravel more

requirepartners totransfer to

foreignlocation

relocate HQof portfolio

co.to benear our

firm

open newoffices inforeignlocation

hireinvestmentstaff w ith

expertise intarget

countries

imvest inlocal

portfolio co.with

significantoperations

outsidecountry

global US Non US

53%

23%

8%

4% 12%

FOREIGN INVESTMENT CURRENTLY HELD BY FIRMS

1-2 investment

3-5 investment

6-10 investment

11-15 investment

16+ investment

Figure: 3.5 Foreign investment currently held by firms

Allocations by U.S. and non-U.S. firms alike for the most part represent less than 5 percent of

capital invested overseas in fewer than three to five deals. Survey results indicate that there

will not be significant change during the next five years.

36

RESPONSE FROM U.S. RESPONDENTS

34%

24%

11%

9%

6%

4% 7%5%

Primary locations where investors would like to expand investment focus (U.S. respond-

ents)

china

India

canda

UK & Ireland

Israel

other Asia

other Europe

others

Figure: 3.6 Primary focused location for investment (U.S) respondents

Here from the above chart we can see that the highest percent of respondents are interested in

China for setting up their businesses. India is the second choice for the global investors.

37

RESPONSE FROM (APAC) RESPONDENTS

37

27

18

9

3 3 3

PRIMARY LOCATION WHERE INVESTOR WOULD LIKE TO EXPAND INVESTMENT FOCUS (APAC) RESPOND-

ENTS

CHINA

OTHER ASIA

U.S.

INDIA

MIDDLE EAST

SOUTH KOREA

JAPAN

Figure: 3.7 Primary focused location for investment (APAC) respondents

While China, India, Israel, and Canada are by far the most seductive target markets for

investment by U.S. firms, venture capitalists in non-US countries have a different focus. By

far the greatest contrast is among European respondents, who indicated a strong preference

for investing in other parts of Europe (67 percent) and the United States (17 percent), with the

remainder focused on Asia. Asian respondents had a similar level of interest in the United

States (18 percent), but looked primarily inward to other Asian countries (78 percent), with

the remainder focused on the Middle East. This data shows that while non-U.S. investors are

interested in making deals outside of their home countries, there’s still a desire to remain

somewhat close to home and do business with cultures close to theirs. Most of APAC

38

respondents like to investment china and other Asia. There is 3% ready to invest in South

Korea, Japan and South Korea.

39

VC Industry in India

The first major analysis on risk capital for India was reported in 1983. It indicated that new

companies often confront serious barriers to entry into capital market for raising equity

finance which undermines their future prospects of expansion and diversification. It also

indicated that on the whole there is a need to revive the equity cult among the masses by

ensuring competitive return on equity investment. This brought out the institutional

inadequacies with respect to the evolution of venture capital.

In India, the Industrial finance Corporation of India (IFCI) initiated the idea of VC when it

established the Risk Capital Foundation in 1975 to provide seed capital to small and risky

projects. However the concept of VC financing got statutory recognition for the first time in

the fiscal budget for the year 1986-87.

The Venture Capital companies operating at present can be divided into four groups:

Promoted by All – India Development Financial Institutions

Promoted by State Level Financial Institutions

Promoted by Commercial banks

Private venture Capitalists.

Promoted by all India development financial institutions

The IDBI started a VC fund in 19876 as per the long term fiscal policy of government of

India, with an initial capital of Rs. 10 cr which raised by imposing a cess of 5% on all

payments made for the import of technology know- how projects requiring funds from rs.5

lacs to rs 2.5 cr were considered for financing. Promoter’s contribution ranged from this fund

was available at a concessional interest rate of 9% ( during gestation period) which could be

increased at later stages.

The ICICI provided the required impetus to VC activities in India, 1986, it started providing

VC finance in 1998 it promoted, along with the Unit Trust of India (UTI) Technology

Development and Information Company of India (TDICI) as the first VC company registered

under the companies act, 1956. The TDICI may provide financial assistance to venture

40

capital undertakings which are set up by technocrat entrepreneurs, or technology information

and guidance services.

The risk capital foundation established by the industrial finance corporation of India (IFCI) in

1975, was converted in 1988 into the Risk Capital and Technology Finance company (RCTC)

as a subsidiary company of the ifci the rctc provides assistance in the form of conventional

loans, interest –free conditional loans on profit and risk sharing basis or equity participation

in extends financial supoort to high technology projects for technological upgradations. The

RCTC has been renamed as IFCI Venture Capital Funds Ltd.(IVCF)

Promoted by State Level Financial Institutions

In India, the State Level financial institutions in some states such as Madhya Pradesh,

Gujarat, Uttar Prades, etc., have done an excellent job and have provided VC to a small scale

enterprises. Several successful entrepreneurs have been the beneficiaries of the liberal

funding environment. In 1990, the Gujarat Industrial Investment Corporation, promoted the

Gujarat Venture Financial Ltd.(GVFL) along with other promoters such as the IDBI, the

World Bank, etc. The GVFL provides financial assistance to businesses in the form of equity,

conditional loans or income notes for technologies development and innovative products. It

also provides finance assistance to entrepreneurs.

The government of Andhra Pradesh has also promoted the Andhra Pradesh Industrial

Development Corporation (APIDC) venture capital ltd. To provide VC financing in Andhra

Pradesh.

Promoted by commercial banks

Canbank Venture Capital Fund, State Bank Venture Capital Fund and Grindlays bank

Venture Capital Fund have been set up by the respective commercial banks to undertake vc

activities.

41

The State Bank Venture Capital Funds provides financial assistance for bought –out deal as

well as new companies in the form of equity which it disinvests after the commercialization

of the project.

Canbank Venture Capital Fund provides financial assistance for proven but yet to b

commercially exploited technologies. It provides assistance both in the form of equity and

conditional loans.

Private Venture Capital Funds

Several private sector venture capital funds have been established in India such as the 20 th

Centure Venture Capital Company, Indus Venture Capital Fund, Infrastructure Leasing and

Financial Services Ltd.

Some of the companies that have received funding through this route include:

Mastek, on of the oldest softwear house in India

Ruskan software, Pune based software consultancy

SQL Star, Hyderabad-based training and software development consultancy

Satyam infoway, the first private ISP in India

Hinditron, makers of embedded software

Selectia, provider of interactive software selectior

Yantra, ITLInfosy’s US subsidiary, solution for supply chain management

Rediff on the Net, Indian website featuring electronic shopping, news,chat etc.

42

4.2 INDUSTRY LIFE CYCLE:

From the industry life cyle we can know in which stage we are standing. On the basis of

this management can make future strategies of their business.

Figure: 4.1 Industry life cycle

The growth of VC in India has four separate phases:

4.2.1 Phase I - Formation of TDICI in the 80’s and regional funds as GVFL & APIDC in the

early 90s.

The first origins of modern venture capital in India can be traced to the setting up of a

Technology Development Fund in the year 1987-88, through the levy of access on all

technology import payments. Technology Development Fund was started to provide financial

support to innovative and high risk technological programmes through the Industrial

Development Bank of India.

The first phase was the initial phase in which the concept of VC got wider acceptance. The

first period did not really experience any substantial growth of VCs’. The 1980’s were

marked by an increasing disillusionment with the trajectory of the economic system and a

belief that liberalization was needed. The liberalization process started in 1985 in a limited

43

INTRODUCTION GROWTH

way. The concept of venture capital received official recognition in 1988 with the

announcement of the venture capital guidelines.

During 1988 to 1992 about 9 venture capital institutions came up in India.

Though the venture capital funds should operate as open entities, Government of India

controlled them rigidly. One of the major forces that induced Government of India to start

venture funding was the World Bank. The initial funding has been provided by World Bank.

The most important feature of the 1988 rules was that venture capital funds received the

benefit of a relatively low capital gains tax rate which was lower than the corporate rate. The

1988 guidelines stipulated that VC funding firms should meet the following criteria:

Technology involved should be new, relatively untried, very closely held, in the process

of being taken from pilot to commercial stage or incorporate some significant

improvement over the existing ones in India

Promoters / entrepreneurs using the technology should be relatively new, professionally

or technically qualified, with inadequate resources to finance the project.

Between 1988 and 1994 about 11 VC funds became operational either through reorganizing

the businesses or through new entities.

All these followed the Government of India guidelines for venture capital activities and have

primarily supported technology oriented innovative businesses started by first generation

entrepreneurs. Most of these were operated more like a financing operation. The main feature

of this phase was that the concept got accepted. VCs became operational in India before the

liberalization process started. The context was not fully ripe for the growth of VCs. Till 1995;

the VCs operated like any bank but provided funds without collateral. The first stage of the

venture capital industry in India was plagued by in experienced management, mandates to

invest in certain states and sectors and general regulatory problems. Many public issues by

small and medium companies have shown that the Indian investor is becoming increasingly

wary of investing in the projects of new and unknown promoters.

44

The liberation of the economy and toning up of the capital market changed the economic

landscape. The decisions relating to issue of stocks and shares was handled by an office

namely: Controller of Capital Issues (CCI). According to 1988 VC guideline, any

organization requiring to start venture funds have to forward an application to CCI.

Subsequent to the liberalization of the economy in 1991, the office of CCI was abolished in

May 1992 and the powers were vested in Securities and Exchange Board of India. The

Securities and Exchange Board of India Act, 1992 empowers SEBI under section 11(2)

thereof to register and regulate the working of venture capital funds. This was done in 1996,

through a government notification. The power to control venture funds has been given to

SEBI only in 1995 and the notification came out in 1996. Till this time, venture funds were

dominated by Indian firms. The new regulations became the harbinger of the second phase of

the VC growth.

4.2.2 Phase II - Entry of Foreign Venture Capital funds (VCF) between 1995 -1999

The second phase of VC growth attracted many foreign institutional investors.During this

period overseas and private domestic venture capitalists began investing in VCF. The new

regulations in 1996 helped in this. Though the changes proposed in 1996 had a salutary

effect, the development of venture capital continued to be inhibited because of the regulatory

regime and restricted the FDI environment. To facilitate the growth of venture funds, SEBI

appointed a committee to recommend the changes needed in the VC funding context. This

coincided with the IT boom as well as the success of Silicon Valley start-ups. In other words,

VC growth and IT growth co-evolved in India

4.2.3 Phase III - (2000 onwards) - VC becomes risk averse and activity declines:

Not surprisingly, the investing in India came “crashing down” when NASDAQ lost 60% of

its value during the second quarter of 2000 and other public markets (including those in

India) also declined substantially. Consequently, during 2001-2003, the VCs started investing

less money and in more mature companies in an effort to minimize the risks. This decline

broadly continued until 2003.

4.2.4 Phase IV – 2004 onwards - Global VCs firms actively investing in India

45

Since India’s economy has been growing at 7%-8% a year, and since some sectors, including

the services sector and the high-end manufacturing sector, have been growing at 12%-14% a

year, investors renewed their interest and started investing again in 2004. The number of

deals and the total dollars invested in India has been increasing substantially.

4.3 Growth of venture capital in India

Growth of VC in India

1160 937 591 470

2200

7500

14234

6390

1650

280

110

78

146

299

170

387

71

56

0

2000

4000

6000

8000

10000

12000

14000

16000

2000 2001 2002 2003 2004 2005 2006 2007 1st halfof 2008

0

50

100

150

200

250

300

350

400

450

Value of deals No.of deals

USD Million No. of Deals

Figure: 4.2 Growth of Venture capital in india

The venture capital is growing 43% CAGR. However, in spite of the venture capital scenario

improving, several specific VC funds are setting up shop in India, with the year 2006 having

been a landmark year for VC funding in India. The total deal value in 2007 is 14234 USD

Million. The NO. of deals are increasing year by year. The no. of deals in 2006 only 56 and

now in 2007 it touch the 387 deals. The introduction stage of venture capital industry in India

is completed in 2003 after that growing stage of Indian venture capital industry is started.

46

There are 160 venture capital firms/funds in India. In 2006 it is only but in 2007 the number

of venture capital firms are 146. The reason is good position of capital market. But in 2008

no. of venture capital firms increase by only 14. the reason is crashdown of capital market by

51% from January to November 2008. The No. of venture capital funds are increasing year

by year.

2000 2001 2002 2003 2004 2005 2006 2007 2008

841 77 78 81 86 89 105 146 160

www.nasscom.org, strategic review 2008 published by (National Association of Software

and Service Companies)

Venture capital growth and industrial clustering have a strong positive correlation. Foreign

direct investment, starting of R&D centres, availability of venture capital and growth of

entrepreneurial firms are getting concentrated into five clusters. The cost of monitoring and

the cost of skill acquisition are lower in clusters, especially for innovation. Entry costs are

also lower in clusters. Creating entrepreneurship and stimulating innovation in clusters have

to become a major concern of public policy makers. This is essential because only when the

cultural context is conducive for risk management venture capital will take-of. Clusters

support innovation and facilitates risk bearing. VCs prefer clusters because the information

costs are lower. Policies for promoting dispersion of industries are becoming redundant after

the economic liberalization.

The venture capital firm invest their money in most developing sectors like health care, IT-

ITes,, telecom, Bio-technology, Media& Entretainment, shipping & ligistics etc.

47

2007 VC INVESTMENTS BY INDUSTRY TOTAL US$14.2Bn

9881638

3979

1628478

1101

616

685

1839

1284

IT&ITES ManufacturingBFSI Eng & ConstructionHealthcare & lifesciences EnergyMedia&Entertinment Shipping&LogisticsTelecom Others

Source : TSJ Venture Intelligence India

Figure: 4.3 Total sector wise venture capital investment-2007

Now venture capital is nascent stage in india. Now due to growth of this sector, the venture

capital industry is also grow. The top most player in the industries are ICICI venture capital

fund, Avishhkar venture capital fund, IL&FS venture capital fund, Canbank.

48

Venture Capital investment Q3, 2008.

Venture Capital firms invested $274 million over 49 deals in India during the three months

ending September 2008. The VC investment activity during the period was significantly

higher compared to the same quarter last year (which had witnessed 36 investments worth

$252 million) as well as the immediate previous quarter ($165 million invested across 28

deals).

The latest numbers take the total VC investments in the first nine months of 2008 to $661

million (across 108 deals) as against the $648 million (across 97 deals) during the

corresponding period in 2007.

4.4.1 Top Investments

The largest investment reported during Q3 2008 was the $18 million raised by online tutoring

services provider TutorVista from existing investors Sequoia Capital India and LightSpeed

Ventures.

4.4.2 Investments by Industry

Information Technology and IT-Enabled Services (IT & ITES) industry retained its status as

the favorite among VC investors during Q3 ’08.

VC Investments by Industry

49

Industry Volume

Q3 ‘ 08

No. of Deals

YTD**

Value

Q3’ 08

(US $ M)

YTD

IT & ITES 25 58 147 361

BFSI 5 8 34 54

Engg & Construction 3 4 23 33

Healthcare & Life

Sciences

6 12 4 52

Education 2 3 17 23

Other Services 1 6 15 29

Manufacturing 2 2 13 13

Media 2 5 11 19

Energy 2 6 6 48

Travel & Transport 1 2 4 14

Retail - 1 - 10

Telecom - 1 - 5

Table: 4.2 Venture capital investment by industry

Led by the $12 million investment by Bellwether and others into Chennai-based microfinance

firm Equitas, BFSI emerged as the second largest (in value terms) for VC investments during

the period. Other microfinance firms that attracted investments during Q3 ’08 included

Kolkata-based Arohan Financial Services (which raised funding from Lok Capital and others)

and Guwahati-based Asomi Finance (IFC and Aavishkaar Goodwell).

50

INVESTMENT BY INDUSTRY (Q3 ' 08)

54%

12%

8%2%

6%6%

5% 4% 2%1%

IT & ITES BFSI

Engg & Construction Healthcare & Life Sciences

Education Other Services

Manufacturing Media

Energy Travel & Transport

Figure: 4.4 investment by industry Q3,2008

51

4.4.3 Investment by Stage

About 67% of VC investments during Q3 ‘08 were in the early stage segment.

VC Investments by Stage

Stage of Company

Development

Volume

Q3 '08 YTD

Value

Q3 '08 YTD

Early 33 67 172 339

Growth 16 41 102 322

Table: 4.3 Venture investment by stage

STAGE WISE INVESTMENT

67%

33%

EARLY LATER

52

Figure: 4.5 Stage wise investment

4.5 Need for growth of venture capital in India

In India, a revolution is ushering in a new economy, wherein entrepreneurs mind set is taking

a shift from risk averse business to investment in new ideas which involve high risk. The

conventional industrial finance in India is not of much help to these new emerging

enterprises. Therefore there is a need of financing mechanism that will fit with the

requirement of entrepreneurs and thus it needs venture capital industry to grow in India.

Few reasons for which active Venture Capital Industry is important for India include:

Innovation : needs risk capital in a largely regulated,

conservative, legacy financial system

Job creation: large pool of skilled graduates in the first

and second tier cities

Patient capital: Not flighty, unlike FIIs

Creating new industry clusters: Media, Retail, Call Centers and back office

processing, trickling down to organized effort of support services like office services,

catering, transportation

53

Factors Affecting Venture Capital

ECONOMIC FACTORS:

MERGER & ACQUISITION :

Venture backed liquidity events by year 2001-2008 through M&A

Quarter/

Year

Total

M&A

Deals

M&A Deals

with

Disclosed

Values

Total

Disclosed

M&A Value

($M)

Average

M&AsDeal

Size($M)

2002 318 152 7,916.4 52.1

2003 290 122 7,721.1 63.3

2004 339 186 15,440.6 83.0

2005-1 81 45 4,351.9 96.7

2005-2 81 34 4,725.0 139.0

2005-3 101 48 18,056.0 376.2

2005-4 87 39 2,594.0 66.5

2005 350 166 29,727.0 179.1

2006-1 107 52 5,607.5 107.8

2006-2 105 40 4,018.5 100.5

2006-3 94 42 3,894.8 92.7

2006-4 62 26 5,616.8 216.0

2006 368 160 19,137.6 119.6

2007-1 82 29 4,540.3 156.6

2007-2 87 36 3,972.3 110.3

2007-3 100 52 10,810.0 207.9

2007-4 86 43 9,084.1 211.3

2007 355 160 28,406.7 177.5

2008-1 70 28 3,602.4 128.7

2008-2 50 14 2,397.3 171.2

2008 120 42 5,999.7 142.9

54

www.thomsonreuters.com

Table: 5.1 Venture backed liquidity events by year 2001-2008 through M&A

VENTURE BACKED LIQUIDITY BY EVENTS

8512.6

5999.7

169

120

0

1000

2000

3000

4000

5000

6000

7000

8000

9000

FIRST TWO QUARTER OF2007

FIRST TWO QUARTER OF2008

VA

LU

E O

F D

EA

LS

0

20

40

60

80

100

120

140

160

180

No

.OF

DE

AL

S

Value of Deals No. of Deals

Figure: 5.3 Venture backed M & A deals

MERGERS AND ACQUISITIONS VOLUME DECLINES

In the second quarter of 2008, 50 venture-backed M&A deals were completed, 14 of which

had an aggregate deal value of $2.4 billion. M&A volume of 120 transactions in the first half

of 2008 was down 28 percent from the first half of 2007 when 169 transactions were

completed. The average disclosed deal value for the quarter was $171.2 million. Due to this

V/C is directly affected negatively because M&A is the exit route for Venture capital

industry. The reason behind decreasing No. of M&A deals is crashdown of SENSEX by 51%

55

Quarter/Year

No.of

IPO's

Total Offer

Amount

Average IPO

Offer

Amount

  ($M) ($M)

2002 22 2,109.10 95.9

2003 29 2,022.70 69.8

2004 93 11,014.90 118.4

2005-1 10 720.7 72.1

2005-2 10 714.1 71.4

2005-3 19 1,458.10 76.7

2005-4 18 1,592.10 92.2

2005 57 4,485.00 78.7

2006-1 10 540.8 54.1

2006-2 19 2,011.00 105.8

2006-3 8 934.2 116.8

2006-4 20 1,631.10 81.6

2006 57 5,117.10 89.8

2007-1 18 2,190.60 121.7

56

2007-2 25 4,146.80 165.9

2007-3 12 945.2 78.8

2007-4 31 3,043.80 98.2

2007 86 10,326.30 120.1

2008-1 5 282.7 56.5

2008-2 0 0 n/a

2008 5 282.7 56.5

www.thomsonreuters.com

Table: 5.2 Number of IPOs during 2002-2008

Here the No. of IPO is decreased in first two quarter of 2008 as compared to first two quarter

of previous two years. The no. of IPO in 1st two quarter of 2007 are 43 and in first two quarter

of 2008 are only 5 IPO. Because due to crash down of IPO nobody like to bring IPO. IPO is

the exist route for venture capital company. It comes a barrier for venture capital to exist

from a venture capital.

INFLATION RATE

57

INFLATION v/s VC GROWTH RATE

7.4

4.5

3.2

5.8251.06

33.33

89.79

240.91

0

1

2

3

4

5

6

7

8

2004 2005 2006 2007

INF

LA

TIO

N R

AT

E

0

50

100

150

200

250

300

VC

GR

OW

TH

RA

TE

INFLATION RATE VC GROWTH RATE

Source : www.rbi.org.in, Macroeconomic and Monetary Development,

annual statement on monetary policy, First Quarter Review 2008-09

Figure: 5.4 Inflation V/S Venture capital growth rate

IMPACT

In above chart the inflation rate is decreased to 4.5 in 2005 from 7.4 in 2004. At same time

the growth of VC is also declining to 33.33% in 2005 from 251.06% in 2004. From the above

chart we can conclude that inflation and VC has positive relationship. Now in June 2008 the

inflation rate was 11.9 and the NO. of deal in first two quarter in 2008 was 170 and value of

deal was 6390 US$mn and in third quarter of 2008 there was only four deals. And in October

the inflation touch the 13.01%. Due to increase in inflation rate the people will going to spend

more. Thus, their savings will decrease. So more money will come into the market and

demand of the products will increase continuously. now due to growth of any sector will

attract new entrepreneur to enter in the industry. For that they must need funds. So there is a

great opportunity for venture capital industry to attract this new entrepreneur.

GDP GROWTH RATE

58

GDP V/S VC GROWTH RATE

8.57.5

9.69.4240.91

33.33

251.06

89.79

0

2

4

6

8

10

12

2004 2005 2006 2007

GD

P G

RO

WT

H R

AT

E(%

)

0

50

100

150

200

250

300

VC

GR

OW

TH

RA

TE

(%)

GDP GROWTH RATE VC GROWTH RATE

Source :CII (Confederation of Indian Industry) July 2008 Presentation

Figure: 5.5 GDP V/S Venture capital growth rate

IMPACT

In above chart there was a positive relation ship there was between GDP growth rate. But in

2007 the growth of VC was decline to 89.79% from 240.91% in 2006 but here the value of

deal was increasing. In 2008 the growth rate is 9% and project the next year GDP 8% to 9%.

So there is a hope, the growth of VC industry can be increased.

India is the 4th largest economy in terms of PPP. GDP of India is US$ 3787.3 billion in PPP

terms.

Taking Indian Purchasing Power Parity (PPP) into consideration, this would be equivalent to

$22 billion worth of investment in the US. Since about $1.75 billion (or approximately 40%

of $4.4 billion) has been already raised, even if only $2.2 billion is raised by December 2006.

59

Evalueserve cautions that there will be a glut of VC money for earlystage investments in

India. This will be especially true if the VCs continue to invest only in currently favourite

sectors such as IT, BPO, software and hardware products, telecom, and consumer Internet.

CONTRIBUTION OF SECTOR IN GDP:

GDP COMPOSITION

19%

27%

54%

AGRICULTURE INDUSTRY SERVICES

Source : CII (Confederation of Indian Industry) July 2008, Presentation

Figure: 5.6 Contribution of sector in GDP

In Indian GDP growth rate the contribution of service and manufacturing sectors are

increasing. In 1991 the contribution of service and industry sectors are 41% and 27% and

now in 2008 it is 54% and 27% respectively.

IMPRESSIVE GROWTH IN INDUSTRY SECTOR :

Items 2004-05 2005-06 2006-07 2007-08(AE)

Industry 9.8 10.15 11 8.1

Mining and Quarrying 7.5 4.87 5.7 4.7

Manufacturing 8.7 8.98 12 8.8

Electricitym gas water supply 7.5 4.68 6 6.3

60

Construction 14.1 16.46 12 9.8

IMPRESSIVE GROWTH IN SERVICES SECTOR :

Source : Confederation of Indian Industry, July 2008

Most of the venture capital industry invest their money in IT companies, hotels, transport,

communication, bio-technology, BIFS etc. This shows an impressive growth year by year.

This are emerging sectors for venture capital industry.

SENSEX CRASHDOWN

61

Items 2005-06 2006-07 2007-08(AE)

Services 10.34 11.9 10.7

Trade, hotels, transport &

communication

11.51 11.8 12.0

Financial, real estate &

business services

11.41 13.9 11.8

Community, social and

personal services

7.21 6.9 7.3

SENSEX IN 2008

9092.72

9788.06

12860.4314564.53

14355.75

13461.6

16415.5717287.31

15644.44

17578.72

17648.71

02000400060008000

100001200014000160001800020000

JAN

FEB

MARCH

APRILM

AY

JUNE

JULY

AUGSEPT

OCT

NOV

www.bseindia.com

Figure: 5.7 SENSEX in 2008

IMPACT

The SENSEX is down by 51% from January 2008 to Nov 2008. So one company is try to

come up with IPO. IPO in first two quarter of 2007 is 43 and value of IPO is 6337.4 and in

first two quarter of 2008 there is only 5 IPO and value is only 282.7 through VC company go

for exit. Because IPO is one of the exit route for Venture capitalist from the company. It is

also favorable for venture capital company because no one try to come up with IPO so they

must go to the venture capital for money

SMALL SCALE INDUSTRIES

62

No. deals V/S No. of SMEs

56 71

146

299

387

109.49

113.95

118.59

123.42

128.44

0

50

100

150

200

250

300

350

400

450

2003 2004 2005 2006 2007

100

105

110

115

120

125

130

No. of deals No. of SMEs

Source: www.MSME.org.in, Economiv Survey 2007-08,chapter 8

Figure: 5.8 No. of deals V/S No. of SMEs

IMPACT

VC, to be able to contribute to developing entrepreneurship in India, needs to concentrate its

investment in small and medium enterprises. A “Package for Promotion of Micro and

Small Enterprises” was announced in February 2007. This includes measures addressing

concerns of credit, fiscal support, cluster-based development, infrastructure, technology, and

marketing. Capacity building of MSME Associations and support to women entrepreneurs

are the other important features of this package. SMEs have been allowed to manage their

direct/indirect exposure to foreign exchange risk by booking/canceling/roll over of forward

contracts without prior permission of RBI.

To boost the micro and small enterprise sector, the bank has decided to refinance an amount

of 7000 crore to the Small Industries Development Bank of India, which will be available up

to March 31, 2010. The Central Bank said that it is also working on a similar refinance

facility for the National Housing Bank (NHB) of an amount of Rs 4, 000 crore.

INTEREST RATE :

63

INTEREST RATE

6.11

7.987.23

8.73 9.11

0

2

4

6

8

10

MARCH--06

MARCH--07

MARCH--08

JUNE--08

JULY--08

PE

RC

EN

TA

GE

Sources:- The Macro economic and monetary development annual statement on monetary

policy, First Quarter Review 2008-09

Figure: 5.9 Interest Rate

IMPACT :

The interest rate increase year by year. It is 6.11% in March-2006 and now in July 2008 it is

9.11%. venture capital firms generally borrow from banks now if interest rates are increasing

interest cost of venture capital firms will also increase which led reduce the profitability of

Venture Capital firms. Because if anyone is investing in any option he will look for good

return, so here if they will maintain their own profits they will have to give less return to

investors then investors will go for other options. Here increase in bank rates affect Venture

Capital firms in both ways from the suppliers as well as buyers side.

64

CURRENCY RISK :

Exchange Rate(INR/US$)

45.75 47.73 48.42 45.95 44.87 44.09 45.1140.01

0

10

20

30

40

50

60

2000-01

2001-02

2002-03

2003-04

2004-05

2005-06

2006-07

2007-08

EX

CH

AN

GE

RA

TE

Figure: 5.10 Exchange Rate(INR/US$)

IMPACT

From the above chart we can see that exchange rate is highly fluctuated. Nowadays the

exchange rate touches to 50 Rs. Per dollar. Now due to globalization venture capital firms are

entering at global level. Nowa for a particular country currency risk can be defined in two

ways.

Indian venture capital are concentrated on global level due to increasing opportunity

in global level. They make a deal with global company. So there is directly affect the

movement of exchange rate.

In second way , Foreign institutional investor incest their money Indian stock market

and nowadays due to crash down of market the investment of FII is decreasing. Due

to this nobody like to bring IPO. It is directly affected to venture capital company

because IPO is one way for exist.

65

EXPORT AND IMPORT

VALUE OF EXPORT AND IMPORT

52.7

78.1

111.5

149.2

185.7 185.7

63.883.6

103.1

155.5

126.4

61.4

0

20

40

60

80

100120

140

160

180

200

2002-03 2003-04 2004-05 2005-06 2006-07 2007-08

US

do

llar

s in

bil

lio

ns

EXPORT IMPORT

Figure: 5.11 Value of export and import

IMPACT :

The value of Import and export are increasing year by year. In 2002-03 the value of import

and export are 52.7 and 61.4 US$bn respectively and in 2007-08 the value of import and

export are 155.7 and 185.7 US$bn. It means industry need more money for import and

export. So it is an opportunity for venture capital. On the other side when company going to

export the company must have good contact with other country’s company. So for that

venture capital industry is useful because they have good contact and affiliation network with

other country’s company.

66

REPO RATE

The Repo Rate is now reduced to 6.5 from 8.5 in july 2008. It is directly affect the home loan

rate. The rate of home loan is reduced so it is very helpful for real estate sector. And most of

the Venture Capital companies invest their money in real estate sector. There is an improve

the flow of credit to productive sectors of the economy.

LACK OF FINANCIAL TRANSPERANCY AND OTHER PROCESSES :

Again, partly because the Indian economy was a “socialistic and closed” economy and

partly because Indian entrepreneurs are not as proficient at business development as their

counterparts in the US, Indian start-ups lack financial transparency and often have limited

experience in implementing effective financial processes. This usually makes the task of

the Venture Capital much more difficult not only during the due-diligence phase, but also

in helping the start-up grow rapidly.

FACTOR FAVOURABLE UNFAVOURABLE BOTH

MERGER&

ACQUISITION,IPO

√

INFLATION RATE √

GDP GROWTH

RATE

√

SENSEX

CRASHDOWN

√

SMALL SCALE

INDUSTRIES

√

INTEREST RATE √

67

CURRENCY RISK : √

EXPORT & IMPORT √

REPO RATE √

Table: 5.3 Result of Economic factors

5.2.3 SOCIAL FACTORS:

Demographic factor:

AGE:

Population Demographic Shift

Age % of population 1997 2002 2007

Under 15 years 37.20% 33.50% 30.00%

Between 15-59 years 56.10% 59.30% 62.30%

Above 60 years 06.60% 06.90% 07.50%

Table: 5.4 Population Demographic Shift

68

AGE BETWEEN 15-59 YEARS

56.1

59.3

62.3

52

54

56

58

60

62

64

1997 2002 2007

PE

RC

EN

TA

GE

(Source: Planning Commission Projection data)

Figure: 5.12 population demographic shift between 15-59 years

In above chart we can see young working people in India is increasing rapidly. Earlier the

young working peoples are 56.1% out of total population and nowadays it is 62.3%. Young

people out of total population. The average young age in India is 25 upto year 2025.

UNEMPLOYMENT RATE:

UNEMPLOYMENT RATE

8.8 8.89.5 9.2 8.9

7.8 7.2

0

2

4

6

8

10

2002 2003 2004 2005 2006 2007 2008

PE

RC

EN

TA

GE

www.indexmundi.com

Figure: 5.13 Unemployment rate

In India the unemployment rate is very high. No doubt it is decreasing year by year. It is

9.5% in 2004 and now it is 7.2% in 2008. Here there is a great opportunity for Venture

capital firm because there is a huge untapped market and they require amount fr strting the

business.

69

According to one survey by National Entrepreneurship Development Board (NEBD),

Ministry of SSI & ARI, Govt. of India, on ‘Entry barriers to entrepreneurship as

perceived by youth’. In this survey out of 1625 respondents 19.2% people have future plan

to become entrepreneur for starting the business and 80.8% persons are not ready for

business. But out of this 80.8% persons 58.3% person are ready for becoming

entrepreneurship if they get help in finance, project idea, and training for business and

management. So here there is a great opportunity for venture capital firms.

70

Venture Capitalists: Scenario 2010

But the value proposition of the VC industry toward its two clients—investors and

entrepreneurs—have since weakened. For one thing, VC has never recovered from the

commercialization of the internet, which brought a staggering 250% increase in deals

between 1997 and 2000 and a quintupling of investment dollars. IRR rose spectacularly, but

perversely this attracted too much capital too quickly from too many investors, which in turn

funded too many inexperienced VC partnerships competing for portfolio companies.

Meanwhile, deal activity has dried up. The total number and value of investments in 2009

reached their lowest points since 1997 (see the exhibit “Few Deals”). This has dramatically

thrown out of whack investment multiples and returns industry-wide.

Further weakening the VC proposition to investors is the lengthening time to liquidity—

owing in part to the credit crunch and stricter post-boom revenue requirements for start-ups

(see the exhibit “Long Waits”). To be an attractive investment category, venture capital needs

to off er competitive returns to alternatives on a risk adjusted basis. Part of that risk

adjustment should include a premium for non liquidity. If IPOs are harder to create and take

longer to achieve, then VCs will need to pay the premium and IRR, ceteris paribus, will fall.

That means VCs are now in the unenviable position of offering investors higher-risk, lower-

yield investment opportunities.

What’s more, VCs are losing their ability to attract the entrepreneurs that will generate better

returns. They’ve fallen short in marketing their relevance to entrepreneurs who don’t need

capital as much as they need guidance. Instead of marketing their operational expertise, their

well-developed networks of experts, and the personalized attention they can offer, many VC

firms have resorted to peddling wildly attractive financing options. “The perception is that

top fi rms have too much money to waste time on small investments,” says the CEO of the

VC-backed Silicon Valley firm. “Combine that with the fact that many internet services

companies have low capital needs. Why go to big firm when a business angel can cover

financing and give more personalized attention?”

What’s happening to the industry is, as one VC insider puts it, “a train wreck in slow

motion.” And whether the train can get back on the track is, frankly, an open question, thanks

to what Fred Wilson, a VC industry expert, calls the VC math problem.He calculates how

much cash VCs need to generate from liquidity exit events to recoup even a minimum return

for investors. Wilson believes that VC funds need to generate gross investment multiples of 3

71

(or 2.5 after accounting for management expenses). He estimates that the industry is returning

a multiple of only 1.6 on investors’ capital, which translates to about a 10% annual IRR.

Essentially, Wilson argues that the venture capital asset class does not scale, and thus the

industry must “downsize to get returns back on track.”

Is Downsizing the Answer?

Whether these changes are structural or cyclical is a matter of ongoing vigorous debate. But

to make the math work in the current climate, the VC industry must, above all, get smaller.

“[The attrition has] already started,” says a VC partner in San Francisco with more than $840

million in active investments, and “it will be significant both in number of firms and number

of investment professionals per firm. I think a 50% decrease in industry size is a fair

estimate.”

The only truly safe firms are the small number of top-tier firms in the VC industry. They will

continue to set the terms for investment, generally meaning 2.5% in management fees and

30% in carried interest.

The next tier will have to negotiate harder for their terms and will have to accept lower

management fees and stakes. The rest will have an even tougher time raising new funds

unless they are able to establish uniquely specialized strategies. Many will likely perish.

“This is the story,” said the CEO of a VC backed firm, who asked to remain anonymous to

protect his funding. “Every VC I know thinks there are too many VCs, too much dumb

money, too many people bidding up valuations and reducing returns for the top guys. Too

many—except, of course, themselves!”

But it’s not just size that counts. What industry veteran Gailen Krug calls the “spray and

pray” approach—investing in dozens of firms in hopes of a few hits—is on the wane. “We

see the thoughtful, quality VCs moving to a more focused approach of investing larger

amounts of capital into fewer, more fundamentally sound companies with a higher potential

for success,” says Krug. “This shift in strategy dictates that the marketing and fund-raising

process must change.”

In a sense, the road ahead for VCs appears to be retro. Venture capitalists must return to their

roots of being patient, handson consultancies that nurture their start-ups until they are

sustainable, while returning healthy dividends to deep-pocketed, risk-taking investors.

“When we enter an investment, we don’t think about how to sell it,” says Bernard Liautaud, a

partner at Balderton Capital, a leading European VC firm, and cofounder of Business

72

Objects, one of the most successful VC-backed firms of this decade.“We think about how to

help the entrepreneur build a great company.”

How a VC firm accomplishes that goes well beyond handing over a pile of cash. “Forward-

thinking VC funds do not stay still; they evolve,” Liautaud says. “I believe in a Darwinian

VC ecosystem where the ones who adapt will succeed.”

73

74

Case Study

Picking Winners or Building Them?

Selection Criteria in New Venture Financing and Performance

In the entrepreneurial setting, financial intermediaries such as venture capital firms (VCs) are

perhaps the dominant source of selection shaping the environment within which new ventures

evolve. VCs affect selection both by acting as a scout able to identify future potential and as a

coach that can help realize it. It is generally taken-for-granted that VCs are expert scouts and

coaches, and so the ways in which VCs actually enhance start-ups performance are not well

understood (Shepherd and Zacharakis 2001). But only a fraction of the firms VCs fund

succeed, most achieving an average rate of return on invested capital (Gifford 1997).

Moreover, while research shows VC-backed start-ups outperform comparable non-VC-

backed start-ups (Megginson and Weiss 1991), research has rarely sought to identify whether

these results are attributable to inherent differences between VC-backed and non-VC-backed

start-ups or to post-investment benefits that accrue to VC-backed firms. Existing research

thus offers little insight into how VCs create value.

If VCs pick winners, start-ups characteristics that attract VC investment should also enhance

their future performance. If VCs build winners, start-ups characteristics that attract VC

investment need not be associated with future start-ups performance, and may even impede it.

The question to be asked is are VCs are good scouts adept at identifying exceptionally

promising start-ups ventures or that they are good coaches skilled at injecting expertise and

sound business judgment into start-ups ventures.

Prior research implicates three broad types of signals that may affect VCs’ assessments of

start-ups:

Alliance Capital . A start-up’s alliances provide signals both of access to valuable

resources and knowledge critical to early performance, as well as serving as external

endorsements, suggesting that the start-up has earned positive evaluations from other

knowledgeable actors. Alliance advantages are particularly strong when timely access

to knowledge or resources is essential or when ambiguous technologies force reliance

on indirect indicators to assess firm performance.

Intellectual Capital . The ability to stake technological claims is a critically important

early signal of a start-up’s future potential. By signalling innovative capabilities,

75

patents and patents pending help start-ups possessing them to acquire additional

resources, increasing the likelihood that they will obtain VC financing. The

appropriability regime surrounding biotechnology patents is particularly strong because

patented compounds are difficult to circumvent (Lerner 1995).

Human Capital . The identity and background of top management are widely regarded

as important signals of a start-up’s future potential, increasing its chances of obtaining

VC financing. VCs report that “nothing is more important than people…” and, in

particular, that they look “for people who have high levels of energy, are willing to

work around the clock, and are still hungry for success” (Byrne 2000: 96). Top

management team experience and skills are the most frequent selection criteria self-

reported by VCs.

A research done on the above by analyzing VC financing and performance of Canadian

biotechnology start-ups, 1991 to 2000 gave the following results:

All three ‘capitals’ are implicated in VC financing decisions. Notably, the largest

magnitude effects are associated with human capital. One standard deviation

increases in the size of a start-up’s top management team and its president’s number

of other presidencies increased the estimated value of VC financing by C$800K-

900K annually. A start up whose president currently acted as president for one other

biotechnology startup is estimated to raise nearly $4M more in VC financing per

year. While smaller, the effects of alliance and intellectual capital are also large

relative to the mean value of annual VC financing ($879K, S.D. = $6.3M).

Nevertheless, in the empirical setting, human capital effects appear to predominate

in VC financing decisions.

The alliance variables generally have significant effects on performance, although

the effects for upstream alliances are generally weaker, and in some cases the

alliance effects are detrimental to performance. In contrast, the human capital

variables have limited impact on start up performance, and the few significant

effects are split equally between enhancing and impeding performance. Given the

large impact of human capital on VC financing decisions, the weak link between

human capital and start up performance is surprising.

The Conclusions were as follows:

76

Taken together, the convergent influence of alliance, intellectual and human capital on VCs’

financing decisions and start-ups’ technological performance, and divergent influence of

these factors on start-ups’ revenue growth and survival point to a combined logic of scouting

out start-ups with the right technological and relational ‘stuff’ and coaching troubled startups

to which, given their technological potential, VCs offer the greatest potential value post-

investment. Start-ups may thus need to increase their short-term risk of failure in order to

attract VCs capable of enhancing their long-run prospects. Our findings may also reflect

VCs’ emphasis on picking portfolios of start-ups in which to invest, rather than considering

investments independently. This account is also consistent with classic notions of risk and

return – since VCs traditionally seek extremely high returns, they are naturally attracted to

more risky start-up, and consequently a start up that is at low risk of failure may also offer a

return too low to interest a VC.

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