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MBA

(DISTANCE MODE)

DBA 1751 HIRE PURCHASE, LEASING AND VENTURE CAPITAL

III SEMESTER COURSE MATERIAL

Centre for Distance Education


Anna University Chennai Chennai 600 025

Author Ms .A.Shameem Ms.A.Shameem


Professor & Head Department of Management Studies, Aalim Mohamed Salegh College of Engineering Avadi-IAF Chennai

Reviewer Mr .Ja y anth Jacob Mr.Ja .Jay


Senior Lecturer, Department of Management Studies, Anna University Chennai, Chennai - 600 025.

Editorial Board Dr .T .V .Geetha Dr.T .T.V .V.Geetha


Professor Department of Computer Science and Engineering Anna University Chennai Chennai - 600 025

Dr .H.P eer u Mohamed Dr.H.P .H.Peer eeru


Professor Department of Management Studies Anna University Chennai Chennai - 600 025

Dr .C . Chella ppan Dr.C .C. Chellappan


Professor Department of Computer Science and Engineering Anna University Chennai Chennai - 600 025

Dr .A.K annan r.A.K


Professor Department of Computer Science and Engineering Anna University Chennai Chennai - 600 025

Copyrights Reserved (For Private Circulation only) ii

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ACKNOWLEDGMENT

The author has drawn inputs from several sources for the preparation of this course material, to meet the requirements of the syllabus. The author gratefully acknowledges the following sources:

Raising Venture Capital, Rupert Pearce and Simon Barnety, John Wiley & Sons, Ltd. Corporate Venturing, Zenas Block & Lan.C. Macmillian, Harvard Business School Press. Merchant Banking and Financial Services, Dr. S. Guruswamy, Thomson. ICFAI material on Merchant Banking and Financial Services.

Inspite of at most care taken to prepare the list of references any omission in the list is only accidental and not purposeful.

Ms.A.Shameem Author

DBA 1751 HIRE PURCHASE, LEASING AND VENTURE CAPITAL


UNIT I INTRODUCTION Hire purchase finance- definition Hire purchase Vs installmant payment Rights of Hier- Rate of interest Methods of interest calculation Hire purchase Act 1972 Legal and tax aspects Accounting and financial evaluation. UNIT II LEASING Leasing Definition and characteristics Cash flow of a lease Lease debt eqivalence Types of lease Financial lease and operating lease- Leasing process- advantages of leasing Limitations Legal and tax implications of leasing Lease evaluation by leasor and leasee. UNIT III VENTURE CAPITAL Venture capital meaning and definition Fetures Origin and growth of venture capital- Seed capital and startup financing Key factors for consideration for appraisal Management buy-outs and buy-in stages of venture capital financing-Financial analysis Recommendation of SEBI (Chandrasekar committee) 2000; SEBI venture capital Funds Regulations1996- SEBI Foreign venture capital investors regulations 2000. UNIT IV INVESTMENT PROCESS Assessing venture capital Choosing a venture capital firm-The investment process Preparing for the investment process term sheet-Investment structure-Selection of investment-Syndication Milestones- Equity participation Provisions relating to share capital Tranfer restrictions Transfer pre-emption rights and tag along rights structuring the deal/financial instruments Investments, after care valuation of portfolio Structural aspects-exit. UNIT V CORPORATE VENTURING Corporate venturing Framing and managing the venturing process selecting oppurtunities- Locating the venture in the organization Developing the business plan Organising and controlling the venture. REFERENCES 1. Merchant banking and financial services, Dr.S.Gurusamy, Thomson. 2. Raising Venture Capital, Rupert Pearce ans Simon Barnes, John Wiley & Sons, Ltd. Corporate Venturing., Zenas Block & Lan.C.Macmillan, Harvard Business School Press.
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CONTENTS

UNIT - I INTRODUCTION

1.1. 1.2. 1.3. 1.4. 1.5. 1.6. 1.7. 1.8. 1.9. 1.10. 1.11. 1.12. 1.13. 1.14. 1.15. 1.16. 1.17. 1.18.

1.19. 1.20. 1.21. 1.22. 1.23.

INTRODUCTION LEARNING OBJECTIVES DEFINTION OF HIRE PURCHASE SALIENT PROVISIONS OF A HIRE-PURCHASE AGREEMENT SALIENT FEATURES OF HIRE PURCHASE AGREEMENT FORMS OF HIRE PURCHASE AGREEMENTS DIFFERENCES BETWEEN HIRE PURCHASE AND INSTALLMENT SALE AND CONDITIONAL SALE NATURE OF AGREEMENT THE SELLER AND THE OWNER IMPLIED WARRANTIES AND CONDITIONS TO PROTECT THE HIRER THE HIRERS RIGHTS THE HIRERS OBLIGATIONS THE OWNERS RIGHTS TERMINATION OF HIRE-PURCHASE AGREEMENT REMEDIES AVAILABLE IN CASE OF BREACH REGISTRATION HIRE PURCHASE AND ITS MATHEMATICS DETERMINATION OF EFFECTIVE RATE 1.18.1. When Payments Made In Advance 1.18.2. Comparison Between The Two Plans DP AND DL CALCULATION OF INTEREST REBATE EFFECTIVE RATE OF INTEREST METHOD RULE OF 78" METHOD OTHER METHODS LEGAL ASPECT OS HIRE PURCHASE
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1 1 1 2 2 3 4 4 4 5 5 6 6 6 7 7 8 8 10 12 13 13 14 17 17

SALIENT LEGAL ASPECT OF HIRE PURCHASE TRANSACTIONS TAX ASPECTS 1.25.1. Income Tax Aspects 1.25.2. Sales-Tax Aspects 1.25.3. Service Tax Aspects 1.26. ACCOUNTING ASPECTS 1.26.1 In the Books of the Hirer 1.26.2 In the books of the Finance Company 1.27. SOLVED EXAMPLES 1.28. SUMMARY 1.29. SHORT QUESTIONS 1.30 LONG QUESTIONS

1.24. 1.25.

18 20 20 22 23 23 23 27 30 39 42 42

UNIT - II LEASING
2.1. 2.2 2.3 2.4. 2.5. 2.6. 2.7. 2.8. INTRODUCTION LEARNING OBJECTIVES DEFINITION IMPORTANCE OF LEASING LEASE CONTRACT CHARACTERISTICS OF LEASING BASIC DIFFERENCES BETWEEN HIRE PURCHASE AND LEASE FORMS OF LEASE FINANCING 2.8.1 Operating And Finance Lease 2.8.2. Features Of A Finance Lease 2.8.3 Differences Between Operating and Financial Lease 2.8.4 Sale and Leaseback and Direct Lease 2.8.5. Single Investor Lease and Leveraged Lease 2.8.6 Domestic Lease Vs. International Lease 2.9. METHODS OF STRUCTURING LEASE RENTALS 2.10. ADVANTAGES OF LEASE 2.11. DISADVANTAGES OF LEASE 2.12. DIFFERENCES BETWEEN FINANCIAL LEASE AND DIRECT PURCHASE 2.13 METHODS FOR EVALUATING A LEASING PROPOSAL 2.13.1 Present value Analysis method
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47 47 47 48 48 48 49 50 51 55 55 56 58 59 59 64 65 65 66 66

2.14.

2.15 2.16 2.17 2.18 2.19. 2.20. 2.21. 2.22.

2.13.2 I.R.R. method 2.13.3. Bower Herringer Williamson (BHW) Method OTHER TYPES OF LEASE ARE AS LISTED BELOW 2.14.1 Net lease. 2.14.2. Capital Lease 2.14.3 Direct Financing Lease (Direct Lease) 2.14.4 First Amendment Lease 2.14.5 Full Payout Lease 2.14.6 Guideline Lease 2.14.7 Open-end Lease 2.14.8 Sales-type Lease 2.14.9 Synthetic Lease 2.14.10 Tax Lease 2.14.11 Trac Lease 2.14.12 True Lease TAX MATTERS 2.15.1 Income tax provisions and Sales Tax Provisions relating to Leasing DIFFERENCE BETWEEN PROCESS OF LEASING AND THAT OF DIRECT PURCHASE EQUIPMENT LEASING AND HIRE PURCHASE SALIENT POINTS OF LEASING PROBLEMS AND SOLUTIONS SUMMARY SHORT QUESTIONS LONG QUESTIONS

71 71 73 73 73 74 74 74 74 74 75 75 75 75 75 75 75 77 77 78 80 134 136 136

UNIT - III VENTURE CAPITAL


3.1 3.2. 3.3 3.4. 3.5. 3.6 3.7. INTRODUCTION LEARNING OBJECTIVES MEANING AND DEFINTION WHAT DOES A VENTURE CAPITALIST OFFER FEATURES BENEFITS OF VENTURE CAPITAL DRAWBACKS OF VENTURE CAPITAL
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141 141 141 143 143 144 144

3.8.

3.9. 3.10. 3.11. 3.12. 3.13. 3.14. 3.15. 3.16. 3.17. 3.18. 3.19. 3.20. 3.21. 3.22. 3.23. 3.24. 3.25. 3.26. 3.28. 3.29. 3.30.

CATEGORIZATION OF VC INVESTORS 3.8.1. Incubators 3.8.2. Private Equity Players: They are established investment bankers. ORIGIN AND GROWTH OF VENTURE CAPITAL SEED CAPITAL AND STARTUP FINANCING KEY FACTORS FOR CONSIDERATION FOR APPRAISAL MANGEMENT OF BUY-OUTS THE PURPOSE OF AN MBO FINANCING A MANAGEMENT BUYOUT MANGEMENT BUY-IN STAGES OF VENTURE CAPITAL FINANCING FINANCIAL ANALYSIS HOW WILL A VENTURE CAPITALIST VALUE A COMPANY HOW WILL AN INVESTMENT BE STRUCTURED WHERE DO VENTURE CAPITALISTS GET THEIR MONEY ANGELS AND THEIR ROLES IN THE VENTURE CAPITAL (VC) MARKET SOURCE AND EXTENT OF FUNDING RECOMMENDATIONS OF SEBI (CHANDRASEKAR COMMITTEE) 2000 VC AND THE ENVIRONMENT INDIAN VENTURE CAPITAL INDUSTRY INVESTMENT OBJECTIVES OF SOME INDIAN VC FIRMS SUMMARY SHORT QUESTIONS LONG QUESTIONS

146 146 147 148 151 152 153 154 156 156 156 159 159 160 160 161 162 163 168 170 171 176 177 177

UNIT IV INVESTMENT PROCESS


4.1 4.2. 4.3 4.4 4.5. 4.6. INTRODUCTION LEARNING OBJECTIVES VENTURE INVESTMENT PROCESS THE VENTURE INVESTMENT VALUATION IN INDIA ORGANIZATION OF VC BUSINESSES UNDERSTANDING THE PROCESS - TARGET A VENTURE CAPITAL PARTNER
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199 199 199 205 208 211

4.7. PROFILE OF A TYPICAL VENTURE CAPITAL FUND 4.8. PRICING AND CONTROL: THE INVESTORS PERSPECTIVE 4.10. WHAT IS INVOLVED IN THE INVESTMENT PROCESS 4.11. CHOOSING THE VENTURE CAPITAL FIRM 4.13. SHORT QUESTIONS 4.14. LONG QUESTIONS

211 214 226 229 235 235

UNIT V CORPORATE VENTURING


5.1 CORPORATE VENTURING 5.1.1 What is Corporate Venture 5.1.2 Why do Companies Venture 5.1.3 Should all companies ventures SELECTING OPPORTUNITIES 5.2.1 Selecting the Ventures Format 5.2.2 Why would a company choosing t give up full ownership of a venture 5.2.3 Venture location options FACTORS INFLUENCING HOW SEPARATED THE VENTURE SHOULD BE FROM THE PARENT COMPANY SAFEGUARDING THE VENTURE FROM ORGANISATIONAL ANTAGONISM 237 237 238 239 241 241 241 242 246 248

5.2

5.3 5.4

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HIRE PURCHASE, LEASING AND VENTURE CAPITAL

UNIT - I

NOTES

INTRODUCTION
1.1. INTRODUCTION There are many alternatives offered by a finance company to help companies acquire assets. Among the alternatives asset financing plans, hire purchase is one of the popular methods. Hire purchase transactions are generally in the nature of finance transactions entered into by the companies engaged in the business of financing. 1.2. LEARNING OBJECTIVES After going through this chapter, the reader is expected to : 1. 2. 3. 4. 5. 6. Know the concept and characteristics of Hire Purchase Understand the mathematics of Hire Purchase Know the legal aspects pertaining to Hire Purchase Understand tax aspects pertaining to Hire Purchase Understand the accounting aspects of Hire Purchase Understand the framework for financial evaluation of Hire Purchase versus Leasing.

1.3. DEFINTION OF HIRE PURCHASE A hire purchase can be defined as a contractual arrangement under which the owner lets his goods on hire to the hirer and offers an option to the hirer for purchasing the goods in accordance with the terms of the contract. In India the market hire purchase has been predominant with financing of commercial vehicles. This helped the road transport operators to acquire commercial vehicles in a big way. But in the last few years, hire purchase, as a means of financial equipments has also come into popular use.
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Given the choice between hire purchase and equipment leasing, the question before the hirer (lessee) is: Which one should I choose? A similar question before the finance company (lessor) is : Which one is more profitable? A contract of hire is governed by the provisions of Chapter IX of the Indian Contract Act. It usually covers the common day finance agreements like purchase of consumer durables like Motor Vehicles, Computers, Household appliances like Televisions, Refrigerators etc. In the Industrial sector purchase of machinery etc is also financed by this method of hire purchase. The basic principle underlying the transaction is that the installment determined is taken as hire (rental) till the time the agreement envisages such payments. On determination of the said period the Hirer (Purchaser) has the option of paying a nominal amount to become the owner of the goods. 1.4. SALIENT PROVISIONS OF A HIRE-PURCHASE AGREEMENT To be valid, HP agreements must be in writing and signed by both parties. They must clearly set out the following information in a print that all can read without effort: 1. A clear description of the goods 2. The cash price for the goods 3. The HP price, i.e., the total sum that must be paid to hire and then purchase the goods 4. The monthly installments (most states require that the applicable interest rate is disclosed and regulate the rates and charges that can be applied in HP transactions 5. A reasonably comprehensive statement of the parties rights (sometimes including the right to cancel the agreement during a cooling-off period). 6. The right of the hirer to terminate the contract when he feels like doing so. 1.5. SALIENT FEATURES OF HIRE PURCHASE AGREEMENT In a hire-purchase agreement, the owner hires goods to the hirer with an option to purchase the goods when he has made the payment of a certain sum. By this system, the purchaser who is unable to pay the full price of the asset at one lump sum, gets facilities to acquire an asset and after making the payment of an
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initial amount called premium, the purchaser pays the balance consideration money in installments. After the payment of all the installments, the property in the goods passes to the hirer. The hirer has an option to return the goods during the period of hire. In a hirepurchase agreement, the hirer has the right to terminate the agreement for hire at his pleasure and is not bound to pay the value of the goods. A hire-purchase agreement is a form of bailment; the hirer is given the right to purchase the goods on certain conditions. That, however, is an option not an obligation to purchase. The hirer may elect to purchase the goods and when he does so, after he fulfills all the conditions prescribed in the agreement, the title to the goods will pass to him. But he may elect not to do so, and in that event he is entitled to return the goods and terminate the agreement in the manner provided therein.

NOTES

1.6. FORMS OF HIRE PURCHASE AGREEMENTS Hire-purchase agreements are of two forms. 1. In the first form the goods are purchased by the financier from the dealer and o The financier obtains a hire-purchase agreement from the customer o Under which the customer becomes the owner of the goods o On payment of all the installments of the stipulated hire and exercising his option to purchase the goods on payment of a nominal price. o The owner gets his money from the financier, who recovers the cost from the customer. 2. In other form The customer purchases the goods and he executes a hire-purchase agreement with a financier, Under which he remains in possession of goods, subject to payment of amount paid by the financier on his behalf to the owner. The financier gets a right to seize the goods in the event of non-fulfillment of conditions of hire-purchase agreement by the customer.
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1.7. DIFFERENCES BETWEEN HIRE PURCHASE AND INSTALLMENT SALE AND CONDITIONAL SALE Firstly the call option and the right of termination available with the hirer form the basis for distinguishing a hire purchase transaction from installment sale and conditional sale. Secondly in hire purchase the ownership is transferred to the hirer only when he exercises the option to purchase or on payment of the last installment. But in case of installment sale, the ownership of the asset is transferred to the buyer on the payment of the first installment. 1.8. NATURE OF AGREEMENT The true nature of the transaction is determined from the terms of the agreement and the court unless prohibited by statute can go behind the documents to determine the true nature of the transaction. If the purchaser desiring to purchase the goods, who is not having sufficient money for purchasing the same, borrows the amount from a third party and pays it over to the vendor, the transaction between the customer and the third party will be a loan transaction. The true nature of the transaction will not change if the lender himself is owner of the goods and he accepts the promise by the purchaser to pay the balance money due against delivery of goods 1.9. THE SELLER AND THE OWNER If the seller has the resources and the legal right to sell the goods on credit (which usually depends on a licensing system in most countries), the seller and the owner will be the same person. But most sellers prefer to receive a cash payment immediately. To achieve this, the seller transfers ownership of the goods to a Finance Company, usually at a discounted price, and it is this company that hires and sells the goods to the buyer. This introduction of a third party complicates the transaction. Suppose that the seller makes false claims as to the quality and reliability of the goods that induce the buyer to buy. In a conventional contract of sale, the seller will be liable to the buyer if these representations
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prove false. But, in this instance, the seller who makes the representation is not the owner who sells the good to the buyer only after all the instalments have been paid. 1.10. IMPLIED WARRANTIES AND CONDITIONS TO PROTECT THE HIRER The extent to which buyers are protected varies from state to state, but the following are usually present: The hirer will be allowed to enjoy quiet possession of the goods, i.e. No-one will interfere with the hirers possession during the term of this contract The owner will be able to pass title to, or ownership of, the goods when the contract requires it That the goods are of merchantable quality and fit for their purpose, save that exclusion clauses may, to a greater or lesser extent, limit the finance companys liability Where the goods are let by reference to a description or to a sample, what is actually supplied must correspond with the description and the sample.

NOTES

1.11. THE HIRERS RIGHTS The hirer usually has the following rights: To buy the goods at any time by giving notice to the owner and paying the balance of the HP price less a rebate (each state has a different formula for calculating the amount of this rebate) To return the goods to the buyer this is subject to the payment of a penalty to reflect the owners loss of profit but subject to a maximum specified in each states law to strike a balance between the need for the buyer to minimise liability and the fact that the owner now has possession of an obsolescent asset of reduced value With the consent of the owner, to assign both the benefit and the burden of the contract to a third person. The owner cannot unreasonably refuse consent where the nominated third party has good credit rating Where the owner wrongfully repossesses the goods, either to recover the goods plus damages for loss of quiet possession or to damages representing the value of the goods lost.
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1.12. THE HIRERS OBLIGATIONS The hirer usually has the following obligations: 1. To pay the hire installments 2. To take reasonable care of the goods (if the hirer damages the goods by using them in a non-standard way, he or she must continue to pay the installments and, if appropriate, compensate the owner for any loss in asset value) 3. To inform the owner where the goods will be kept. 1.13. THE OWNERS RIGHTS The owner usually has the right to terminate the agreement where the hirer defaults in paying the installments or breaches any of the other terms in the agreement. This entitles the owner: 1. 2. 3. 4. To forfeit the deposit To retain the installments already paid and recover the balance due To repossess the goods (which may have to be by application to a court depending on the nature of the goods and the percentage of the total price paid) 5. To claim damages for any loss suffered. 1.14. TERMINATION OF HIRE-PURCHASE AGREEMENT The hire-purchase agreement can be terminated in any of the following ways: i. In terms of the agreement- The hire-purchase agreement stipulates the circumstances in which the agreement can be terminated. The agreement is generally terminated by return of the goods by the hirer, notice of termination by the owner on account of hirers breach of conditions or notice of termination by the hirer. By performance- The hire-purchase agreement is terminated by performance on the exercise of the option to purchase the goods by the hirer.

ii.

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iii. By renewal - The parties to an agreement may enter into a fresh agreement terminating the hire-purchase agreement, which has not already been terminated. iv. Notice by either party- The hire-purchase agreement can be terminated by notice given by either party. v. By acceptance of repudiation by other party- An agreement is terminated, when a party to an agreement renounces his future obligations under the agreement or commits a breach of the agreement, which indicates that he does not want to remain bound by its provisions, and the other party accepts the renunciation or breach as discharging the contract. vi. By release- Where one party to an agreement releases the other party from the performance of the obligations by him under the agreement, the agreement comes to an end. vii. By frustration- When performance of the agreement becomes impossible by reason of some act or event occurring subsequent to the formation of the agreement, comes to an end and the parties will be discharged from further obligations under the agreement e.g. when the goods are destroyed during the currency of hire-purchase agreement without negligence on the part of the hirer, the agreement comes to an end. viii. By efflux of time- When the hirer is given time to exercise option to purchase the goods within a stated period and he does not exercise the option within the said period, the agreement comes to an end. 1.15. REMEDIES AVAILABLE IN CASE OF BREACH In case of breach of the hire-purchase agreement, the owner is entitled to (i) Recover the goods by physical repossession; or (ii) to abandon any claim to the goods and sue for damages. 1.16. REGISTRATION The registration of a hire purchase agreement is not necessary, as no immovable property is conveyed thereby to the hirer.

NOTES

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1.17. HIRE PURCHASE As you are aware interest included in hire purchase installments is calculated with reference to a flat rate of interest. You are also aware that interest changed on the basis of flat rate ignores the fact that the original amount of the loan is repaid in installments over the term of the loan. You may also be aware of the fact that when it comes to declining balance method, an effective rate of interest is applied for determining the interest component of each installment payable on the loan. It, therefore, follow that for a given flat rate of interest the equivalent effective rate of interest has to be higher. 1.18. DETERMINATION OF EFFECTIVE RATE To determine the effective rate of interest we can apply any one of the following two approaches : 1) Trial and error approach or 2) Approximation formula Illustration 1 Cauvery Finance offers a hire purchase for its corporate clients on the following terms: Rate of interest Repayment period Frequency of payment Down Payment Assuming investment cost : : : : 13% flat 3 years Monthly in Arrear 20%

to be Rs. 1,000, calculate :

a. The effective rate of interest per annum or the Annual Percentage Rate (APR) using : (i) Trial and Error approach and (ii) The approximation formula b. Assuming that the payments have to be made in advance, calculate the APR using the approaches mentioned in (a) above for an investment cost of Rs. 1,000.
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Solution : Down payment Amount of loan Total credit charges Monthly installment = = = = 20% 0.8 x Rs. 1,000 Rs. 800 x 13% x 3 years Rs. (800 + 312) /36

NOTES
= = = Rs. 800 Rs. 312 Rs. 30.89

a. i. If we take i as the effective rat of interest per annum or the APR, the value of I can be obtained from the following equation : (30.89 x 12) x PVIFAm (i,3) = Rs. 800 Rs. 800

i.e., 370.68 x i x PVIFA (i,3) = i (12) i.e., x i x PVIFA (i,3) = Rs. 2.158 (12) i From the PVIFA tables we can find that At i = 0.24, LHS of the equation i = 0.26, LHS of the equation = = 2.191 2.143

Interpolating in the range, we get i = 0.2538 or 25.38% ii. Approximation Formula Method: i =
n x 2F n +1

Eq. (1)

where

n F

= =

Total number of repayments and Flat rate of interest per unit time.

Now if we apply the above equation (1) we get,


36 x 2 x 0.13 37

0.235 or 25.3%

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b.

The value of i can be obtained from the equation : (30.89 x 12) x PVIFA m (I,3) i.e., At
i d
(12 )

= = = =

Rs. 800 2.158 2.185 2.141

i = 0.26, LHS of the equation i = 0.28, LHS of the equation

Interpolating in the range, we get i = 0.2723 or 27.23% 1.18.1. When payments made in advance If payments are made in advance, we should use the following modified version of eq (1). i =
n x 2F n 1

Eq. (2)

Using eq (2), we get


36 x 2 x 0.13 35

i app

0.2674 or 26.74%

From the above calculations as you can see we can infer that due to a change in the profile of monthly payments from arrear to advance, the effective rate of interest has increased by almost two percentage. The annual percentage rate of a conventional hire purchase plan involving a Down Payment can be calculated along the aforesaid line. But in the case of Deposit-Linked hire purchase plans, the calculation of APR involves the following steps : Step 1 : Define the periodic cash flows over The repayment period Step 2 : Equate the present value of the cash flows to the present value of the cash inflows and solve for the unknown rate of interest (i) The value of i reflects the APR.
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Illustration 2 Sridevi Financial Services offers a hire purchase plan under which the hirer is provided with hundred percent finance on the following terms : Rate of interest Repayment period Frequency of payment : : : 13% 3 years Monthly in Arrear

NOTES

The hirer is required to invest 20% of the investment cost in the cumulative fixed deposit scheme of the company for a period of 3 years. The company offers a rate of interest of 15% p.a. compounded monthly. Calculate the APR of the scheme assuming an investment cost of Rs. 1,000. Solution Total charge for credit = Rs.(1,000 x 0.13 x 3) =
Rs.1,390 36

Rs. 390

Monthly installment

= Rs. 38.61 Amount of deposit to be made initially (at time 0) Accumulated value of the deposit after 3 years = Rs. 200

= =

0.15 2001 + 12
Rs. 312.79

By defining i as the effective rate of interest (APR) of the plan, we can obtain the APR by first calculating the net cash flows over the repayment period.

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Monthly Cash Flows By equating the present value of the cash outflows equal to the present value Of the cash inflows at a particular rate of interest taken as i, we get, Rs. 12 x 38.61 x PVIFA
i i
(12 )

35 Rs.. 800 i, 12 =

= 274.18 x PVIF (i,3)

i.e., 463.32 x

x PVIFA

(i, 2.9167)

= Rs. 800 = 274.18 x PVIF(i, 3) = - 4.14 = 9.53

At

i = 0.32 (LHS RHS) of the equation i = 0.30 (LHS - RHS) of the equation

Interpolating the range, we get,


9.53 = 0.3139 or 31.39% 13.67

i = 0.30 + 0.02 x

1.18.2. Comparison Between the two Plans - DP AND DL A comparison of the Deposit Linked (DL) plan of Cauvery Financial Services with the Down Payment (DP) plan of Sridevi Financial Services shows that under both the plans, the hirer parts with an amount of Rs. 200 at time 0. While under the down payment plan, the amount contributed by the hirer goes towards reducing the amount of debt finance,

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under the deposit linked plan, the same amount is invested by the hirer in a fixes deposit scheme. Since the down payment made by the hire under the DP plan goes towards reducing the amount of debt whose interest cost is more than what the hirer can earn by keeping the same amount in fixed deposit, we find that the effective rate of interest implied by the DP plan to be less than the effective rate of interest implied by the DL plan. As on date the effective rate of interest charged by finance companies is not subject to any statutory minimum or maximum. The proposed amendment to Hire Purchase Act, 1972, seeks to fix an upper limit on the effective rat of interest. But when with the deregulation of internet rates on debentures and term loans, it is doubtful whether the amendment will be passed by the Parliament. 1.19. CALCULATION OF INTEREST REBATE Another aspect of the hire purchase mathematics relates to the calculation of the interest rebate for early payments. From a purely economic angle, the finance company will try to allow the minimum interest rebate while the hirer will like to avail of the maximum possible rebate. While the true and fair interest rebates can be determined by applying the Effective Rate of Interest Method, the finance companies follow methods which favour the lender rather than the borrower. The following is a brief discussion about the mechanics of the Effective Rate of Interest Method and two other methods followed by fianc companies in practice. 1.20. EFFECTIVE RATE OF INTEREST METHOD Under the Effective Rate of Interest Method, the interest rebate is equal to the total amount of outstanding (but not due) installments less the discounted value of the outstanding installment as on the date of early repayment. Some finance companies refer to this method of getting interest rebate as the IRR method.

NOTES

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Illustration 3 Let us again consider the data provided in Illustration 1. Immediately after paying the 24th monthly installment, the borrower wishes to repay the outstanding loan and purchase the equipment. Calculate the interest rebate according to the Effective Rate of Interest Method. Solution : The total amount of installments outstanding on the date of repayment is : = Rs. 30..89 x 12 = Rs. 370.68 (A)

Discounted value of the outstanding installments as on the date of repayment : = Rs. 30.89 x PVIFA m (25.38,1)

= Rs. 30.89 X 12 x 0.2538 x PVIFA (25.38,1) 0.2283 = Rs. 30.89 X 12 x 0.2538 x 0.7976 0.2283 = Rs. 328.68 (B) Interest Rebate = (A) (B) = Rs. 42. 1.21. RULE OF 78 METHOD In practice, some finance companies use an alternative method known as the Rule of 78 Method (also known as the Sum of Years Digit Method) to calculate the interest rate on loans made on the basis of a flat rate of interest. R where , t = number of installments that are not due but outstanding.
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t (t + 1) X D n (n + 1)

Eq. (3)

HIRE PURCHASE, LEASING AND VENTURE CAPITAL

n D R Illustration 4

= = =

total number of installments total charge for credit and interest rebate

NOTES

Considering the date given in illustration and with the following additional information provided in illustration 3, let us calculate the interest rebate according to the Rule of 78 Method. Solution Total charge for credit = Interest Rebate = Rs. (800 x 0.13 x3) 12 x 13 36 x 37 x 312 = = Rs. 312 Rs. 36.54

On comparing the answers obtained in Illustration 3 and 4, we find that the interest rate rebate offered under the Rule of 78 Method is less than what is offered under the Effective Rate of Interest Method and therefore the Rule of 78" works to the advantage to the lender. As far as the hirer is concerned the implication would be as follows. A lower interest rebate means a higher effective rate of interest on the completed transaction. Put differently the hirer who opts for early repayment and get an interest rebate calculated on the basis of Rule of 78 will pay an effective rate of interest which would be higher than what was implied by the original transaction. Illustration 5 Considering the data provided in illustration 1 and 3 let us now calculate the effective rate of interest implied by the completed transaction if the interest rebate is calculated according to : a. b. Effective Rate of Interest Method and Rule of 78 Method
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Solution a. Taking i as the effective rate of interest implied by the completed transaction, the value of i can be obtained from the equation : Rs. 30.89 x 12 x PVIFA m (i1, 2) + (370.68 42) x PVIF (i1, 2) i.e., 30.89 x 12 x I x PVIFA (i1,2) + 328.68 X PVIF (i1,2) i1(12) At i1 = 25.38%, LHS of equation = Rs. 800 = Rs. 800

= Rs. 800

Therefore, the rate of interest implied by the completed transaction is the same as the rate of interest implicit in the original transaction if interest rebate is calculated according to the Effective Rate of Interest method. b. If the interest rebate is calculated on the basis of Rule of 78, the value of i1 can be obtained from the equation : Rs. 30.89 x 12 x PVIFA m (i1, 2) + (370.68 36.54) x PVIF (i1, 2) = Rs. 800 i.e., 30.89 x 12 x i x PVIFA (i1,2) + 334.14 X PVIF (i1,2) i1(12) = Rs. 800

At i1 = 26%, LHS of equation will be : [370.68 x 1.114x1.424] = [334.14 x 0.630] = Rs. 799

In practice some finance companies use modified versions of the Rule of 78 which allow for a deferment period and thereby further reduces the interest rebate made available to the hirer. The general formula for calculating the interest rate on the basis of the modified Rule of 78 is : Interest Rebate = (t ) (t + 1) x D; if t n = 0 n ( n + 1) Eq. (4)

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if

t where,

NOTES

= deferment period and the other symbols are as defined in Eq. (3) 1.22. OTHER METHODS The Hire Purchase Act, 1972 defines the following formula fr calucation the minimum interest rebate as : Interest Rebate = 2 x 1 x D 3 n Eq. (5)

According to this Act, if the terms of the hire purchase agreement entitle the hirer to a rebate higher than that allowed under the Act, the hirer shall be entitled to the rebate provided by the hire purchase agreement. The next question that arises in our mind is whether the interest rebate calculated as per Rule of 78 exceeds the minimum interest rebate provided as per eq. (5). This would depend upon the number of the unpaid and not due installments (t) as on the date of early repayments. In general, if t exceeds 2/3 (n-1) the Rule of 78 will provide an interest rebate higher than the amount obtained as per eq. (5). 1.23. LEGAL ASPECT OF HIRE PURCHASE In India as of date there is no legislation that exclusively deals with hire purchase transaction. Although the Hire Purchase Act, was passed in 1972, it has not so far been enforced. The Act passed in 1972 has been repealed by passing the Hire Purchase (Repeal) Bill in 2005 in the Parliament in the year 2005. So the legal aspects of the hire purchase transactions have to be ascertained from the relevant provisions of the following Acts : Indian Contract Act, 1872 Sale of Goods Act, 1930 and The Judgments pronounced by the Courts on issues related to these types of contracts.
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1.24. SALIENT LEGAL ASPECT OF HIRE PURCHASE TRANSACTIONS The salient legal aspects of hire purchase transactions are as follows : 1. Under the hire purchase contract the owner has the following obligations : i. ii. He must have a title to the goods let on hire at the time of delivering the goods. He must ensure that the hirer has quiet possession of the goods and this quiet possession is not tampered with either by himself or by the lawful acts of third parties. He has to deliver possession of the goods to the hirer because the hiring does not commence until the goods have been delivered. He has to ensure that the goods are of merchantable quality and that they are reasonably fit for the purpose for which they are to be used. The obligation relating to ensuring fitness arises only where the hirer has made known to the owner the particular purpose for which the goods are required. Where goods are let by description, the owner is required to ensure that the goods actually let on hire answer the description. Similarly, in cases where the goods are let by reference to a sample, the owner has to ensure that the bulk corresponds with the sample and also offer an opportunity to the hirer to compare the bulk with the sample.

iii. iv.

v.

2. Under the hire purchase contract, the hirer has the following implied obligations : vi. vii. viii. The hirer has to take reasonable care of the goods The hirer cannot sell the goods or pledge them or use them for a purpose different from that stipulated in the contract during the period of the contract. The hirer must pay the sums stated in the contract at the specified points of time and in the manner prescribed by the contract. However, some occasional delays in payment over the hire period does not empower the owner to terminate the contract unless the default(s) can be linked to an intention on the part of the hirer to repudiate the contract.

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3. Apart from the implied obligations of the hirer, the hire purchase agreement expressly imposes certain obligations on the hirer : ix. He is required to arrange for a comprehensive insurance cover for the goods hired. The cover can be taken in the joint names of the owner and the hirer or in the name of the hirer bearing an endorsement recording the owners interest in the goods. The hirer is required to pay the insurance premiums and do everything that is required to keep the insurance policy in force. He is required to indemnify the owner against any loss or damage that results from his negligence. He has to obtain all permits and consents necessary for the use of goods and not contravene any law or regulation that has a bearing on the usage of the asset. He is required to bear all costs incurred in connection with maintaining goods in serviceable condition.

NOTES

x. xi.

xii.

4. Usually, a hire purchase agreement provides for the owners right for repossession of the goods upon breach of the hire purchase agreement by the hirer. The courts have held that in the absence of a specific enactment governing hire purchase transactions, the owner is entitled to repossess the goods through means specified in the hire purchase agreement and in the process he is entitled to use such physical force as may be necessary. 5. A hire purchase agreement usually provides for : xiii. xiv. The right of the hirer to terminate the hire purchase contract at any time before the final payment and The right of the hirer to purchase he goods at any time before the final payment. In the former case, the agreement provides for the mode of terminating the contract and in the later case, it provides for the method to be followed for calculating the interest rebate.

6. Since the owner, in a typical hire purchase transaction is a finance company which does not deal in the class of goods that are let on hire, usually the imposed obligations of the owner stated in (iv) and (v) of (1) are irrelevant. To prevent the possibility
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of the hirer invoking these implied conditions, an exclusive clause is included in the hire purchase agreement which states that no liability can be attached to the owner if : (i) The goods are not of merchantable quality (ii) The goods are unfit for the particular purpose for which they are (iii) required (iv) The goods fail to correspond with the description (v) The bulk does not correspond with the sample and (vi) There is a violation of the conditions, warranties or representations made by a dealer or a supplier (provided the dealer or the supplier is not acting as an agent of the owner). 7. One of the legal issues relating to a tripartite hire purchase transaction is the legal relationship between the hirer and the dealer (or supplier). Clearly, there is no direct contractual relationship between the hirer and the dealer. The question is : can the hirer hold the dealer liable for the express warranties made by him? There is no legislative provision which says Yes. But there are some English case laws which state that when the hirer has entered into a hire purchase contract placing reliance on the promises or representations made by the dealer regarding the nature, quality or quantity of goods, it gives rise to a collateral contract between the hirer and the dealer and the hirer is entitled to claim damages for breach of warranty included in the collateral contract. 1.25. TAX ASPECTS The tax aspects of hire purchase can be divided into three parts: 1. Income Tax 2. Sales Tax and 3. Service Tax aspects. 1.25.1. Income Tax Aspects The provisions of a CBDT circular issued way back in 1943 govern the treatment of a hire purchase transaction from the income tax angle.
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According to this circular, the hirer is entitled to : The tax shields on description calculated with reference to the cash purchase price and The tax shield on the consideration for hire (total charge for credit).

NOTES

The circular defines consideration for hire the way we have defined the total charge for credit and requires this amount to be spread evenly over the term of the agreement. From the owners angle the consideration for hire received by him is liable to tax. If you are familiar with the provisions of the Income Tax Act governing depreciation you will find a conflict between the contents of the CBDT circular and the relevant provisions of the Act. Section 32 of the Income Tax Act states that an assessee can claim depreciation on business assets if and only if : a. The assets are owned by the assessee and b. The assets re used for the purpose of business of the assessee. In hire purchase transaction, the hirer is not legal owner until he exercises the purchase option. Thus there is an apparent inconsistency in permitting the hirer to claim depreciation. This inconsistency had resulted in some litigation in the past. But in such cases, the courts had upheld the provisions of the circular issued by the CBDT. While we are on this subject, we must also make a mention of the controversy relating to deduction of tax at source from the consideration for hire paid to the owner. Section 194 A of the Income Tax Act requires every assessee (other than an individual and a HUF) to deduct tax at source on interest payments made to residents at the prescribed rate. Since for all practical purposes, the hire purchase is an asset-financing plan, the question that naturally arises is: Can consideration for hire be treated as interest payment and tax deducted at source? Based on the form of the contract, one can argue that consideration for hire represents renting charges. On the other hand, based on the substance of the contract one can argue that the consideration represents interest.

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In 1981 the CBDT issued a circular clarifying its stand on this issue. According to this circular, the provisions of Section 194 A of the Income Tax Act are not applicable to the consideration for hire paid in respect of hire purchase contracts which expressly provide for the option of purchasing the goods at any time or of returning the same before the total amount paid. Does this mean that consideration for hire in respect of other hire purchase contracts (contracts which do not expressly provide for the aforesaid options) must be paid after deducting tax at source? The answer continues to be elusive. 1.25.2. Sales-Tax Aspects The sales tax aspects of hire purchase contracts have to be gleaned from the provisions of the Constitution (Forty-Sixth Amendment) Act, 1982 and a maze of High Court and Supreme Court rulings on the subject. The salient sales tax aspects are as follows: 1. Hire-purchase transactions per se are liable to sales tax. The Forty Sixth Amendment Act clearly states that the tax on the sale or purchase of goods includes a tax on the delivery of goods on hire purchase or any other system of payment by installments. 2. For the purpose of levying sales tax a sale is deemed to take place only when the hirer exercises the option to purchase. 3. The amount of sales tax must be determined with reference to the depreciated value of the goods at the time when the hirer exercises the purchase option. The appropriate method for computing the depreciated value is to be determined by the sales tax authorities. 4. The state in which the goods have been delivered (to the hirer) is the state entitled to levy and collect sales tax. 5. Sales tax on hire purchase will not be levied if the state in which the goods are delivered has a single point levy system in respect of such goods and if the owner (finance company) had purchased the goods within the same state. 6. Sales tax cannot be levied on hire purchase transactions structured by finance companies provided these companies are not dealers in the class of goods let on hire. 7. There is no one uniform rate of sales tax applicable to hire purchase transactions. The rate varies from state to state. 8. Does the Central Sales Tax (CST) apply to hire purchase transactions?
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As per Section 2(g) of the CST Act, transfer of goods on hire purchase or any other system of payment by installments is included within the definition of Sale. But then the statement of objects and reasons to the 46th Amendment Act clearly states that a Sale is deemed to take place only at the time of exercising the purchase option. Since the inter state movement of goods would have occurred before the hirer exercises the option to buy, no hire purchase transaction is likely to be subject to central sales tax. 1.25.3. Service Tax Aspects From 1st April 2005 hire purchase services come under financial services of banks. The interest earned by the hire purchase companies is taxed @ 10% under Service Tax. 1.26. ACCOUNTING ASPECTS 1.26.1. In the Books of the Hirer The accounting treatment from the hirers angle is as follows: 1. The cash price of the asset is capitalized and the capital content of the hire purchase installments (the cash purchase price less the down payment) is recorded as a liability. 2. Depreciation is charged on the cash purchase price of the asset in line with the depreciation policy pursued by the hirer with regard to other owned (similar) assets. 3. The total charge for credit or the unmatured finance charge at the inception of the hire purchase transaction is allocated over the hire period using one of the following methods: Effective Rate of Interest Method. Sum-of-the-Years Digits (SOYD) Method Straight Line Method.

NOTES

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Illustration 10 Zenith Corporation has recently acquired equipments worth Rs. 300 lakh under the industrial hire purchase scheme offered by Prakash Financial Services. The salient features of the scheme are as follows: Rate of Interest Frequency of Payment Number of Payments Pattern of Payment Down Payment : : : : : 13% Monthly in Advance 48 Equated 25%

Zenith Corporation follows the WDV method of depreciation and applies a rate of 30% p.a on assets of a similar nature. a. Compute the finance charge to be allocated to the accounting periods assuming that the hirer follows: (i) Effective Rate if Interest Method (ii) SOYD Method; (iii) Straight Line Method. b. Show how the transaction will be referred in the financial statements for the first two years. Note: Assume that the net salvage value of the equipments after four years is insignificant. Solution: a. Total charge for credit Monthly installment = (225 x 0.13 x 4) = (225 x 117)/ 48 = = Rs. 117 lakh Rs. 7.125 lakh

The effective rate of interest per annum (i) can be found from the equation: __ = 225 7.125 x 12 x PVIFA 12(i, 4) i.e., 7.125 x 12 x i x PVIFA 12(i, 4) d(12) i.e. . i d(12) x PVIFA 12(i, 4) = 2.632 = 225

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i.e. .

i x PVIFA 12(i, 4) ____ d(12)

2.632

NOTES

At i =28%, LHS of equation i = 26%, LHS of equation

= =

2.568 2.635

Interpolating in the range (26%, 28%) we get I = 26.1% The allocation of the total charge for credit based on the effective rate of interest method will be as follows: Allocation of Total Charge for Credit

The annual installment equivalent to the value of twelve monthly payments is determined as follows: 7.125 * x 12 x

i d
(12 )

where, i = 0.261

= 7.125 x 12 x 1.1363 = Rs. 97.15 lakh Note 2: i. The annual installment and interest content have been netted for an interest amount equal to Rs. [97.15 (7.125 x 12)] lakh = Rs. 11.65 lakh ii. The allocation of the total charge for credit-based on the SOYD will be as follows:

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NOTES

Allocation of Total Charge for Credit (SOYD Method)

iii. The equated annual finance charge under the Straight Line Method 117 = Rs. 29.25 lakh ____ 4 Presentations in Financial Statements Year 1: Income Statement =

(Rs. In lakh)

Balance Sheet (Rs. In lakh)

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Year 2: Income Statement (Rs. In lakh)

NOTES

Balance Sheet (Rs. In lakh)

1.26.2 In the books of the Finance Company In the books of the finance company (owner) the accounting treatment will be as follows: 1. At the time of entering into the transaction, the finance company records the hire purchase installments receivable as a current asset (stock on hire) and the (unearned) finance income component of these installments as a current liability under the head Unmatured Finance Charges. 2. At the end of each accounting period, the finance company recognizes an appropriate part of the Unmatured Finance Income as current income of the period. The methods that are followed for allocating the unmatured finance income over the relevant accounting periods are the ones we are familiar with Effective Rate of Interest Method and Sum of Years Digit Method and Straight line Method.

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3. At the end of each accounting period, the hire purchase price less the installments received is shown as a receivable (stock on hire) and the finance income component of these installments is shown as a current liability (Unmatured Finance Charges). 4. The direct costs associated with setting up the transactions are either expensed immediately or allocated against the finance income over the hire period. Illustration 11 Considering the information given in illustration 1 and assuming that the hirer wants to repay the outstanding loan immediately after paying the24th installment and the finance company calculates the interest rebate on the basis of the modified Rule of 78 which provides for a deferment period of 3 months, show how the transactions will be reflected in the financial statements of Binoy Financial Services for the first two years assuming that the company follows the Effective Rate of Interest Method for allocating the finance income. The initial costs of setting up the transaction is Rs. 2.4 lakhs. Solution First we have to calculate the effective rate of interest. Since the number of installments remaining unpaid is equal to the deferment period, interest rebate will be equal to zero. The effective rate of interest (i1) on the completed transaction can be obtained from the equation : 30.89 x 12 x PVIFA m (i1,2.75) + 92.67 x PVIF(i1,2.75) = Rs. 800

We find that rate of interest implied by the completed transaction is about 26% p.a. The allocation of unearned fianc income is as follows :

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NOTES

Presentation in Financial Statements Year 1 : Income Statement (Rs. In lakh)

Balance Sheet (Rs. In lakh)

Year 2: Income Statement (Rs. In lakh)

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Balance Sheet (Rs. In lakh)

1.27. SOLVED EXAMPLES 1. Penguin Chemicals has recently acquired some equipments costing Rs.100 lakh under the industrial hire purchase scheme of Sundaram Finance. The company is required to pay a hire purchase installment of Rs.3,94,440 per month for a period of 36 months. a) Calculate the flat rate of interest charged by Sundaram Finance. b) Calculate the effective rate of interest p.a. implicit in the scheme. Assume that the hire purchase installments are payable at the end of every month. c) Penguin Chemicals follows the Sum of the Digits Method for allocating the interest charged over the 3 year period. Calculate the interest allocated to each year by Penguin Chemicals Note : PVIFA (1% 36 months) PVIFA (1% 35 months) PVIFA (2% 36 months) PVIFA (2%, 35 months) PVIFA (3%, 36 months) PVIFA (3%, 35 months) = = = = = = 30.108 29,409 25.489 24.999 21.832 21.487

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Solution : a. Cash price of equipments = Monthly installments payable = Total hire purchase price = Flat rate of interest = Rs.100 lakh Rs.3,94,440 3,94,440 x 36 = Rs.141,99,840 14%

NOTES

b. Rate of interest implicit in the scheme is that rate which would equate the present value of rentals to the cash price 3,94,440 x PVIFA(k,36) = 100,00,000 PVIFA (k,36) =
1,00,00,000 = 25.3524 3,94, 440

From the additional information given, PVIFA (2%, 36) = 25.489 PVIFA (3%,36) = 21.832 k=2+ The implicit rate of interest per annum (1+0.0204)12 -1 = 27.42% c. The sum of the years digits would be, 36 + 35 + 34 + .. + 3 + 2 + 1 = 666 Total interest payable for the three year period = Rs.41,99,840.

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2. Evergreen Financial Services company is evaluating the financial flexibility of the following hire purchase plan: Cost of asset Down payment Rate of Interest Duration Frequency : : : : : Rs.30,000 25% 12% p.a. flat 3 years Monthly in Arrears

The asset is entitled to a tax relevant rate of depreciation of 25% and the net salvage value after 3 years is estimated to be 10% of the original cost. The D/E ratio of the company is 4:1. It s pre tax cost of debt is 20% and expected return on equity is 24%. The company attracts a tax of 43%. a. Calculate the NPV of the hire purchase plan, assuming FFS company follows the SOYD method for spreading the total charge for credit. Ignore Interest Tax. b. Calculate the effective rate of interest using the approximation formula. Solution a. Cost of capital = 20 (1-0.43) x
4 1 + 24 5 5

= 9.12 + 4.8 = 14 (approx.)

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Loan amount = 30,000 x 0.75 = Rs.22,500 Monthly HP = = 22,500 + 22,500 0.12 3 = Rs850 36 PV of HP = 12 x 850 x PVIF (14,3) x * = 10,200 x 2.322 x 1.0626 = Rs.25,167 * i = Effective rate of interest implied by the completed transaction i/i12 can be found out from the Table 1 at the end of the textbook. For i = 0.14, i/i12 = 1.0626 Total charge for credit = 22,500 x 0.12 x 3 = 8,100

NOTES

PV of tax on finance charge = [4,451 PVIF (14,1) + 2,700 PVIF (14,2) + 949 PVIF (14,3)] x 0.43 =(4,451 x 0.877 + 2,700 x 0.769 + 949 x 0.675) x 0.43 = Rs. 2847.3 NPV = -22,500 + PV of HP PV of tax on finance charge b. Effective rate of interest =
36 n ( 2F) = 2 12 = 23.35 37 n +1

3. Meena Financial Service Ltd. is offering equipment finance under the following schemes: Hire Purchase Down payment

20%
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Flat rate of interest Duration Repayment Lease Primary lease period Lease rental Frequency of lease rentals

15% 3 years Monthly in advance 5 years 27 ptpm Monthly in advance

Prema Steels Corporation (PSC) has considered a modernization program for which it requires to invest in an equipment worth Rs.280 lakh. The company has given the following information a. b. c. d. e. Tax rate applicable is 30% Debt equity ratio 3:1 Cost of debt 16% Cost of equity 28% Tax relevant depreciation for the assets is 25%.

Assume that the salvage value is insignificant and interest allocation is according to the SOYD method. Ignore Interest Tax. You are required to recommend which scheme should PSC opt for. State assumptions made, if any. Solution 3 1 Cost of capital = 16 0.7 + 28 = 15.4 4 4 Cost of Leasing A. PV of Lease Rentals i = 0.027 x 280 x 12 x (12 ) *12 PVIFA 16%,5) = 322.17 d PV of TS on Lease Rentals = 280 x 0.027 x 12 x PVIFA(15.4%,5) x 0.3 =90.384
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HIRE PURCHASE, LEASING AND VENTURE CAPITAL

COL = A - B = 231.79 Cost of Hire purchase C. EMI D. PV of hire payments = 9.02 x 12 x PVIFA(16%, 3) x Total charge for credit = 224 x 0.15 x 3 = 100.8 Interest Allocation
i = 263.70 d12

NOTES

E. F.

PV of TS on charge for credit


224 + 224 0.15 3 = = 9.02 36 = [55.39 PVIF(15.4,1) + 33.6 PVIF(15.4,2) + 11.81 PVIF(15.4,3) ]0.3=Rs.24.28

F. PV of DTS = [70 PVIF(15.4,1) + 52.5 PVIF(15.4,2) + 39.38 PVIF(15.4,3) + 29.53 (15.4,4) PVIF(15.4,4) + 22.15 PVIF(15.4,5)] 0.3 = Rs. 45.97 lakh COHP = C + D E F = 56 + 263.7 24.28 45.97 = Rs.249.45 lakh COHP > COL, leasing is recommended. * For I = 0.16, d12 = 0.1475
i d
(12 )

= 1.0847

(From Tables given at the end of the book)


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4. Krishnan Financial Service (KFS) offers both lease and hire purchase to its corporate clientele. The salient features of these plans are follows: A. Lease Plan Primary period Lease rate

5 years Rs.28 per thousand per month (per thousand per month) Frequency of payment Monthly in Arrear Hire Purchase Plan Hire period Rate of Interest Frequency of payment Down payment 3 years 16% p.a. flat Monthly in arrear 20%

B.

Sitara Industrial Corporation (SIC) which is contemplating a capital expenditure of Rs.360 lakh on modernization and technology up gradation is evaluating the financial desirability of the two plans. The following information is available : Useful life of plant and machinery Residual value after 5 years Tax relevant rate of depreciation Marginal rate of tax Marginal cost of capital Marginal (pre tax) cost of debt 5 years Rs.45 lakhs 25% 51.75% 16% 20%

SIC follows the sum of the year digits method for spreading over the total charge for credit (unexpired finance charge) under the HP Plan. Solution . Cost of leasing can be determined as follows:

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A.

Present value of lease payments

NOTES

= 360 x 0.28 x

i d
(12 )

* 12 PVIFA ( 20,5)

= 360 x 0.028 x 1.1053 x 12 x 2.991 = Rs. 339.88 lakh

B.

Present value of tax shield on lease payments

= 360 x 0.028 x 12 x 0.5175 x PVIFA(16,5) = 62.6 x 3.274 = Rs.204.94 lakh Cost of hire purchase can be determined as follows: C. Down payment = 360 x 0.2 = Rs.72 lakh

D. Monthly hire purchase installment


= 360 0.8 (1 + 0.16 3) = Rs.11.84 lakh 36

E. Present value of monthly HP installments = 11.84 x ** x 12 x PVIFA (20,3) = 11.84 x 1.0887 x 12x 2.107 = Rs.325.92 lakh F. Unexpired finance charge at the inception of the HP transaction = 360 x 0.8 x 0.16 x 3 = Rs.138.24 lakh Allocation of the unexpired finance charge over the lease period based on the SOYD method will be as follows:

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G. Present value of tax shield on finance charge = [(75.97 x PVIF(16,1) + 46.08 x PVIF(16,2) + 16.19 x PVIF(16,3)] x0.5175 = [(75.97 x 0.862 + 46.08 x 0.748 + 16.19 x 0.641] x 0.5175 = Rs.56.98 lakh H. Present value of depreciation tax shields = [(90 x PVIF(16,1)+ 67.5 x PVIF(16,2) + 50.62 x PVIF(16,3) + 37.97 x PVIF(16,4) + 28.48 x PVIF(16,5)] x 0.5175 = [(90 x 0.862) + (67.5 x 0.743) + (50.62 x 0.6,41) + (37.97 x 0.552) +(28.48 x 0.476) x 0.5175 = Rs.100.75 lakh I. Present value of net salvage value = J. K. 45 x PVIF(16,5) = 45 x 0.476 = Rs.21.42 lakh

Cost of Leasing = A B = Rs.194.94 lakh Cost of HP = C + E H I G = Rs.218.67 lakh Since cost of leasing is less than the cost of hire purchase leasing is recommended.

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*For i = 20% =0.20, = 1.1053 (From Tables given at the end of the book) ** For i 20%=0.20, = 1.0887 (From Tables given at the end of the book) 1.28. SUMMARY A hire purchase can be defined as a contractual arrangement under which the owner lets his goods on hire to the hirer and offers an option to the hirer for purchasing the goods in accordance with the terms of the contract. A contract of hire is governed by the provisions of Chapter IX of the Indian Contract Act. It usually covers the common day finance agreements like purchase of consumer durables like Motor Vehicles, Computers, Household appliances like Televisions, Refrigerators etc. The basic principle underlying the transaction is that the installment determined is taken as hire (rental) till the time the agreement envisages such payments. On determination of the said period the Hirer (Purchaser) has the option of paying a nominal amount to become the owner of the goods. To be valid, HP agreements must be in writing and signed by both parties. They must clearly set out the following information in a print called the Hire Purchase Agreement. The rate of interest quoted on a hire purchase transaction is always a flat rate. To convert the flat rte (F) into the effective rate (i) under the Down Payment Plan we use the following approximation formula = x 2F where n denotes the number of repayments. _____ n+1 In case the installments are payable in advance instead as arrears, the relationship between i an d F is given by the following formula : = n x 2F _____ n1 n

NOTES

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NOTES

There are two types of plans Down Payment Plan and Deposit Liked Plan. In case of deposit linked plant, the effective rate of interest is calculated as follows :

Step 1 : Define the periodic cash flows over The repayment period Step 2 : Equate the present value of the cash flows to the present value of the cash inflows and solve for the unknown rate of interest (i). The value of i reflects the APR. If the hirer opts to exercise the purchase option before the payment of the last installment, then the amount to be paid by him to terminate the agreement will be equal to the aggregate amount of the outstanding hire purchase installments less an interest rebate. The true interest rebate can be calculated using the Effective Rate of Interest Method. An alternative method would be to calculate as per the Rule of 78 for which the formula is t (t + 1) X D ______________ n (n + 1)

where , t n D R = = = = number of installments that are not due but outstanding. total number of installments total charge for credit and interest rebate

It is to be however noted that interest rebate calculated by the Rule of 78 will be always less than the true interest rebate. Although the Hire Purchase Act, was passed in 1972, it has not so far been enforced. So the legal aspects of the hire purchase transactions have to be ascertained from the relevant provisions of the following Acts (a) Indian Contract Act, 1872 (b) Sale of Goods Act, 1930 and (c) the Judgments pronounced by the Courts on issues related to these types of contracts.
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The circular issued by the Central Board of Direct Taxes in 1943, governs the income tax aspects of hire purchase transactions. According to this circular, the hirer is entitled to (a) tax shields on description calculated with reference to the cash purchase price and (b) tax shield on the consideration for hire (total charge for credit). The circular also requires amount of total finance charges to be evenly allocated over the term of the agreement. As per the 46th amendment made to the Constitution, hire purchase transactions are eligible to sales tax. However, there are many court ruling which state that hire purchase transactions structured by finance companies (not dealing in the class of goods let on hire) are in essence financing transactions and therefore not liable to sales tax. AS decision on hire purchase is taken by making a financial evaluation a hire purchase vis-a vis a lease from the hirers stand point. By comparing the cost of hire purchase and cost of lease. The accounting treatment in the books of the hirer is done as follows : (a) the cash price of the asset is capitalized and the capital content of the hire purchase installments (the cash purchase price less the down payment) is recorded as a liability (b) depreciation is charged on the cash purchase price of the asset in line with the depreciation policy pursued by the hirer with regard to other owned (similar) assets (c) The total charge for credit or the unmatured finance charge at the inception of the hire purchase transaction is allocated over the hire period using one of the following methods: (1) Effective Rate of Interest Method (2) Sum-of-the-Years Digits (SOYD) Method and (3) Straight Line Method. In the books of the finance company (owner) the accounting treatment will be as follows : (a) at the time of entering into the transaction, the finance company records the hire purchase installments receivable as a current asset (stock on hire) and the (unearned) finance income component of these installments as a current liability under the head Unmatured Finance Charges. (b) at the end of each accounting period, the finance company recognizes an appropriate part of the Unmatured Finance Income as current income of the period. (c) the direct costs associated with setting up the transactions are either expensed immediately or allocated against the finance income over the hire period.
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TEST YOUR KNOWLEDGE 1.29. SHORT QUESTIONS 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. Define hire purchase Mention the salient features of hire purchase What are the different form of hire Purchase agreements? What are the differences between hire purchase and installment sale? What do you mean by implied warranties? What are the remedies available in case of a breach? What are the different methods available for calculating interest rebate? What are the Acts which are referred to in case of hire purchase transactions? What are the three parts of tax aspects relevant to hire purchase? What do you mean by Unmatured Finance Charges?

1.30.

LONG QUESTIONS

1. Elaborate on the rights and obligations of the hirer and owner with respect to a hire purchase agreement. 2. Mention the ways in which a hire purchase agreement could be terminated. 3. Briefly explain the legal aspects pertaining to a hire purchase contract. 4. Clearly explain how accounting is shown in the books of the hirer and owner. 5. Explain the various methods available for calculating the interest rebate. Also compare the results shown by each method. 6. Sindhiya Finance offers a hire purchase plan for its borrowers on the following terms. Rate of interest Repayment period Frequency of payment Down payment : : : : 13.5% 4 years Monthly in arrear 25%

Calculate the effective rate of interest per annum or the annual percentage rate (APR) using (a) the trial and error approach and (b) the approximation formula.

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7. PTS Chemicals Limited manufactures a wide range of specialty chemicals which find applications in a number of industries such as detergents, cosmetics leather, textiles, pharmaceuticals and pesticides industries. In order to step up its capacity, the company has incurred a capital expenditure of Rs.1,200 lakh of which equipments costing Rs.600 lakh have been acquired under a hire purchase plan on the following terms: Rate of Interest Frequency of payments Pattern of payment Down payment Period 16% flat Annually in arrear Equated 25% 4 years

NOTES

The company follows the straight line method of depreciation and charges depreciation at the rate of 12% p.a for similar equipments. a. Prepare tables showing the year wise allocation of finance charge using (i) the effective rate of interest method (ii) the SOYD method and (iii) the straight line method. b. Show how the transaction will be reflected in the financial statements of PTS chemicals at the end of the first year of the hire period. 8. Sahadev Financial Service offers a hire purchase plan under which the hirer is provided with 100% finance in the following terms: Rate of Interest = Repayment period = Frequency of payment = 14% 4 years Monthly in arrear

The hirer is required to invest 25% of the investment cost in the cumulative fixed deposit scheme of the company for a period of 4 years. The Company offers a rate of interest of 15% p.a. compounded monthly. Calculate the APR of the scheme.

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9. Five Star Finance Ltd (FFL) offers the following finance scheme to its customers Amount (Rs.) Repayment Period (Mths) Equated Monthly Instalment (Rs.) (Payable at the beginning of every month) Down payment 4,00,000 48 9,250 25%

The company levies a service fee of Rs.2,000 and offers a prompt payment bonus of Rs.8 per Rs.10,000 per month on expiry of the repayment period. After paying 36 installments (at the end of 3 years) one of the borrower opts for an early settlement. The company allows the prompt payments bonus in respect of the installment paid and offers an interest rebate in accordance with the Rule of 78 method. You are required to calculate the effective rate of interest on the completed transaction. 10. Zeno Financial Services Ltd. (ZFSL) Offers finance to individuals to purchase four wheelers on the following terms: Deposit of 20% of the cost of the asset should be made at the inception of the transaction. 48 EMIs have to be made each at the beginning of every month. Front end service charge of 2% should be made. Deposit carrying an interest of 12% p.a. compounded monthly would be repaid at the end of 48 months.

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You are required to: a. Calculate the maximum monthly payments to be made by a borrower if his opportunity cost of funds is 18% p.a. and cost of the asset is Rs.4 lakh. b. Calculate the effective interest rate on the completed transaction if the borrower would like to make to prepayment at the end end of 36 months after paying 36 installments. Deposit would be repaid at the end of 36 months. The company offers an interest rebate calculated in accordance with the Rule of 78 Method. Assume the EMIs as obtained in (a) above.

NOTES

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UNIT - II

NOTES

LEASING
2.1. INTRODUCTION Leasing denotes procurement of assets through lease. The subject of leasing falls in the category of finance. Leasing has grown as a big industry in the US and UK and spread to other countries during the present century. In India, the concept was pioneered in 1973 when the First Leasing Company was set up in Madras and the eighties have seen a rapid growth of this business. 2.2 LEARNING OBJECTIVES After going through this chapter, the reader is expected to : 1. 2. 3. 4. 5. 6. 7. Know the concept and characteristics of Leasing Understand the mathematics of Leasing Know the different types of lease Understand the Leasing process Understand the evaluation of leasing from the aspect of the lessee and Lessor Understand the tax aspects pertaining to leasing and hire purchase.

2.3 DEFINITION A lease transaction is a commercial arrangement whereby an equipment owner or manufacturer conveys to the equipment user the right to use the equipment in return for a rental. In other words, lease is a contract between the owner of an asset (the lessor) and its user (the lessee) for the right to use the asset during a specified period in return for a mutually agreed periodic payment (the lease rentals).

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The purchase of the asset bestows the ownership rights and also responsibility of all consequential gains and losses. Further, the owner has to bear the maintenance cost also. Lease involves the use of an asset without assuming ownership. The owner of the asset is called Lessor and lessor under leasing arrangement retains ownership. Lessee, a firm or person acquiring an asset, has to pay rental (or otherwise called lease money) to the lessor. 2.4. IMPORTANCE OF LEASING Leasing industry plays an important role in the economic development of a country by providing money incentives to lessee. The lessee does not have to pay the cost of asset at the time of signing the contract of leases. Leasing contracts are more flexible so lessees can structure the leasing contracts according to their needs for finance. The lessee can also pass on the risk of obsolescence to the lessor by acquiring those appliances, which have high technological obsolescence. To day, most of us are familiar with leases of houses, apartments, offices, etc 2.5. LEASE CONTRACT Lease financing is one of the methods of long term financing. Leasing contract stipulates the lease period rental payments, periodic intervals of payments repairs and maintenance, purchase option, taxes, insurance, risk of obsolescence, penalty for delay or non payment of rental etc. It is an agreement under which the use and control of asset is permitted without passing on the title of the asset. In case the agreement provides, the lessor has to do maintenance and bear the cost of maintenance and upkeep of the equipment. In some cases, the lessee has to bear the cost of maintenance. In any case, it has to be stipulated clearly in the leasing contract about the maintenance. If the lease is not renewed the lessor takes the possession of the asset after the expiry of existing lease period. 2.6. CHARACTERISTICS OF LEASING The characteristics of a lease are as follows: i. Parties to the lease : In case of leasing there are two parties namely the lessor and the lessee. The lessor a person who agrees to give the right to use an asset to another person called the lessee for a periodic rental payment. Lessee is a person who obtains the right to use the asset from the lessor for a periodic rental payment for a greed period of time.
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ii. Asset on Lease : Leasing is used for financing the use of assets possessing a high value. The asset is the property that is to be leased and may include plant and machinery, building a car, a house, etc. The main point to be noted here is the separation of the ownership of the asset from its usage. iii. Term of the Lease Contract : The term of the lease contract is called the lease period. It is illegal to have a lease without a specified term. In India, we find perpetual lease in operation where the lease period is for an indefinite period of time. In case of an operating lease, on the expiry of the least period, the asset is returned to the lessor. In case of a financial lease, the lease period is in consistence with the economic life of the asset, so that the lessee is given the advantage of making exclusive use of the asset throughout its useful life. At time the lease period could be divided into two periods : primary lease period and secondary lease period. During the primary lease period, the lessor desires to recoup the investment together with interest. In the secondary lease period he may desire to get only nominal rental in order to keep he lease contract operational. iv. Lease Rentals : This refers to the consideration payable by the lessee as specified in the lease contract to the lessor. The rentals payable by the lessee are usually determined to cover such costs as interest on the lessors investment, cost of any repairs and maintenance that are part of the lease package, depreciation on the leased asset any other service charges in connection the with lease contract. 2.7. BASIC DIFFERENCES BETWEEN HIRE PURCHASE AND LEASE

NOTES

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2.8. FORMS OF LEASE FINANCING Based on variations, the following classifications have been developed: i. ii. iii. iv. Operating and Finance Lease Sale and Leaseback and Direct Lease Single Investor Lease and Leveraged Lease Domestic Lease and International Lease

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2.8.1. Operating and Finance Lease The distinction between operating and finance lease is based on the extent to which the risks and reward of ownership are transferred from the lessor to the lessee. Operating Lease Operating lease refers to a non payout lease in which lessors obligations may include services attached to his leased property such as maintenance, repair and technical advice. The cost of maintenance, repairs taxes, insurance etc, are all borne by the lessor (in which case it will be called as a wet lease). An operating lease where the lessee bears the cost of insurance and maintaining the lease asset is called a dry lease. It is a revocable one i.e. it can be cancelled by the lessee prior to its expiration date. It is usually of a shorter duration and bears no relation to the economic life of the asset. The lease rental is generally not sufficient to fully amortise the cost of the asset. The lessee is protected against the risk of obsolescence. The lessor has the option to recover the cost of the asset from another party on cancellation of operating lease by leasing out the asset.

NOTES

An operating lease is particularly attractive to companies that continually update or replace equipment and want to use equipment without ownership, but also want to return equipment at lease-end and avoid technological obsolescence. An operating lease usually results in the lowest payment of any financing alternative and is an excellent strategy for bypassing capital budgeting restraints. It typically qualifies for off-balance sheet treatment and can result in improved Return On Asset (ROA) due to a lower asset base. It can also result in higher reported earnings in the early years of the lease. In India since the resale market for used capital equipment lacks breadth, operating leases are not in popular use. However this type of lease is ideal for firms operating in sun rise industries which are characterized by a high degree of technological risk.

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Finance Leasing A lese is defined as finance lease if it transfers a substantial part of risks and rewards associated with ownership from the lessor to the lessee. According to the International Accounting Standards Committee (IASC), there is a transfer of a substantial part of the ownership-related risks and rewards if : i. The lease transfers ownership of the asset o the lessee by the end of the lease term; (or) ii. The lessee has the option to purchase the asset at a price which is expected to be sufficiently lower than the fair market value at the date the option become exercisable and at the inception of the lease, it is reasonably certain that the option will be exercised; (or) iii. The lease term is for a major part of the useful life of the asset. The title may r may not eventually be transferred; ((or) iv. The present value of the minimum lease payments is greater than or substantially equal to the fair market value of the asset at the incepting of the lease. The title may or may not eventually be transferred. The aforesaid criteria are largely based on the criteria evolved by the Financial Accounting Standards Board (FASB) of USA. The FASB has in fact defined certain cutoff points for criteria (iii) and (iv). According to the FASB definition of a finance lease, if the lease term exceeds 75% of the useful life of the asset or if the present value of the minimum lease payments exceeds 90% of the fair market value of the asset at the inception of the lease, the lease will be classified as a finance lease. Illustration 1 XYZ Ltd. Has recently leased equipment costing Rs. 350 lakhs for three years. The terms and conditions of the lease are as follows: Lease rental Frequency of payment : : Rs 435 per thousand per annum Annually in arrears

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The incremental borrowing rate for XYZ Ld is 20% p.a. You are required to determine if the above transaction can be classified as finance lease according to the FASB, given the following information : a. The useful life of the asset is 5 years b. The useful life of the asset is 8 years. Solution : a. Lease term : 3 years Useful life of the asset : 5 years Lease term as a percentage of the useful life of the asset = 60%

NOTES

* Since the lease term does not exceed 75% of the useful life of the asset, it cannot be classified as a finance lease. Present value minimum lease payments = 0.435 x 350 = 152.25 = 152.25 x PVIFA(20,3) = 15.25 x 2.106 = 320.64 Fair market value of the asset at the time of inception of the lease = 350 lakhs Present value as a percentage of the fair market value =

320.64 = 91.61% 350.00

** As the present value of the minimum lease payments exceed 90% of the fair market value of the asset, the lease cannot be classified as a finance lease. b. Lease term : 3 years Useful life of the asset : 8 years Lease term as a percentage of the useful life of the asset = 37.50%

As the lease term does not exceed 75% of the useful life of the asset, it cannot be classified as a finance lease. However considering the fact that the present value of minimum lease payments exceeds 90/% of the fair market value of the asset at the time f inception, the transaction can be classified as a finance lease.
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* For a lease to be classified as a finance lease, the lease term should exceed 75% of the useful life of the asset. ** For a lease to be classified as a finance lease, the PV of the minimum lease payments should exceed 90% of the fair market value of the asset. Illustration 2 Genius Finance Company Ltd, has recently structured a leveraged lease transaction involving an investment of Rs. 65 crore. The investment is funded in the following manner: Genius Finance company Ltd. being the equity participant is to invest 30% f the total cost. The balance is to be raised by means of debt from Sterling Bank which is the loan participant. The rate of interest on the loan component is 16% p.a. and the repayment is to be made in 5 equated annual installments. You are required to calculate the annual lease rental assuming hat the required rate of return of Genius Finance Company Ltd. is 20% p.a. Solution Loan component Equity component Equated annual installment Let us take the annual rental as Y Then (Y-13.89) x PVIFA(20,5) (Y 13.89) x 2.991 Y 13.89 Y = = = = Rs. 19.5 crore Rs. 19.5 crore Rs. 6.52 crore Rs. 20.41 crore 65.00 x0.70 crore 19.5 crore(65x0.3) 45.50 / PVIFA(16,5) 45.50/3.274 45.50 crore

13.89 crore

In terms of the standard quote, the lease rental works out to be 20.41 x 1,000/65 314.00/1,000 per annum i.e., 314 per thousand per annum

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2.8.2. Features of a Finance Lease Finance lease may be defined as a lease that transfer all the risk and rewards incidental to the ownership of the asset. The burden of all these expenses is placed on the lessee unless the contract provides to the contrary. It is a non-revocable contract i.e. it cannot be cancelled by the lessee prior to its expiration date. In this case, the lease period is usually related to the useful life of the asset. The lease rental would cover the lessors original investment cost plus ROI. The lessee has to take the risk of obsolescence in the case of financial The lessor is only financier and is not interested in the asset

NOTES

A finance lease is a full-payout, non-cancelable agreement, in which the lessee is responsible for maintenance, taxes and insurance. Finance leases are most attractive in cases where the lessee wants the tax benefits of ownership or expects the equipments residual value to be high. These leases are structured as equipment financing agreements with residuals up to 10 percent. The lessee purchases the equipment upon lease termination at a pre-agreed amount. The term of a finance lease tends to be longer, nearly covering the useful life of the equipment. 2.8.3. Differences Between Operating And Financial Lease

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2.8.4. Sale and Leaseback and Direct Lease Sale and lease back In a sale and leaseback transacting the owner of equipment sells it to a leasing company, which in turn leases it back to the erstwhile owner (the lessee). The leaseback arrangement in this transaction can be in the form of a finance lease of an operating lease. An example of this type of transaction is the sale and leaseback of safe deposit vaults resorted y commercial banks. Under this arrangement, the bank sells the safe deposit vaults to a leasing company at a market price which is substantially higher than the book value. The leasing company offers these lockers on a long-term lease to the bank. The advantages to the bank are as follows : It is able to unlock its investment in a low income yielding asset It is able to enjoy the uninterrupted use of the lockers (which can be leased to its customers) It can invest the sale proceeds (which are not subject to the serve ratio requirements) in high income yielding commercial loans.

From the leasing companys angle a sale and leaseback transaction poses certain problems. They are as follows : Firstly it is difficult to establish a fair market value of the asset being acquired because the secondary market for the asset may not exist. Even if it exists, it may lack breadth. Secondly, the Income Tax Authorities can disallow the claim for depreciation on the fair market value if they perceive the fair market value as not being fair.

A direct lease can be defined as any lease transaction, which is not a sale and leaseback transaction. In other words, in a direct lease, the lessee and the owner are two different entities. A direct lease can be of two type : Bipartite Lease and Tripartite Lease

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Bipartite Lease In a bipartite lease, there are two parties to the transaction the equipment supplier cum lessor and the lessee. It is typically structured as n operating lease with in-built facilities like predation of the equipment (upgrade lease) or additions to the original equipment, configuration. The lessor undertakes to maintain the equipment and even replace he equipment that is in need of major repair with similar equipment in working condition (swap lease). Of course, all these add-ons to the basic lease arrangement are possible only if the lessor happens to be a manufacturer or a dealer in the class of equipments covered by the lease. Tripartite Lease A tripartite lease is a transaction involving three different parties the equipment supplier, the lessor and the lessee. Most of the equipment lease transactions fall under this category. An innovative variant of the tripartite lease is the sales-aid lease where the equipment supplier catalyzes the lease transaction. In other words, he arranges for the lease fianc for a prospective customer who is in need of help. Sales-aid leasing can take one of the following forms: a. The equipment supplier can provide a reference about the customer to the leasing company b. The equipment supplier can negotiate the terms of the lease with the customer and complete the necessary paper work ob behalf of the leasing company. c. The supplier can write the lease on his own account and discount the lease receivables with the designated leasing company. The effect of the transaction is that the leasing company owns the equipment and obtains an assignment of the lease rental. By and large, sales-aid lease is supported by a to the supplier in the vent of default by the lessee. The recourse can be in the form of the supplier offering to buyback the equipment from the lessor in the event of default by the lessee or in the form of providing a guarantee o behalf of the lessee.

NOTES

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2.8.5 Single Investor Lease and Leveraged Lease This classification is also based on the number of parties to the lease transaction. In a single investor lease transaction there are only two parties to the transaction the lessor and the lessee and in contrast in case of a leveraged lease there are three parties to the transaction the lessor (equity investor), the lender and the lessee. Single Investor Lease In a single investor lease the leasing company (lessor) funds the entire investment by raising an appropriate mix of debt and equity. The important point to be noted is that the debt funds raised by the leasing company are without recourse to the lessor. Put differently, the lender cannot demand payment from the lessee in the event of the leasing company defaulting on its debt-servicing obligations. Leveraged leasing This type of leasing is linked with the financing of asset which requires large capital outlay. There are three parties involved in leveraged leasing: The lessee The Lessor (equity investor) and The lender

Under this arrangement, the position of lessee does not changed but role of lessor changes. Here the leasing company (called the equity investor) invests in the equipments by borrowing a large chunk of the investment with full recourse to the lessee and without any recourse to it. The lender (also called the loan participant) obtains an assignment of the lease and the rentals to be paid by the lessee and a first mortgage on the leased asset. The transaction is routed through a trustee who looks after the interests of the lender and lessor. On receiving the rentals from the lessee, the trustee remits the debt-service component of the rentals to the loan participant and the balance to the lessor.

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2.8.6 Domestic Lease Vs. International Lease A lease transaction is classified as a domestic lease if all parties to the transaction the equipment supplier, the lessor and the lessee - are domiciled in the same country, On the other hand, if these parties are domiciled in different countries, the transaction is classified as an international lease transaction. 2.9. METHODS OF STRUCTURING LEASE RENTALS The different methods of structuring lease rentals is explained through the following illustration. Illustration 3 Sunrise leasing has made available the following data : Investment Cost Pre-tax required rate of return Primary lease period Residual value after the primary period Nil Rs. 40 lakhs 20% p.a. 5 years

NOTES

It seeks your help in determining the annual lease rentals to be charged under the following rental structures: a. b. c. d. Equated Stepped (Assume an increase of 15% p.a) Ballooned (Assume an annual rental of Rs. 4 lakhs for years 1 though 4) Deferred (Assume a deferred period of 2 years)

Solution a. Let Y be the annual rental to be charged. The value of Y can be obtained from the equation : Y x PVIFA(20,5) = Rs. 40 lakhs

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40 2.991

Rs. 13.37 lakhs.

b. Let Y be the annual rental to be charged in year 1. The value of Y can be obtained from the equation : Y x PVIF(20,1) + (1.15)Y x PVIFA(20,2) + (1.15)2Y x PVIFA(20,3) + (1.15)3Y x PVIFA(20,4) + (1.15)4Y x PVIFA(20,5) = 40 i.e., 0.833 Y + [(1.15)Y x 0.694] + [(1.15)2Y x 0.579] + [(1.15)3Y x 0.482] + [(1.15)4Y x 0.402] = 40 i.e., 3.833Y = 40 i.e., Y = Rs. 10.44 lakh

The lease rental to be charged over the lease term will be :

c. Let Y be the ballooned payment to be made in year 5. The value of Y can be obtained from the equation: [4 x PVIFA(20,4) = Y X PVIF(20,5) i.e., 10.36 + 0.402y i.e., 0.402Y or Y = = = =
60

40 40 40 Rs. 73.73 lakh.


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d. Let Y be the equated rental to be charged between years 3 through 5. the value of Y can be obtained from the equation : Y x PVIF(20,3) + Y x PVIF (20,4) + Yx PVIF (20.5) = i.e., (0.579 + 0.482 + 0.402)Y i.e., i.e., Illustration 4 With the help of the given data you are required to determine the annual lease rental to be charged under he following rental structures : a. Equated b. Deferred (Assuming a deferment of 1 year) Investment cost Rs. 45 lakhs Pr-tax required rate of return 22% Primary lease period 5 years Residual value after the primary period Nil Solution a. Let the Equated Rental be denoted by L L x PVIFA(22,5) = 45 lakh L x 2.86 = 45 L = 15.73 lakh When the lese rental is deferred for 1 year, the rental structure will be as follows : 1.463Y Y = = = 40 40 40 Rs. 27.34 lakh.

NOTES

b.

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L x 2.044 L = 45/2.044

= =

45 lakhs 22.02

The deferred lease rental will thus be :

Illustration 5 From the following data given by Raj Ltd. you re required to determine the lease rental as per the stepped (increase of 10% p.a.) and ballooned (annual rental for years one to four is Rs. 3 lakhs) rental structure. Cost of the asset Rs. 80 lakhs Lessors required pre-tax rate of return 20.5% Lease period 5 years Residual value of the primary least Nil

Solution The lessor will have to price his lese so as to obtain a gross pre-tax return of 20.5% p.a. Lease rental under the Stepped Rental Structure Let us assume the lease rental to be charged as L and this is expected to increase by 10% p.a. L x PVIF(20.5,1) + 1.10L PVIF(20.5,2) + 1.21L PVIF(20..5,3) + 1.33L PVIF(20.5,4) + 1.461L PVIF(20.5,4) + 1.10L PVIF(20.5,5) = Rs. 80 lakhs
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(L x 0.830) + (1.01L x 0.689) + (1.21L x 0.572) + (1.33L x 0.474) + (1.461L x 0.394) = Rs. 80 lakhs L(0.83) + L(0.76) + L(0.69) = L(0.63) + L(0.58) L(3.49) L = = Rs. 80 lakhs Rs. 80 /3.48 + Rs. 22.92 lakhs = Rs. 80 lakhs

NOTES

Ballooned Rental Structure : 3 x PVIF(20.5,1) + 3 x PVIF(20.5,2) + 3 x PVIF(20..5,3) + 3 x P VIF(20.5,4) + L x PVIF(20.5,5) = Rs. 80 lakhs (3 x 0.830) + (3 x 0.689) + (3 x 0.572) + (3 x 0.474) + (L x 0.394)= Rs. 80 lakhs 2.49 + 2.07 + 1.72 + 1.42 + L(0.39) = Rs. 80 lakhs L(3.94) L = = Rs. 80 lakhs 7.70 Rs. 185.39 lakhs.

The ballooned payments to be made in he fifty years is Rs. 185,39 lakhs, Therefore, the least rental structure will be :

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2.10. Advantages of Lease 1. 2. 3. 4. A firm with limited funds can make better use of working capital. In case of lease the risk of obsolescence can be shifted to the lessor. Leasing is more flexible than ownership. Incase of assets of technological improvements, leasing on a short term basis is more desirable than acquisition of such assets. It is an insurance against out of data technology. 5. Leasing offers tax benefits also lease rent is tax deductible. 6. Leasing avoids much outlay for down payments. In some cases, it offers 100% financing without any down payment. 7. In the balance sheet, the current ratio and working capital are higher for lessee, as cash is conserved. Leasing helps in financing the assets without disturbing debt equity ratio. It does not disturb cash flow. 8. Leasing should offer cost savings over direct borrowing. 9. The Interest in case of lease financing is usually lower than what is charged by the commercial banks and financial institutions. 10. Immediate availability of funds: Borrowing from commercial banks requires a number of formalities to be followed but in case of leasing companies the formalities are very less. 11. There is no limit for financing by leasing companies. The companies will get funds as much as they need. 12. But now, pay letter: Lease rentals can be paid out of cash generated from the use of new asset obtained on lease. Earnings will be received first and then lease rent will be paid at the end of agreed periods, say, quarterly, half yearly or annually. 13. No interference by the lender. 14. No Government control. 15. Lease financing provides a hedge against inflation. 16. Leasing companies are liberal as compared to the commercial banks and financial institutions. 17. Import of machinery / equipment: Import formalities in regard to import of machinery / equipment can be completed with the help of lessor. 18. Expansion: Since the lease finance offer, in some cases, to the extent of even 100% without any down payment, expansion / diversification can be attempted without experiencing difficulties.

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19. Borrowing powers: Generally, all the companies will be having some borrowing powers to the extent limits provided by the commercial banks and financial institutions. These borrowing powers need not be disturbed in case lease financing is resorted to. In case of emergent circumstances, the borrowing powers can be exercised. 2.11. Disadvantages of Lease 1. The main drawback of lease is that ownership remains vested with lessor. 2. Long term leasing is generally more expensive to the lessee. 3. During the period of inflation the real estate values may increase during the lease period. In such case, the benefit of capital gain will be enjoyed by the lessor. The lessee losses the advantages of such appreciation in the value of asset. 4. Problems may arise if the lessee decides to alter the physical shape of the asset. 5. The interest cost on leasing is usually higher than the interest on debt. 6. Companies, which are not able to borrow at convenient terms, are forced to enter into a leasing arrangement with disadvantageous terms and conditions. 7. If a lessee is not able to honour the obligations of lease agreement, a lessor may suffer a loss. 2.12. Differences between Financial Lease and Direct Purchase

NOTES

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2.13. Methods For Evaluating A Leasing Proposal There are three methods for evaluating a leasing proposal as discussed below: 2.13.1. Present value Analysis method In this method, the present value of lease payments is compared with that of present value of payments under loan financing. In both these cases, necessary adjustments for tax benefits are to be made for arriving cash outflows. If the present value of cash outflows under the lease option is lower, it is considered advantageous and vice versa. Illustration 6 A company can purchase an asset at a price of Rs.1,10,000 with Rs.10,000 down payment and balance payable in 10 equal installments of Rs.10,000 each. The other related details are as follows : Rate of Interest Depreciation Tax rate : : : 15% p.a 10% p.a. on straight line method. 50%

Scrap value of the asset at the end of 10 years will be Rs.20,000. On the other hand the company could lease the asset by paying a lease rental of Rs. 15,000 per annum as lease rent. Tax rate applicable to the company is 50%. Advice the company on the option to be chosen. Solution Buying Option Yearly installments on purchase with interest at 15% p.a. Amount of loan Annuity factor at 15% for 10 years

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1,00,000 5.188 Rs. 19,925 per year.

NOTES

Leasing Option Yearly lease rent Less tax saving at 50% Net lease cost Present value of lease cost Rs.15,000 Rs.7,500 Rs. 7,500 yearly for 10 years 7,500 x 5.0188 = Rs.37,641.

Solution continued on next page The present value of loan financing at 15% per annum is Rs.37,608 whereas the present value of lease cost is Rs.37,641. Hence, it will be cheaper to purchase an asset through borrowings as compared to obtaining it on lease. In case of buying option, tax saving will be on Investment allowance, Interest and depreciation. But in respect of lease, the tax saving will be on one item only i.e. lease rent paid. Further, lease payment is lesser than the yearly installment under installment purchase system. Even then, buying will be cheaper because of tax savings as calculated above. Note: 1. For availing tax deduction under investment allowance, the company should own and use the asset. Lessor owns the asset but it is used by the lessee. Hence, lessor also will not get tax saving in the respect of investment allowance. 2. In case of difficulty of present value analysis in the absence of cost of capital, Internal Rate of Return (IRR) method may be used for deciding to lease or buy an asset.

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3. After the depreciation of 10 years, WDV of an asset will be nil. Hence, the scrap value Rs.20,000 will be treated as profit on sale of asset taxes accordingly. Therefore, cash inflow after tax has been taken at Rs.10,000 only. Illustration 7 An industrial unit desires to acquire a diesel generating set costing Rs.20 lakhs which has an economic life of ten years at the end of which the asset is not expected to have any residual value. The unit is considering in the alternative choices of : a. Taking the machinery on lease, or b. Purchasing the asset outright by raising a loan. Lease payments are to be made in advance and the lessor requires the asset to be completely amortised over its useful period and that the asset will yield him a return of 10% The cost of debt is worked at 16% per annum. Average rate of income tax is 50%. It is expected that the operative costs would remain the same under either method. The following factors may also be taken into account i. The present value discount factors for even stream of cash flows over the number of years are:

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Solution a. Taking the machinery on lease: Lease payments are to be made in advance i.e., 1st installment in advance and the balance in 9 years. From Annuity table i.e., table 2, annuity factor may be taken at 1+5.76 = for 9 years = 6.76. Lease Payment = 2,00,000 = Rs. 2,95,858 and it is debitable to P and L a/c. 6.76 Hence, the cost of debt after tax = 16% (1-0.50 tax) = 85. Statement of P.V of Cash Outflow

NOTES

b. Purchasing the asset outright by raising a loan Loan of Rs.20,00,000 at 16% per annum. Repayment is assumed at the end of each year. Interest is on the outstanding balances of loan. 20,00,000 Installment = 4.83 = Rs. 4,14,079

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NOTES

Schedule of Repayment of Loan and Interest (Rs.)

Statement of P.V. of cash outflow

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Advice It will be cheaper to purchase the asset outright by raising a loan of Rs.20,00,000 at 16% interest per annum. 2.13.2. I.R.R. method IRR may be worked out in case of both the alternatives of lease financing and loan financing. This rate may be used for comparison with the cost of debt and for assessing the relative advantage or disadvantage of leasing. 2.13.3. Bower Herringer Williamson (BHW) Method Bower, Herringer and Williamson divide the payments into two parts: The cash flows associated with financing and cash flows associated with tax saving. They assure that the loan payment schedule is same as the lease payment schedule. They measure the incremental impact of a loan by subtracting the present value of lease payments from the present value of loan payments. Both are discounted at interest rate on loan (as followed in the above illustration).

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The difference is the financial advantage or disadvantage of leasing. Present value of loan payments Less : tax saving on investment allowance Rs.1,10,000 Rs. 13,750 Rs. 96,250 Less : Present value of lease payments 15,000 + 5.0188 Financial advantage of leasing Rs. 75,282 Rs. 20,968

As a second part, they determine the incremental present value of the tax savings associated with leasing. It is observed in the above illustration that the tax savings is on the declining trend in case of borrowing alternative whereas the tax savings is constant in case of leasing. The difference represents the decrease in the firms tax payments which is associated with leasing as opposed to borrowing. Then these decreases are to be discounted at the cost of capital. The total of the present value of this decrease is called as operating advantage of the lease: Present value of decrease in tax payments in case of leasing BHW Method (continuing the above illustration)

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2.13.2.2. Decision criteria BHW Method

NOTES

In the case of above illustration, as both are advantageous, lease financing should be used according to BHW method.

2.14. OTHER TYPES OF LEASE ARE AS LISTED BELOW : 2.14.1. Net lease. The lessee pays all the costs of maintenance, repairs, taxes, insurance and other expenses. It is also called financial lease and is for longer period. In case of hire purchase, the contract provides automatic transfer of ownership of the assets to the lessee (hirer) at the end of stipulated period whereas in the case of lease operating lease as a foot note to the balance sheet. 2.14.2. Capital Lease Type of lease classified and accounted for by a lessee as a purchase and by the lessor as a sale or financing, if it meets any one of the following criteria: (a) the lessor transfers ownership to the lessee at the end of the lease term; (b) the lease contains an option to purchase the asset at a bargain price; (c) the lease term is equal to 75 percent or more of the estimated economic life of the property (exceptions for used property leased toward the end of its useful life); or (d) the present value of minimum lease rental payments is equal to 90 percent or more of the fair market value of the leased asset less related investment tax credits retained by the lessor.
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2.14.3. Direct Financing Lease (Direct Lease) A non-leveraged lease by a lessor (not a manufacturer or dealer) in which the lease meets any of the definitional criteria of a capital lease, plus certain additional criteria. 2.14.4. First Amendment Lease The first amendment lease gives the lessee a purchase option at one or more defined points with a requirement that the lessee renew or continue the lease if the purchase option is not exercised. The option price is usually either a fixed price intended to approximate fair market value or is defined as fair market value determined by lessee appraisal and subject to a floor to insure that the lessors residual position will be covered if the purchase option is exercised. If the purchase option is not exercised, then the lease is automatically renewed for a fixed term (typically 12 or 24 months) at a fixed rental intended to approximate fair rental value, which will further reduce the lessors end-of-term residual position. The lessee is not permitted to return the equipment on the option exercise date. If the lease is automatically renewed, then at the expiration of that initial renewal term, the lessee typically has the right either to return the equipment without penalty or to renew or purchase at fair market value. 2.14.5. Full Payout Lease A lease in which the lessor recovers, through the lease payments, all costs incurred in the lease plus an acceptable rate of return, without any reliance upon the leased equipments future residual value. 2.14.6. Guideline Lease A lease written under criteria established by the IRS to determine the availability of tax benefits to the lessor. 2.14.7. Open-end Lease A conditional sale lease in which the lessee guarantees that the lessor will realize a minimum value from the sale of the asset at the end of the lease.
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2.14.8. Sales-type Lease A lease by a lessor who is the manufacturer or dealer, in which the lease meets the definitional criteria of a capital lease or direct financing lease. 2.14.9. Synthetic Lease A synthetic lease is basically a financing structured to be treated as a lease for accounting purposes, but as a loan for tax purposes. The structure is used by corporations that are seeking off-balance sheet reporting of their asset based financing, and that can efficiently use the tax benefits of owning the financed asset. 2.14.10. Tax Lease A lease wherein the lessor recognizes the tax incentives provided by the tax laws for investment and ownership of equipment. Generally, the lease rate factor on tax leases is reduced to reflect the lessors recognition of this tax incentive. 2.14.11. Trac Lease A tax-oriented lease of motor vehicles or trailers that contains a terminal rental adjustment clause and otherwise complies with the requirements of the tax laws. 2.14.12. True Lease A type of transaction that qualifies as a lease under the Internal Revenue Code. It allows the lessor to claim ownership and the lessee to claim rental payments as tax deductions. 2.15. Tax Matters Lease money paid is taken as a business expense in the books of lessee and reduces the tax liability: Lease money paid x (1-tax rate). No depreciation is allowed under Income tax Act 1961 as the asset is not owned by the lessee.

NOTES

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If it is purchased, the interest on borrowing is taken as business expense and depreciation is allowed as operating expense. This will result in saving the Income tax as followed. Interest x (1-tax rate) Depreciation x (1-tax rate) Investment allowance also will result in saving of income tax but the question of investment allowance does not arise in case of lease. It is noted that will the abolition of investment allowance from the assessment year 1988-89 as per the long term fiscal policy, lease financing will be cheaper than to acquire the assets by own funds or loan funds. Cash salvage value is an inflow in case of purchase and it will be discounted at the cost of capital in order to arrive at the presence value. But lessee does not have any right on salvage value of asset as the title of the asset remains with the lessor. If the maintenance cost is to be borne by the lessee, it can also be shown as a business expense in P and L account in the books of the lessee and reduces the tax liability. In case of lease hold assets, the capital base will be lower in the books of lessee because of no investment for the lease hold assets and consequential non creation of investment allowance reserve. Hence, it will involve higher companies profits sur tax provided that the chargeable profit is above the statutory deduction limit. Leasing companies are not permitted to issue C forms for availing the concessions under Sales Tax. 2.15.1. Income tax provisions and Sales Tax Provisions relating to Leasing 2.15.1.1. Income Tax Provisions a. b. c. d. The asset will be sold by the lessee at the book value and not at revalued price. Lessee can claim lease rental as allowable expenditure in his books. Lessor should account lease rentals as income. Lessor is entitled for depreciation on the asset only on the basis of book value.

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2.15.1.2. Sales Tax Provisions Many States are charging sales tax on leased income. 2.16. Difference Between Process Of Leasing And That Of Direct Purchase Lease financing is one of the methods of long term financing. In a financial lease, lessor arranges the following three functions: a. Arranging finance b. Acquire the equipment as per the requirement of lessee c. Lessor would hold the title of asset. It is an arrangement under which the use and control of asset is permitted without passing on the title of the asset. The lessor acts as an intermediary in the capital market and equipment market. Lessee, a firm a person acquiring an asset, has to pay rental or lease money to the lessor. 2.17. Equipment Leasing and Hire Purchase: The hire purchase system is a system under which money is paid for goods by means of periodical instalemnts (which include interest) with the view of ultimate purchase. Under this system, the hire purchaser acquires the possession of goods immediately on signing the hire purchase agreement and payment of down payment. The goods will become the property of the buyer only when all the installments have been paid. As the title would ultimately pass on to the buyer, depreciation and interest on finance are allowed as a deduction for income tax purpose. Lease involves the use of an asset without assuming ownership. The owner if the asset is called lessor and ownership is retained by lessor under leasing arrangement. Lessee has to pay rental to the lessor. Lease rent is allowed as a deduction for income tax purpose in the hands of lessee. As per the latest instructions of CBDT, depreciation on the equipment is allowed as a deduction in the hands of lessor.

NOTES

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2.18. SALIENT POINTS OF LEASING 1. Buy now and pay later. Lease rentals can be paid out of cash generated. That is, earnings will be received first and then lease rent will be paid at the end of agreed periods, say, quarterly, half yearly or annually. A lessee will have immediate cash inflow, cash outflow for number of years and cash inflow during terminal year. Hence, it will result into Multiple IRR. 2. The results of this method may be inconsistent. If the lease bases differ in their (a) expected lives or (b) investment or (c) timing of cash inflow. 3. It is not appropriate method for mutually exclusive proposals. 4. The risk is not constant. The salvage value of the asset is riskier. Hence, two discount rates are required. But IRR gives one rate only and hence each cash inflow is not implicitly discounted to reflect its risk. 5. Cost of capital will change in case of firms which do not pay Income Tax and which pay income tax. After tax cost of capital should be compared with after tax rate of return (ATC to be compared with ATR) r > k. r should be more than k. Note : if the company is in a temporary non tax paying category, its cost of capital changes over time. In this case also, one rate is not enough to calculate the Before Tax Cost (BTC) and After Tax Cost (ATC) when it pays income Tax. Chart : Leases: Source: Chartered Accountant Student (Nov.2003)

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NOTES

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2.19 PROBLEMS AND SOLUTIONS Illustration 8 Allsip Finance Ltd. is planning to issue bonds with a face value of Rs. 100 and carrying coupon payments at five percent above the inflation rate of the year. The company wants to price the bond in such a way that investors get a return of 18% on it. The expected rates of inflation during the five-year tenure of the bond are as follows:

What is the price at which the bond can be issued?

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Solution

NOTES

The price at which the bond can be issued : =10 x PVIF(18,1) + 9.5 x PVIF(18,2) + 10 x PVIF(18,3) + 11 x P VIF(18,4) 112.5 x PVIF(18,5) = 10 x 0.847 + 9.5 x 0.718 + 10 x 0.609 + 11 x 112.5 x 0.437 = Rs. 76.22 Illustration 9 The following data is available on the portfolio of leased assets of Stallion Leasing Ltd. for a given financial year.

D lakhs. Sale of assets during the year has been Rs. 13

a. Calculate the tax relevant depreciation charge for the year b. It is expected that fresh investment to the tune of Rs. 40 lakh will be made during the following financial year. The disinvestment proceeds are likely to be around Rs. 22 lakhs. 50% of the fresh investment will be made before September 30th of the financial year. Calculate the projected depreciation charge for the following year.

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Solution a. Depreciation charge for the current financial year WDV at the beginning of the year Add: Cost of assets acquired during the year Less: Proceeds on sale of assets during the eyar Written down value for charging depreciation Depreciation allowance for the year Written down value at the end of the year b. Depreciation charge for eh following financial year Written down value as at the beginning of the year Add : Cost of assets to be acquired during the year Less; Proceeds on sale of assets likely to be realized Depreciation allowance for the year 233.25 40.00 273.25 22.00 251.25 60.31 190.94 Rs. 224.00 100.00 324.00 13.00 311.00 311.00 77.75 233.25 233.25

Working Notes : Normal depreciation allowance LessL depreciation allowance inadmissible in respect to assets Acquired after September 30 - 20* x0.25.0.5 Admissible allowance *50% of the fresh investment. Illustration 10 Vidhya Ltd. plans to acquire capital equipment from Samastha Ltd. at Coimbatore. The cost of the equipment exclusive of sales tax is 67 lakh and the rate of CST payable is
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Rs. 62.81 2.50 60.31

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4%. Vidhya Ltd. is considering to lese the equipment from Malathi Financial Services. The quote on a 3 years lease is Rs. 55.28 per thousand per month payable at he end of every month. Calculate the lease rentals payable by Vidhya Ltd. Solution a. Cost of the equipment to Vidhya Ltd. = = b. Cost of the equipment to Malathi Financial Services = = Lease rentals to be paid by Vidhya Ltd. = Rs. 67 x 1.04 Rs. 69.68 lakhs Rs. 67 x 1.10* Rs. 73.7 lakh Rs. 4.07 lakhs per month

NOTES

* The lessor bears the impact of sales tax at the normal rate of 10%. Illustration 11 The following data is available on the portfolio of leased assets of Radial Leasing Ltd. for the year 2007-08.

Sale of assets during the year have been Rs. 25 lakh and rs. 44 lakh in respect of block A and B respectively. a. Calculate the tax relevant depreciation charge for the year 2007-2008. b. It is expected that fresh investments to the tune of Rs. 85 lakh will be made during the year 2007-2008 as follows

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It is expected that about 50% of the fresh investments will be made before September 30 of the financial year and the rates of depreciation applicable to blocks A and B will be 25% and 40% respectively. Calculate the projected depreciation charge for the following years. Solution a. Depreciation charge for the current financial year

b. Depreciation charge for the follwoing financial year

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Notes : 1.

NOTES

2. Where the entire block of assets have been sold during a year for an amount higher than (a + b) or where the sale proceeds on the part of the block that has been sold is higher than (a + b), the difference will be treated as short-term capital gain and taxed at the marginal rate of tax; in case of widely held companies, where the entire block of assets has been sold for an amount less than (a + b), the difference will be treated as short-term capital loss and the assess will be entitled to a tax shield a the marginal rate of tax. Illustration 12 The FFM Ltd. is in the tax bracket of 35% and discounts its cash flows at 16%. In the acquisition of an asset worth Rs. 10,00,000, it is given two offers either to acquire the asset by taking a bank loan @ 15% per annum repayable in five yearly installments of Rs.2,00,000 each plus interest or to lease in the asset at yearly rentals of Rs.3,24,000 for five years. In both cases the installment is payable at the end of the year. Applicable rate of depreciation is 15% using written down value (WDV) method. You are required to suggest the better alternative. Note: P.V. factor at 16% - year 1: 0.862 : Year 2: 0.743 : Year 3 : 0.641; Year 4: 0.552; and Year 5: 0.476.

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Solution Working Note 1 Calculation of Depreciation Year 1 10,00,000 Less Depn. 15% 1,50,000 --------------WDV 8,50,000 Year 2. Depn 15% 1,27,500 --------------WDV 7,22,500 Year 3. Depn. 15% 1,08,375 --------------WDV 6,14,125 Year 4 Depn 15% 92,119 --------------WDV 5,22,006 Year 5. Depn 15% 78,301 WDV 4,43,705 Working Note 2 Bank loan of Rs.10 lakhs repayable in 5 yearly instalments at the end of each year. Interest at 15% Year 1: 10 lakhs x 15% = 1.50 lakhs Year 2 : 8 lakhs x 15% = 1.20 lakhs Year 3 : 6 lakhs x 15% = 0.90 lakhs Year 4 : 4 lakhs x 15% = 0.60 lakhs Year 5 : 2 lakhs x 15% = 0.30 lakhs

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Solution Option to borrow funds (Rs.)

NOTES

Leasing Option Rental 3,24,000 Less : Tax 35% Net cash outflow 1,13,400 2,10,600

every year for 5 years.

Present value of net cash outflow for 5 years = 2 ,10,600 x 3.274 = Rs.6,89,504 Suggestion: Leasing option is the better alternative as its discounted cash outflow is lower than that of borrowing option. Illustration 13 DLP Pvt. Ltd. is considering the possibility of purchasing a multi purpose machine which cost Rs.10.0 lakhs. The machine has an expected life of 5 years. The machine generates Rs.6.0 lakhs per year before Depreciation and Tax, and the Management wishes to dispose the machine at the end of 5 years which will fetch Rs.1.00 lakh. The Depreciation allowable for the machine is 25% on written down value and the companys tax rate is 50%. The company approached a NBFC for a five year Lease for financing the asset which quoted a rate of Rs.28 per thousand per month. The company wants you to evaluate the proposal with purchase option. The cost of capital of the company is 12% and for lease option it wants you to consider a discount rate of 16%.

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Solution Working Notes 1. Calculation of Depreciation (Rs. Lakhs) Year 1 Original cost 10.00 Depn .25% 2.50 WDV 7.50 1.88

Year 2 Depn. 25% WDV 5.62 Years 3 Depn. 25% WDV 4.22 Year 4 Depn. 25% WDV 3.16 Year 5 Depn. 25% WDV 2.37

1.40

1.06

0.79

2. Purchase option. Statement of NPV (Rs. Lakhs)

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3. Lease Option Rs. 28 per thousand per month 28 --------- x 10,00,000 x 12 months = Rs.3,36,000 per year. 1000 The machine generates Rs.6.00 lakhs per year before depreciation and Tax. No depreciation in case of lease PBDT Less : Lease Rent PBT Less : Tax at 50% PAT 6.00 3.36 2.64 1.32 1.32

NOTES

PV at 16% for 5 years. 1.32 x 3.274 = Rs.4,32,168 i.e. NPV = Rs. 4,32,168 say, Rs.4,32 lakhs Since the NPV of lease option is higher, the company should go in for 5 years lease. Illustration 14 Modern Outlook Ltd. (MOL), a small manufacturing firm is considering the acquisition of the use of a machine. After evaluating equipments offered by seven different manufacturers, it has come to the conclusion that Z was the most suitable machine for its needs. Consequently, it has asked the manufacturers sales personnel to provide information on alternative financing plans available through their financing subsidiary. The subsidiary presented the two alternatives. Alternative I was to lease the Z equipment for 7 years, which was the machines expected useful life. The annual lease payments would be Rs.14,700 and would include service and maintenance. Lease payments would be due at the beginning of the year. Lease payments would be fully tax deductible.

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Alternative II would be to purchase the Z equipment through 100 per cent loan from the financing subsidiary. The cost of the machine is Rs.50,000. It would make seven annual payments of Rs.9,935 each to repay the loan of Rs.50,000. Payments would be, at the end of each year. The MOLs marginal tax rate in 44%. It has estimated that the equipment has an expected salvage value of Rs.1,000. The company plans to depreciate the equipment by using straight line method. The service and maintenance would cost Rs.3,700 annually. You are required to advise MOL on the desirability of the alternative plans, assuming that the rate of interest is 9 per cent p.a. Note : The relevant PV factors are:

Solution Alternative II

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P. V of cash outflow

NOTES

(i)

To purchase the computer for Rs.22,00,000.

(ii) To lease the computer for 3 years from a leasing company for Rs.5,00,000 as annual lease rent plus 10% of gross time share time share service revenue. The agreement also requires an additional payment of Rs.6,00,000 at the end of the third year. Lease rents are payable at the year end, the computer reverts to the lessor after the contract period. The company estimate that the computer under review now will be worth Rs. 10 lakhs at the end of the third year. Forecast revenues are:

Annual operating costs (excluding depreciation / lease rent of computer) are estimated at Rs.9,00,000 with an additional Rs.1,00,000 for start up and training costs at the beginning of the first year. These costs are to be borne by the lessee. XYZ Ltd. will

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borrow at 16% interest to finance the acquisition of the computer; repayments are to be made according to the following schedule.

The company uses the straight line method to depreciate its assets and pays 50% tax on its income.

The management of XYZ Ltd. approaches you, as a company secretary, for advice. Which alternative would you recommend and why? Note Present value factor at 8% and 16% rate of discount:

Present value of cash outflow under Leasing alternative

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Present Value of Cash outflows under Buying / Borrowing Alternative

NOTES

Recommendation 1 Recommend to purchase the computer for Rs.22 lakhs Why The present value of this option is lower as compared to leasing alternative. Working Notes 1. Effective rate of interest or discount = 16% (1- Tax at 50%) = 8%. Hence, PV. Factor at 8% has been taken into account. 2. Tax advantage on Depn. Under SLM method 22-10 = = 4 lakhs x 50% = Rs.2,00,000 3 3. Revenue and operating cost: applicable to both alternatives. Hence, not relevant for decision making.

Illustration 16

Your company is considering to acquire an additional computer to supplement its time share computer services to its clients. It has two options: I. To purchase the computer for Rs.22 lakhs. II. To lease the computer for 3 years from a leasing company for Rs.5 lakhs as annual lease rent plus 10% of gross time share service revenue. The agreement also requires an additional payment of Rs.6 lakhs at the end of the third year. Lease

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rents are payable at the year end, and the computer reverts to the lessor after the contract period. The company estimates that the computer under review will be wroth Rs.10 lakhs at the end of the third year. Forecast revenues are :

Annual operating costs excluding depreciation / lease rent of computer are estimate at Rs.9 lakhs with an additional Rs.1 lakh for start up and training costs at the beginning of the first year. These costs are to be borne by the lessee. Your company will borrow at 16% interest to finance the acquisition of the computer. Repayments are to be made according to the following schedule:

The company uses straight line method (SLM) to depreciate its assets and pays 40% tax on its income. The management approaches the company secretary for advice. Which alternative would he recommended and why?

Note : The PV factors at 8% and 16% rates of discount are:

CS (Final) June, 99

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Solution Present value of cast outflows under leasing alternatives (RS.)

NOTES

Present value of cash outflow under Buying / Borrowing alternative (Rs.)

Recommendation

I recommend to purchase the computer for Rs.22 lakhs. Why? The present value of this option is lower as compared to leasing alternative. 22-10 Note 1 : Depn. Under SLM method : = 4 lakhs 3

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2 Annual operating costs of Rs.9 lakhs and training cost of Rs.1.00 lakh are same under both alternatives and hence these are not included in the calculation of cash outflows. Illustration 17 ABC Limited is considering to acquire an additional sophisticated computer to augment its time share computer services to its clients. It has two options: Either . (a) to purchase the Computer at a cost of Rs.44,00,000. Or, (b) to take the computer on lease for 3 years from a leasing company at an annual lease renal of Rs.10 lakhs plus 10% of the gross time share service revenue. The agreement also requires an additional payment of Rs.12 lakhs at the end of the third year. Lease rentals are payable at the year end and the Computer reverts back to lessor after the period of contract. The company estimates that the Computer will be worth Rs.20 lakhs at the end of the third year.

The Gross revenue to be earned are as follows: Annual operating cost (excluding depreciation / lease rental) are estimated at Rs. 18 lacs with an additional cost of Rs.2 lakhs for start up and training at the beginning of the first year. These costs are to be borne by the lessee in case of lease arrangement also. The company proposes to borrow @ 16% interest to finance the purchase of the computer and the repayments are to be made as per the following schedule:

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NOTES

For the purpose of this computation, assume that the company uses the straight line method of depreciation on assets and pays 50% tax on its income. You are required to analyse and recommend to the company which of the two options is better. (PV factor @ 8% for year 1 (0.926), year 2 (0.857), year 3 (0.794) and @16% for year 1 (0.862), year 2 (0.743) and year 3 (0.641).

Solution Working Note 1 The effective rate of interest is 16% (1-Tax at 50%) = 8%. Hence, P.V. factor at 8% has been taken into account. Solution

Present value of cash outflow under leasing alternative Total present value Less Present value of salvage of computer at the end of Third year 20 lakhs x 0.794 = Total present value = 33,68,940 15,88,000 17,80,940

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Recommendation I recommend to purchase the computer for Rs.44 lakhs Working Notes

Annual Operating cost (excluding depreciation / lease rental) of Rs. 18 lakhs and additional cost of Rs.2 lakhs for start up and training at the beginning of the first year are the cash outflow under both the alternatives. Hence, these are not relevant for decision making.

Illustration 18 P. Securities Ltd., Chennai, is engaged in the business of leasing and hire purchase. The company also functions as a merchant banker, equity researcher, corporate financer, portfolio manager, etc. The company provides fund based as well as non fund based financial solutiosn to both wholesale and retail segments. P. Securities Ltd. has been approached by AA Ltd., Mumbai for financial help, AA Ltd., manufactures process system for food processing. Pharmaceuticals, engineering, dairy and chemical industries. A wide range of centrifugal separators, plate, spray drugers, custom fabricated equipment for exotic metals, refrigeration compressors etc., are also manufactured by the company. One of the major strengths of the company is project management. AA Ltd, has a well equipped R & D centre. It has pilot plant facilities and a modern laboratory for chemical, metallurgical and mechanical analyzer. The company has also set up a technology centre with advanced testing facilities. Recently, the manager of
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the technology centre has requisitioned for the acquisition of a computerized sophisticated, equipment for conducting important tests. The equipment is likely to have the useful life of three years. The cost of the equipment is Rs.10 crore. The scrap value of the equipment at the end of its useful life will be zero for the company. The finance manager of AA Ltd has suggested that the company should take a loan for three years from a commercial bank. Repayment of the loan would be made at the end of each year in three equal instalments. The repayments would comprise (i) the principal; and (ii) interest at 10% per annum (on the outstanding amount in the beginning of the year). AA Ltd. uses a cost of capital of 15% to evaluate the investments of this type. The equipment will be depreciated @ 33 1/3 % per annum (WDV). P. Securities Ltd. has agreed to give the equipment to the company on a three year lease. The annual rental for the lease, payable in the beginning of each year, would Rs. 4 crore P. Securities Ltd. discounts its cash flows @ 14%. The equipment is depreciable at 33 1/3 % per annuam (straight line method). The lessee may exercise its option to purchase the equipment for Rs.4 crore at the termination of the lease. AA Ltd. would bear all maintenance, insurance and other charges in both the alternatives. Both the companies pay tax @ 35%. You are a company secretary in practice. You are approached by the managing director of AA Ltd. to help the company in evaluating the proposal. Prepare a report for the managing director of AA Ltd. showing the effect of the lease alternative on the wealth of its shareholders. Support your answer with appropriate calculations: Note : Present value of Re.1 is :

NOTES

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NOTES

Present value of an annuity of Re 1 is :

Solution To the Managing Director, A.A. Ltd., Sir, as desired, I have evaluated both the options in detail to find out the effect of the lease alternative on the wealth of the shareholders. The following calculations are submitted for your kind consideration:

Bank Loan Option The cost of equipment Useful life Loan period Interest rate Scrap value after 3 years Annual Repayment amount = = = = = = Rs.10,00,000 3 years 3 years (payment in three equal instalments) 10% per annuam 0 Rs.10,00,00,000 Annuity factor of 10% of 3 years Rs.10,00,00,000 = Rs. 4.021 crore 2,487

The cash outflows under bank loan purchase option bifurcated into Annuity of payment into Principal and Interest

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(Rs. in crores)
Year Principal Amount 1 2 3 10,00 6.979 3.656 Instalment of the year 4.021 4.021 4.021 1,000 0.698 0.365 3.021 3.323 3.656 6.979 3.656 Interest @ Repayment of Principal Balance Amount

NOTES
at the end 10%

-Schedule of Depreciation (WDV) Basis (Rs. in Crores)

Evaluation of Bank Loan Option

Year

Loan at the end of each year

Principal

Interest Depreciation @ 10% (Rs.) @ 33-1/3 % p.a. (WDV)

Tax shield (on interest & Dep.)

Net cash

PV f actor @ 15%

PV of Net cash outflows

instalment repayment

@ 35% outflow

1 2. 3.

4.021 4.021 4.021

3.021 3.323 3.656

1.00 0.698 0.365

3.333 2.222 1.482

1.517 1.022 0.646

2.504 2.999 3.375

0.870 0.756 0.658

2.179 2.267 2.221

Total PV of Net Cash outflow = 6.666

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Evaluating of Leasing option (when equipment is not purchased) (Rs. in crores)

Total PV of Net Cash outflow = 7.307 @ cash Inflows. Assumptions It is assumed that the company does not exercise the option to purchase the equipment for Rs.4 crores at the termination of the lease because the value of the equipment to the company after its useful life of 3 years is zero. Bank Loan option : P.V. of cash outflow 6.666 crores. Lease option : P.V. of cash outflow 7.307 crores Hence, Bank loan option will be better. Lease option will have adverse effect on the wealth of companys shareholders. Thanking you, Sd. (P.V.R.) Company Secretary in Practice Illustration 19 Afla Ltd. is thinking of installing a computer. Decide whether the computer is to be purchased outright (through 15% borrowing) or to be acquired on lease rental basis. The rate of income tax may be taken at 40%. The other data available are as under:

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Purchase of computer Rs. 20,00,000 Purchase price Rs.50,000 per year Annual maintenance (to be paid in advaice) 6 years Depreciation (for tax purpose) Straight line method Salvage value Rs.2,00,000 Leasing of Computer : Lease charges to be paid in advance Rs.4,50,000 Maintenance expenses to be borne by lessor. Payment of loan: 6 year end equal installments of Rs.5,28,474. Note : Present value of Re.1 for six years:

NOTES

Solution a. Purchase through borrowing 20 lakhs 2 lakhs Depreciation = = Rs. 3 lakhs 6 years Interest 15%. After tax cost of debt = 15% (1-40%) = 9% Hence, PV factor at 9% is taken into account. Maintenance charges to be paid in Advance : Annuity factor. Year 1 beginning 2 beginning 3 beginning 4 beginning 5 beginning 6 beginning 1.0000 .9174 .8417 .7722 .7084 .6499 Annuity factor 4.8896

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NOTES

Break up of interest and principal repayment

Statement of present value of cash outflow Year 1 to 6 in advance Maintenance 50,000 Less Tax saving at 40% 20,000 30, 000 x End of year Statement of present value of cash outflow Year 1 to 6 in advance Maintenance 50,000 Less Tax saving at 40% 20,000 30, 000 x End of year 1. Installment Less Tax savings on interest & Depn: 3 lakhs + 3 lakhs = 6 lakhs x 40% Net outflow

4.8896 = 1,46,688

4.8896 = 1,46,688

5,28,474

2,40,000 2,88,474 x.9174 = 2,64,646


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2.

Installment Less Tax savings on interest & Depn. 226317 + 3 lakhs = 526317 x 40% Net outflow

NOTES
2,10,527 3,02,182 x 8417 = 2,54,347

3.

Installment Less Tax savings on interest & Depn. 226317 + 3 lakhs = 526317 x 40% = Net outflow

2,10,527 3,17,947

x .7722 = 2,45,519

4.

Instalment Less Tax savings on interest & Depn. 180994 + 3 lakhs = 480994 x 40% Net outflow

1,92,398 3,36,076 5,28,474 1,71,549 3,56,925

x.7084 = 2,38,076

5.

Installment Less Tax savings on interest & Depn. 128872 + 3 lakhs = 428872 x 40% = Net ourflow

x.6499 = 2,31,966

6.

Installment Less Tax savings on interest & Depn. 68932 + 3 lakhs = 368932 x 40% Net outflow Total present value of cash outflow Less : P.V. of salvage value P.V. of cash outflow

1,47,573 3,80,901

x.5963 = 2,27,131 16,08,373 x .5963 = 1,91,260 14,89,113

2,00,000

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b.

Leasing of computer : P.V. of lease charges Lease charges yearly Less tax savings at 40% Net outflow P.V. of net outflow : 4,50,000 1,80,000 2,70,000 2,70,000 x 4.8896 =13,20,192

Note : Maintenance expenses to be borne by lessor and hence it has not been taken into account in the books of lessee. Decision : It is beneficial to acquire the computer on lease rental basis as its present value of cash outflow is lower. Illustration 20 A firm has the choice of buying a piece of equipment at a cost of Rs.1,00,000 with borrowed funds at a cost of 18% p.a. repayable in five annual instalments of Rs.32,000; or to take on lease the same on an annual rental of Rs.32,000. The firm is in the tax bracket of 40%. Assume: i. The salvage value of the equipment at the end of the period is zero ii. The firm uses straight line depreciation iii. Discounting factors are: @ 9% - .917, 842, .722, .708, .650 @ 11% -.901, .812, .731, .659, .593 @18% - .847, .718, .609, .516, .437 Which alternative do you recommend?

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Solution Borrowed fund costs 18% p.a. and after tax is 18 x 60 = 10.8% 100

NOTES

Discounting rate to be applied is 11% The following table estimates the PV. Calculation of net cost of owning. (Rs.)

Computation of present value advantage (Rs.)

It is advantageous to purchase the asset on borrowed funds, as the present value of advantages is positive. Note : 32,000 40% Tax saving = Rs.19,200 Illustration 21

ABC Company Ltd. has two financial options in respect of procuring an Equipment for utilizing the same for 5 years costing Rs.10,00,000. The two options are:

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Option I : Borrow Rs.10,00,000 at an interest rate of 15%. The loan is repayable at 5-year end instalment. The equipment could be sold at the end of its 5 years economic life at a realizable value of Rs.1,00,000. Option II : Lease in the asset for a period of 5 years at an yearly rental of Rs.3,30,000 payable at year end. The rate of Depreciation allowable on the equipment is 15%. The company has to pay Income Tax @ 50% and has a Discounting rate of 16%. Restrict working up to 10th year in case of Option I. Evaluate the two options and give your opinion. Solution Evaluation of Two options

Option II nd Lease In option

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Option : Option II i.e. lease in the asset is more profitable. Note : 1 Depreciation at 15% on Rs.10 lakhs = Rs. 1,50,000 in the first year and calculated on WDV from second year onwards. 2. Cost of equipment Less : Depn. During 5 years WDV at end of 5 years Less : Realisable value WDV 3,43,700 Depn. During 6th year at 15% 10,00,000 5,56,300 4,43,700 1,00,000 51,600

NOTES

3. Depreciation is continued to be charged as we have to restrict working upto 10th year in case of option I. Illustration 22 ABC Company Ltd. is faced with two options as under in respect of acquisition of an asset value Rs.1,00,000. Either: a. To acquire the asset directly by taking a Bank Loan of Rs.1,00,000 payable in 5 years end installments at an interest of 15%. OR b. To lease in the asset at yearly rents of Rs.320 per Rs.1,000 of the asset value for 5 years payable at year end. The following additional information are available. a. The rate of depreciation of the asset is 15% W.D.V. c. The Company has an effective tax rate of 50%. d. The Company employs a discounting rate of 16%. You are to indicate in your report which option is more preferable to the company. Restrict calculations over a period of ten years.

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NOTES

The present value of one rupee due at the end of each year is:

Solution To The Director (Finance) Sir, Sub : Report showing evaluation of 2 options for acquisition of an asset valued at Rs.1,00,000 Working Notes 1. Calculation of Depreciation

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2. Calculation of interest at 15%

NOTES

Solution Option (A) to borrow fund

1 Year

2 Principal Repayment

3 Interest @ 15%

4 Depreciation @ WDV

5 Tax

6 Net

cash Discounted Cash

15% Shield 50% (4)

out flow

ou

of Col (2) + flow (3)-(5) 16%

Col (3) &

1 2 3 4 5 6

20,000 20,000 20,000 20,000 20,000

15,000 12,000 9,000 6,000 3,000

15,000 12,750 10,838 9,212 7,830 6,655 5,657 4,808 4,087 3,474

15,000 12,375 9,919 7,606 5,415 3,327 2,829 2,404 2,043 1,737

20,000 19,625 19,081 18,394 17,585 (3,327) (2,829) (2,404) (2,043) (1,737)

17,241 14,584 12,224 10,159 8,372 (1,365) (1,000) (732) (537) (393) 58,553

Option (B) Leasing Option 7 Lease Rentals at Rs.320 Per Rs.1,000 i.e. Rs.32,000 for 8 Rs1,00,000
9 10 1,00,000

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Advice : Leasing option is more preferable to the company as its discounted cash outflow is lower than that of borrowing option. Date : 17.08.1992 Yours faithfully Sd/Cost Accountant Illustration 23 A person wishing to take on lease office premises has given two options to the prospective landlord. The options are: Option I : Lease period 18 years. Initial non refundable deposit of Rs.2,00,000 A yearly rent of Rs.60,000 to be increased by 10% every 5th year of tenancy. Option II : A yearly rent of Rs.1,00,800 to be increased by 10% every 5th year of tenancy. Lease period 18 years. You are required to give your views on the two alternatives from the point of view of the tenant. The rate of interest to be taken as 18%. The present value of Re.1 payable at the end of each year at 18% starting from year 1 to year 18 are as follows:

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Solution Comparative statements showing two options

NOTES

Views from the point of view of tenant : Option I is preferred.

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Illustration 24 Beta Limited is considering the acquisition of a personal computer costing Rs. 50,000. The effective life of the computer is expected to be five years. The company plans to acquire the same either by borrowing Rs.50,000 from its bankers at 15% interest per annum or by lease. The company wishes to know the lease rentals to be paid annually which will match the loan option. The following further information is provided to you: a. The Principal mount of the loan will be paid in five annual equal installments b. Interest, lease rentals, principal repayment are to be paid on the last day of each year. c. The full cost of the computer will be written off over the effective life of computer on a straight line basis and the same will be allowed for tax purposes. d. The companys effective tax rate is 40% and the after tax cost of capital is 9%. e. The computer will be sold for Rs.1,700 at the end of the 5th year. The commission on such sales is 9% on the sale value and the same will be paid. You are requiredTo compute the annual lease rentals payable by Beta Limited which will result in indifference to the loan option. The relevant discount factors are as follows:

Solution Computation of present value of total after tax cash outflow under loan option 1. Annual loan instalment : 50,000 / 5 = Rs.10,000 2. Interest on loan

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NOTES

3. Annual depreciation on straight line basis : Rs. 50,000/5 = Rs.10,000 4. Inflow at the end of year 5 Sale value Less Commission at 9% Profit on Sale of Computer Less tax at 40% Net inflow 1,700 153 1,547 619 928

(WDV is zero)

5. Computation of net outflow under loan option

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Computation of Annual Lease rentals P.V. of outflow Rs.33,843 Present value factor for Annuity at 9% for 5 years = 3.89 Required Annual after tax outflow = 33,843 / 3.89 = Rs.8,700 (Note : This will result in indifference to the loan option i.e. both are equated) Annual Lease rental (before tax) = 8,700 / (1-0.4) = Rs.14,500 Annual Lease Rentals payable be Beta Ltd. Should be Rs. 14,500 equated to loan option i.e. indifference to loan option at

Note : Annual Lease rentals 14,500 Less : Tax saving at 40% on the above 5,800 Net outflow 8,700 9% after tax cost of capital Illustration 25

Elite Builders, a leading construction company, have been approached by a Foregin Embassy to build for them a block of six flats to be used as guest houses. As per the terms of contract the Foreign Embassy would provide Elite builders the plans and the land costing Rs.25 lakhs. Elite Builders would build the flats at their own cost and lease them out to the Foreign Embassy for 15 years at the end of which that flats will be transferred to the Foreign Embassy for a nominal value of Rs.8 lakhs Elite Builders estimates the cost of construction as follows: Area per flat 1,000 sq.ft. Construction Rs.400 per sq.ft. Registration and other costs 2.5% of cost of construction. Elite Builders will also incur Rs.4 lakhs each in year 14 and 15 towards repairs. Elite Builders proposes to charge the lease rentals as followz: Years 1 to 5 6 to 10 11 to 15 Rentals Normal 120% of Normal 150% of Normal

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Elite Builders present tax rate averages at 50%. The full cost of construction and registration will be written off over 15 years and will be allowed for tax purposes. You are required: To calculate the normal lease rental per annum per flat. For your exercise assume: a. Minimum desired return of 10%. b. Rentals and repairs will arise on the last day of the year c. Construction, registration and other costs will be incurred at time O. d. The relevant discount factors are:

NOTES

Note : Cumulative discount factors may be used. Solution Working Notes 1. Present value of cash out-flows Rs. a. Cost of construction 6 x 1000 x 400 = Registration & other costs at 2.5% Present value 24,60,000 x 1.00 =

24,00,000 60,000 24,60,000 24,60,000 4,00,000 2,00,000 2,00,000

b. Repairs cost at the end of 14th year : Less : Tax saving at 50%

Present value 2,00,000 x 0.26 =


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c.

Repairs cost at the end of 15th year : Less : Tax saving at 50% Present value 2,00,000 x 0.24 = Present value of cash outflow

4,00,000 2,00,000 2,00,000 48,000 25,60,000

Present value of cash inflows: a. Lease rentals : Let normal lease rental per annum for all 6 flats be L.

Total present value = 3.79L + 2.82 L + 2.19 L = Less : Tax of net cash inflow Present value of net cash inflow

8.80L 4.40L 4.40 L

b. Tax saving on cost of construction written off (similar to depreciation as cash inflow). Annual amount written of = 24,60,000 / 15 = 1,64,000 Tax savings at 50% 82,000 82,000 Present value for 15 years = 82,000 x 7.60 = c. Flats transferred to foreign embassy at a nominal Value of Rs.8 lakhs to the end of 15 years Nominal value Less : Tax at 50% Net cash inflow 6,23,200

8,00,000 4,00,000 4,00,000

Present value 4,00,000 x 0.24 = 96,000 Present value of total cash inflow (a+b+c) = 4.40 L + 7,19,200
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c.

Flats transferred to foreign embassy at a nominal Value of Rs.8 lakhs to the end of 15 years Nominal value 8,00,000 Less : Tax at 50% 4,00,000 Net cash inflow 4,00,000

NOTES

Present value 4,00,000 x 0.24 =

96,000

Present value of total cash inflow (a+b+c) = 4.40 L + 7,19,200

Solution Normal lease rentals : This is to be ascertained by equating the present value of cash inflows with present value of cash outflows as follows: 4.4 L + 7,19,200 = 25,60,000 4.4L = 25,60,000 7,19,200 = L = 18,40,800 / 4.4 = Rs.4,18,363.63 Normal Lease rental per flat per annuam = 4,18,363.63 / 6 = Rs.69,727.27 Illustration 26 Welsh limited is faced with a decision to purchase or acquire on lease a mini car. The cost of the mini car is Rs.1,26,965. It has a life of 5 years. The mini car can be obtained on lease by paying equal lease rentals annually. The leasing company desires a return of 10% on the gross value of the asset. Welsh Limited can also obtain 100% finance from its regular banking channel. The rate of interest will be 15% p.a. and the loan will be paid in five annual equal installments, inclusive of interest. The effective tax rate of the company is 40%. For the purpose of taxation it is to be assumed that the asset will be written off over a period of 5 years on a straight line basis.

18,40,800

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a. Advise Welsh Limited about the method acquiring the car. b. What should be the annual lease rental to be charged by the leasing company to match the loan option?

For your exercise use the following discount factors:

Solution Assumption

It is assumed that the loan installments is repaid at the end of the year. a. Computation of annual loan repayment installment = Loan amount 1,26,965 = Annuity factor of 15% 3.35

= Rs. 37,900

Calculation of interest in installment payments (Rs.)

Schedule of present value of cash outflow in debt financing (Rs.) Kd = 15% (1-40%) = 9% i.e. cost of capital is 9%. Hence, PV factor at 9% is taken into account.

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NOTES

Lease Rental = Cost of asset / Annuity Factor of 10% =Year 126965 / 3.79 = 33500 Instalment Interest Depreciation Tax
end payment It is assumed that lease rental is also paid at the end of the year. at 15% year Net cash out flow

Net

(126965 / 5) saving cash

outflow

Lease rental 33,500 less tax saving at 40% Rs.13,400 = Rs.20,100 after tax cash outflow. Present value of Rs.20,100 yearly for 5 years at 9% cost of capital 1 2 = 20,100 x 3,89 = Rs.78,189.

5 40% 6 (2-5) (3+4) 17,775 20,125 16,644 21,256 15,343 22,557 13,847 24,053 12,192 25,708

1 is lower 37,900 19,045 Advice : Present value of cash outflow under lease financing at Rs.78189. Hence, 25,393 2 37,900 16,216 25,393 the car should be acquired on lease basis. 3 37,900 12,964 25,393

b.

Let annual lease rental be L. Tax 40% After tax cost of lease rental = 0.60 L Present value = 0.60 L x 3.89 = 2.334 L 2.334L = 87527 L = 87527 / 2.334 = Rs.37500

4 5

37,900 37,900

9,224 5,086

25,393 25,393

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NOTES

Hence, annual lease rental should be Rs.37,500. This will match the loan option. Illustration 26 ABC Ltd is considering a proposal to acquire an equipment costing Rs.5,00,000. The expected effective life of the equipment is 5 years. The company has two options either to acquire it by obtaining a loan of Rs.5 lakhs at 12% interest per annum or by lease. The following additional information are available: 1) the principal amount of loan will be repaid in 5 equal yearly installments. 2) the full cost of the equipment will be written off over a period of 5 years on straight line basis and it is be assumed that such depreciation charge will be allowed for tax purpose. 3) The effective tax rate for the company is 40% and the after tax cost of capital is 10%. 4) The interest charge repayment of principal and the lease rentals are to be paid on the last day of each year. You are required to work out the amount of lease rental to be paid annually, which will match the loan option.

The discount factor at 10% is as follows: Solution Working Notes 1. Annual loan instalment = 5.00 lakhs / 5 years = Rs.1.00 lakh

2. Interest on loan : (Rs. lakhs) 3 Annual depreciation on straight line basis = Rs.5.00 lakhs / 5 years = 1.00 lakh
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Solution Statement of present value of cash outflow under loan option (Rs. lakhs)

NOTES

Computation of Annual lease Rental : P.V. of Cash outflow : 3.144 i.e. Rs.3,144,00. P.V. factor for Annuity at 10% for 5 years = 3.790 Required Annual after tax outflow = 3,14,400 / 3.79 = Rs.82,955 (Note : This will match the loan option i.e. both are equated). Annual lease rental (before tax) = 82,955 / 1-40% = Rs.1,38,258 Annual lease rental payable by ABC Ltd. should be Rs.1,38,258. Reconciliation: Rs. Annual lease rental 1,38,258 Less : tax saving at 40% on the above 55,303 Net cash outflow 82,955 Equated to loan option i.e. matching the loan option at 10% after tax cost of capital.

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Illustration 28 a i Beauty Ltd. has an excess cash of Rs.16,00,000 which is wants to invest in short term marketable securities. Expenses relating to investment will be Rs.40,000. The securities invested will have an annual yield of 8%. The company seeks your advice as to the period of investment so as to earn a pre tax income of 4%. ii. Also, find the minimum period for the company to break even its investment expenditure. Ignore time value of money. 6 + 2 = 8 = 8 a. ABC Finance Ltd. is a hire purchase and leasing company. It has been approached by a small business firm interested in acquiring a machine through leasing. The quoted price of the machine is Rs.5,00,000. 10% sale tax is extra. The lease will be for a primary lease period of 5 years. The finance company wants 8% post tax return on the outlay. Its effective Ix rate is 35%. The income tax rate of depreciation on the machine is 25%. (W.D.V.) Lease rents are payable in arrear at the end of each year. Calculate the annual rent to be charged by ABC Finance Ltd. a i. Investment must earn pre tax income of Rs.16,00,000 x 0.04 = Rs.64,000 Let N be the required period of investment so as to earn Rs.64,000 (I = P x N x R) 16,00,000 x N x 0.08 - 40,000 expenses = 64,000 1,28,000 N = 1,04,000 N = 1,04,000 / 1,28,000 = 0.8125 years i.e. 9.75 months ii The required minimum period to break even the investment expenditure will be: 16,00,000 x N x 0.08 40,000 =0 1,28,000 N = 40,000 N = 40,000 / 1,28,000 = 0.3125 i.e.3.75 months

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Determination of cash outflows (at t = 0) Rs. Cost of machine inclusive sale tax (10%) 5,50,000 Less : Tax saving on Depreciation (Tax shield Relief) (WN-1) (1,22,284) P/V of cash outflows for purchase 4,27,716 Calculation of leasing rent Let the required lease rent per year be, R So, the post tax rental income p.a. (1-0.35) = 0.65R P.V. of 5 years post tax rental income = 0.65 x 3.993 This sum should be equal to Rs.4,27,716 0.65 R x 3.993 = 4,27,716 or R = 4,27,716 / 2.59545 = 1,64,795 The annual rent to be charged by ABC Finance Ltd is rs.1,64,795

NOTES

Working Note I Computation of Tax saving on depreciation of the machine

Illustration 29 Hypothetical Ltd is planning to have an access to a machine for a period of 5 years. The company can either have an access through the leasing arrangement or it can borrow money at 14% to buy the machine. The company is in 50% tax bracket. In case of leasing, the company will be required to pay annual year end lease rent of Rs.1,20,000 for 5 years. All maintenance, insurance and other costs are to be borne by the lessee.

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In case of purchasing the machine (which costs Rs.3,43,300), the company would have to repay 14% five year loan in 5 equal annual installments each instalments becoming due at the end of each year. Machine would be depreciated on a straight line basis, with no salvage value. Advise the company which option it should go for, assuming lease rents are paid at the end of the year. Solution Borrowed fund costs 14% per annum and after 14% x 50% = 7%. Hence, discounting rate to be applied on is 7%. 1st option : Lease rent of Rs.1,20,000 Less : tax saving at 50% 60,000 per Net cash outflow = 60,000 per annuam Present value of cash outflow at 7% for 5 years: 60,000 x 4.1002 = Rs.2,46,012 2nd Option: Cash outflow under Buying / Borrowing alternative Present value of Net cash outflow Advice :

per annum

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Present value of Net cash outflow

NOTES

Advice : The company should purchase the machine by borrowing because its present value of net cash outflow Rs.2,02,541 will be lower as compared to that of leasing. Note : 1. Maintenance, insurance and other costs: Applicable to both the alternatives i.e. to be borne by Hypothetical Ltd.Hence, it is not taken into account in the above calculations. It is not relevant for decision making. 2. Depreciation : 3,43,300/5 = Rs.68,660 yearly depreciation. Tax advantage on depreciation = 50% of 68,660 = Rs.34,330 Illustration 30 Diligent Ltd. is considering the lease of an equipment which has a purchase price of Rs.3,50,000. The equipment has an estimated economic life of 5 years with a salvage value zero. As per the income Tax rules, a written down depreciation @ 25% is allowed. The lease rentals per year are Rs.1,20,000. Assume that the company is 16% should the company lease the equipment? Note : Present value of Re.1 for 5 years are:

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Solution Working Notes 1. The effective rate of interest is 16% (1 tax rate 50%) = 8%. Hence, P.V. factor at 8% has been taken into account. 2. Calculation of Depreciation:

3. Borrowing of Rs.3,50,000 repayable within 5 years (assumed) Interest at 16% Rs.

Year 1 : 3.50 lakhs x 16% Year 2: 2.80 lakhs x 16% Year 3 : 2.10 lakhs x 16% Year 5: 0.70 lakhs x 16%

56,000 44,800 33,600 11,200

Year 4 : 1.40 lakhs x 16% 22,400

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Solution Option to borrow funds (Rs.)

NOTES

Leasing Option Lease rental per year Less tax saving at 50% Net cash outflow 1,20,000 60,000 60,000 per year for 5 years

P.V. of net cash outflow for 5 years at 8% = 60,000 x 3.9926 = Rs.2,39,556. Advice: The company should not lease the equipment. It should borrow Rs. 3,50,000 and buy the equipment because its present value of cash outflows is lower than that of lease option. Illustration 31 Agrani Ltd. is in the business of manufacturing bearing. Some more product lines are being planned to be added to the existing system. The machinery required may be bought or may be taken on lease. The cost of machine is Rs.40,00,000 having a useful life of 5 years with the salvage value of Rs.8,00,000. The full purchase value of machine can be financed by 20% loan repayable in five equal instalments falling due at the end of each year. Alternatively, the machine can be procured on a 5 years lease, year- end lease rentals being Rs.12,00,000 per annum. The company follows the written down value method of depreciation at the rate of 25%. Companys tax rate is 35 per cent and cost of capital is 16 per cent.

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I. Advise the company which option is should choose lease or borrow. II. Assess the proposal from the lessors point of view examining whether leasing the machine is financially viable at 14% cost of capital (Detailed working notes should be given. Calculations can be rounded off to Rs. lakhs).

Solution

i. P.V. of Cash outflow under lease option Year Lease Rental after tax 1-5 12,00,000 (I-T) 12,00,000 (1-35%) = 7,80,000 Total P.V. of outflow Annuity factor @ 13% [20% - (1-35%)] 3.5172 7,80,000 x 3,5172 = Rs.27,43,416

Cash outflow under borrowing option 5 equal instalments : Annuity factor at 20% for 5 years = 2.991 Rs.40,00,000 / 2.991 = 13,37,345
Year Loan installments 1 2 3 4 5 13,37,345 13,37,345 13,37,345 13,37,345 13,37,345 Tax advantage On interest (WN3) 2,80,000 2,48,386 1,97,249 1,43,085 78,087 3,50,000 2,62,500 1,96,875 1,47,656 1,10,742 7,07,345 8,26,459 9,43,221 10,46,604 11,48,516 .885 .783 .693 .613 .543 6,26,000 6,47,117 6,53,652 6,41,568 6,23,644 On Depreciation Net cash outflow PVIF 13% Total PV (Rs.)

Total P.V. 31,91,981

Total PV Less : PV Salvage value adjusted for Tax savings on Loss of sale of machiney (Rs.8,00,000 x .543 = Rs.4,34,400) + (Rs.28,359)

31,91,981 4,62,759

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(See working Note on Depreciation) 9,49,219 8,00,000 = 1,49,219 x .35 x .543 = 28,359 Total Present value of cash outflow

NOTES
27,29,222

Decision : PV of cash outflow of lease option higher than borrow option and hence borrow option is recommended. Working notes 1. Loan and interest Payments

2. Tax Advantage On interest 8,00,000 x 35% = 2,80,000 and so on On Depn. : 10,00,000 x 35% = 3,50,000 and so on ii. Proposal from the view point of Lessor Lessor cash flow
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Total PV = Add : tax Saving on sale of Asset Total PV of cash inflow Cost of Machine

34,54,168 27,106 34,81,274

(1,49,219 x 35% x 0.519 = 27,106) + salvage P.V. 8,00,000 x 0.519 = 4,15,200 = 38,96,474 40,00,000 NPV (-) 1,03,526

Decision : Lease rate is not financially viable Hence, it is recommended to increase the lease rental atleast by Rs.50,00 per annum Illustration 32 Armada Leasing Company is considering a proposal to lease out a school bus. The bus can be purchased for Rs.5,00,000 and, in turn be leased out at Rs.1,25,000 per year for 8 year with payments occurring at the end of each year: I. Estimate the internal rate of return for the company assuming tax is ignored. II. What should be the yearly lease payment charged by the company in order to earn 20 per cent compounded rate of return before expenses and taxes? III. Calculate the annual lease rent to be charged so as to amount to 20% after tax annual compound rate of return, based on the following assumptions

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a.. b. c. d. Solution

Tax rate is 40% Straight line depreciation, Annual expenses of Rs.50,000 and Resale value Rs,1,00,000 after the term

NOTES

i. Payback period = 5,00,000 / 1,25,000 = 4 years Annuity factor close to 4 in 8 years is 4,0776 at 18% At 19% it is 3,9544. Hence, IRR lies between 18% and 19% Correct IRR can be ascertained by way of interpolation as follows: 4.0776 - 4.00 18% + = 18.63% 4.0776 3.9544 ii. Annual Lease rent to be charged by the company Lease rent = Investment / Annuity factor for 8 years at 20% 5,00,000 / 3,8372 = Rs.1,30,303.35 per annum Annual Lease rent to be charged: Depreciation = 5 lakhs - one lakhs resale value 8 years = Rs.50,000 Annual expenses = 50,000. total Rs.1,00,000 LR = Lease Rent. Annuity factor [LR 1,00,000) (1-40%) + 50,000 Depn.[ + (1,00,000 x 0.23257) = Investment 1.8372 (0.6 LR 60,000 + 50,000) + 23,257 = 5,00,000 2.32032 LR 2,30,232 + 1,91,860 + 23,257 = 5,00,000 2.30232 LR= 5,00,000 + 15,115 LR = 5,15,115/2.30232 = Rs.2,23,737.36 pe annum

iii.

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Reconciliation Annual Lease Rent 2,23,737.36 Less : Depn & Expenses 1,00,000.00 PBT 1,23,737.36 Less : Tax 40% 49,494.94 PAT 74,242.42 Add : Depn. 50,000.00 Annual cash inflow i.e. CFAT 1,24,242.42 For 8 years at 20% = 1,24,242.42 x 3.8732 Add P.V. of Resale value 1,00,000 x 0.23257 Total P.V. of cash inflow

= = =

4,76,743 23,257 5,00,000

Less investment 5,00,000 NPV = nil IRR is 20% i.e. 20% after tax annual compounded rate of return. 2.20. SUMMARY

A lease transaction is a commercial arrangement whereby an equipment owner or manufacturer conveys to the equipment user the right to use the equipment in return for a rental. In other words, lease is a contract between the owner of an asset (the lessor) and its user (the lessee) for the right to use the asset during a specified period in return for a mutually agreed periodic payment (the lease rentals). The purchase of the asset bestows the ownership rights and also responsibility of all consequential gains and losses. Further, the owner has to bear the maintenance cost also. Lease involves the use of an asset without assuming ownership. The owner of the asset is called Lessor and lessor under leasing arrangement retains ownership. Lessee, a firm or person acquiring an asset, has to pay rental (or otherwise called lease money) to the lessor. Lease financing is one of the methods of long term financing. Leasing contract stipulates the lease period rental payments, periodic intervals of payments repairs and maintenance, purchase option, taxes, insurance, risk of obsolescence, penalty for delay or non payment of rental etc. Based on variations, the following classifications have been developed: a veraged leasing: the lessee, the Lessor (equity investor) and the lender

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a. Operating and Finance Lease : Operating lease refers to a non payout lease in which lessors obligations may include services attached to his leased property such as maintenance, repair and technical advice. Finance lease may be defined as a lease that transfer all the risk and rewards incidental to the ownership of the asset b. Sale and Leaseback and Direct Lease : In a sale and leaseback transacting the owner of equipment sells it to a leasing company which in turn leases it back to the erstwhile owner (the lessee). The leaseback arrangement in this transaction can be in the form of a finance lease of an operating lease c. Single Investor Lease and Leveraged Lease : In a single investor lease the leasing company (lessor) funds the entire investment by raising an appropriate mix of debt and equity. The important point to be noted is that the debt funds raised by the leasing company are without recourse to the lessor. Put differently, the lender cannot demand payment from the lessee in the event of the leasing company defaulting on its debt-servicing obligations. d. Leveraged leasing is linked with the financing of asset which requires large capital outlay. There are three parties involved in leveraged leasing: the lessee, the Lessor (equity investor) and the lender e. Domestic Lease Vs. International Lease : A lease transaction is classified as a domestic lease if all parties to the transaction the equipment supplier, the lessor and the lessee - are domiciled in the same country, On the other hand, if these parties are domiciled in different countries, the transaction is classified as an international lease transaction. The Advantages of Lease are : a firm with limited funds can make better use of working capital, in case of lease the risk of obsolescence can be shifted to the lessor, leasing is more flexible than ownership, incase of assets of technological improvements, leasing on a short term basis is more desirable than acquisition of such assets. It is an insurance against out of data technology, leasing offers tax benefits also lease rent is tax deductible, leasing avoids much outlay for down payments. In some cases, it offers 100% financing without any down payment. Disadvantages of Lease are : The main drawback of lease is that ownership remains vested with lessor., long term leasing is generally more expensive to the lessee, during the period of inflation the real estate values may increase during the lease period. In such case, the benefit of capital gain will be enjoyed by the lessor, the lessee losses the advantages of such appreciation in the value of asset, problems
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may arise if the lessee decides to alter the physical shape of the asset, the interest cost on leasing is usually higher than the interest on debt Methods for evaluating a leasing proposal : The three methods for evaluating a leasing proposal are Present value Analysis method, I.R.R. method and Bower Herringer Williamson (BHW) Method. TEST YOUR KNOWLEDGE 2.21. SHORT QUESTIONS 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. Mention the salient features of leasing What is the different forms of leasing? What are the differences between hire purchase and leasing? What are the differences between operating and financial leasing? What do you mean by Bipartite Lease and Tripartite Lease? What do you mean by Leveraged leasing? Differences between Financial Lease and Direct Purchase Mention the methods for evaluating a leasing proposal Give the Decision criteria used by BHW Method Mention the Income tax provisions and Sales Tax Provisions relating to Leasing

2.22. LONG QUESTIONS 1. 2. 3. 4. Elaborate on the advantages and disadvantages of leasing. Clearly explain how accounting is shown in the books of the lessor and lessee. Explain the various methods of leasing with advantages and disadvantages. Zeta Financial Services Ltd. (ZFSL) Offers finance to individuals to purchase four wheelers on the following terms: Deposit of 20% of the cost of the asset should be made at the inception of the transaction. 48 EMIs have to be made each at the beginning of every month. Front end service charge of 2% should be made.

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Deposit carrying an interest of 12% p.a. compounded monthly would be repaid at the end of 48 months.

NOTES

You are required to: a. Calculate the maximum monthly payments to be made by a borrower if his opportunity cost of funds is 18% p.a. and cost of the asset is Rs.4 lakh. b Calculate the effective interest rate on the completed transaction if the borrower would like to make to prepayment at the end end of 36 months after paying 36 installments. Deposit would be repaid at the end of 36 months. The company offers an interest rebate calculated in accordance with the Rule of 78 Method. Assume the EMIs as obtained in (a) above. 5 Brick well construction Limited has proposed to acquire a machinery costing Rs.100 crore. The equipment has a life of 7 years. The tax relevant rate of depreciation is 25%. The target debt equity ratio is 2:1. The cost of debt and equity are 15% and 18% respectively.

Alternatively, the company can lease the equipment or take it on hire. It had approached vibrant Financial Services which offers both lease and hire purchase to corporates. The lease terms are as follows: Lease rentals during primary 32 ptpm payable monthly in Lease period of 4 years advance Lease rentals during secondary 2 ptpq payable yearly in advance Period of 3 years The hire terms of the company are as follows: Flat rate of interest 13% Structure Payable monthly in advance Hire period 4 years The marginal tax rate of BCL is 30%. BCL follows SOYD method of interest allocation. The planning horizon is 4 years. Assume negligible salvage value at the end of 4 years.

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You are required to a Choose the best alternative between lease and hire purchase from BCL point of view Choose the best alternative between purchase and the alternative obtained in (a) above

1. Fair Finance Ltd (FFL) offers the following finance scheme to its customers Amount (Rs.) Repayment Period (Mths) Equated Monthly Instalment (Payable at the beginning of every month) Down payment 4,00,000 48 (Rs.) 9,250 25%

The company levies a service fee of Rs.2,000 and offers a prompt payment bonus of Rs.8 per Rs.10,000 per month on expiry of the repayment period. After paying 36 installments (at the end of 3 years) one of the borrower opts for an early settlement. The company allows the prompt payments bonus in respect of the installment paid and offers an interest rebate in accordance with the Rule of 78 method. You are required to calculate the effective rate of interest on the completed transaction The following information relates to the loans and advances, hire purchase receivables and lease assets of A to Z Finance Ltd., a non banking finance company. Loans and Advances

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Loans and advances extended during the year amount to Rs.30 lakh, which remained as a standard asset. Of the sub standard assets, Rs.5 lakh became doubtful while Rs.10 lakh worth of assets were upgraded. Out of the doubtful assets, Rs.3 lakh were upgraded. The entire amount of outstanding doubtful debts is fully secured. Hire purchase Assets (Rs. lakhs)

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Net book value of HP and Lease Assets

(Rs. lakhs)

In the 12-24 months category of HP assets and 24-36 months category of lease assets, amount of Rs.5 lakhs and Rs.3 lakhs respectively are outstanding for more than 12 months Required Calculate the provisions to be made by the company on the above assets.

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UNIT - III

NOTES

VENTURE CAPITAL
3.1. INTRODUCTION The composer of the term venture capital is unknown, and there is no standard definition of it. It is, however, generally agreed that the traditional venture-capital era began in earnest in 1946, when General Georges Doriot, Ralph Flanders, Karl Compton, Merrill Griswold and others organized American Research & Development (AR&D), the first (and, after it went public, for many years the only) public corporation specializing in investing in illiquid securities of early stage issuers. 3.2. LEARNING OBJECTIVES After going through this chapter, the reader is expected to : Know the meaning and features of venture capital Know the origin and growth of venture capital Know the key factors considered for appraisal Understand the meaning of buy outs and buy in Know how financial analysis is made Know the Regulation and Recommendations of SEBI with respect of Venture capital

3.3 MEANING AND DEFINTION Venture capital is a type of private equity capital typically provided by professional, outside investors to new, growth businesses. Generally made as cash in exchange for shares in the invested company, venture capital investments are usually high risk, but offer

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the potential for above-average returns. A venture capitalist (VC) is a person who makes such investments. A venture capital fund is a pooled investment vehicle (often a limited partnership) that primarily invests the financial capital of third-party investors in enterprises that are too risky for the standard capital markets or bank loans. Venture capital can also include managerial and technical expertise. Most venture capital comes from a group of wealthy investors, investment banks and other financial institutions that pool such investments or partnerships. This form of raising capital is popular among new companies, or ventures, with limited operating history, who cannot raise funds through a debt issue. The downside for entrepreneurs is that venture capitalists usually get a say in company decisions, in addition to a portion of the equity. Professionally managed venture capital firms generally are private partnerships or closely-held corporations funded by private and public pension funds, endowment funds, foundations, corporations, wealthy individuals, foreign investors, and the venture capitalists themselves. Broadly defined, Venture Capital (VC) is funds invested or available for investment in potentially highly profitable enterprises at considerable risk of loss. Venture capital is often used interchangeably with other terms such as risk capital, patient capital or equity financing. Venture Capital is An Investment in a Start-up business that is perceived to have excellent growth prospects but does not have access to Capital markets. Venture capital is money provided by professionals who invest alongside management in young, rapidly growing companies that have the potential to develop into significant economic contributors. Venture capital is an important source of equity for startup companies. Venture Capitalists are companies or individuals who provide investment capital, management expertise and experience. In return for their investment, Venture Capitalists will take an equity position in the company, usually in proportion to the amount of their investment and the level of risk involved. The future return on their investment is tied to the performance of your company.
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3.4. WHAT DOES A VENTURE CAPITALIST OFFER ? A VC investment is typically longer term (4 to 7 years) and will often take your company through more than one business cycle. Unlike more common debt instruments (i.e. chartered bank loans), the equity position in the company usually does not require regular payment. Instead venture capitalists will look for a capital gain and an increase in the value of their shares. This means the company has cash flow available for growth. This infusion of equity can create tremendous benefits for your company such as allowing for expenditure on capital equipment, providing working capital, or assisting growth strategies. The future sale of a company, its going public, or other forms of appreciation in stock value will give the Venture Capitalist the needed return on investment. This return depends on the success of the company in which they invest. Thus, companys future and the Venture Capitalists future are integrally linked. In many ways a venture financier is a partner, not a lender. Your success is their goal. As an investor-partner, the Venture Capitalist will take part in the management of the r company, whether through its Board of Directors participation (standard) or providing management input on a regular basis (optional and negotiated). The Venture Capitalist will likely take an active role in helping your company grow, providing the most favorable environment for success and minimizing risk to his/her investment. 3.5. FEATURES There are three criteria which differentiate VCs from the conventional secured lenders such as banks: The Venture Capitalist is secured by way of (common) equity or quasi-equity (the right to convert other debt instruments to common equity) investment in the company The investment is long term, typically 4 to 7 years There is active involvement in the business by the Venture Capital company

NOTES

Venture capitalists generally: Finance new and rapidly growing companies,


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Purchase equity securities, Assist in the development of new products or services, Add value to the company through active participation, Take higher risks with the expectation of higher rewards, and Have a long-term orientation.

3.6. BENEFITS OF VENTURE CAPITAL Common desire for success A partner and not a lender Active board of directors participation Experience Contacts Discipline Credibility Does not require regular payments

3.7. DRAWBACKS OF VENTURE CAPITAL While venture capital can be a tremendous boon to a tiny fraction of the companies pursuing it, in the vast majority of cases it presents the entrepreneur with a Faustian Bargain. Venture capital brings with it tremendous meddling and pressure from venture capitalists who in this day and age typically lack both the operating and industry depth of their predecessors. The effect of this on fledgling ventures is loss of control by the entrepreneur which then frequently leads to badand sometimes fatalbusiness decisions being made. 1. The decision to chase venture capital is often a tempting distraction from the much more complex and important entrepreneurial tasks of creating something to sell and persuading someone to buy it. The pursuit of venture capital is sometimes a means by which to postpone the day of reckoning when the marketplace finally decides if the idea will fly. 2. Venture capitalists behave like sheep investing only in whatever industry happens to be the flavor of the month. Everyone else need not apply. 3. Rookie entrepreneurs talking to venture capitalists expose their ideas to increased risk because they cannot distinguish between genuine interest and mere brainsucking to uncover corporate secrets.
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4. Once negotiations begin venture capitalists will typically stall in order to push cash short companies to the brink of bankruptcy as a way of extracting additional equity and concessions at the last moment. 5. Terms demanded by greedy venture capitalists frequently work to erode and ultimately destroy the founding teams motivation and commitment to building a successful company. 6. With the first dollar of venture capital accepted the entrepreneurs control slips away to MBA wonder-boys with only the shallowest of operating experience. 7. As soon as venture capitalists become involved the founders role shifts from critical company building functions to preparing reports, attending endless meetings, writing memos, and hand-holding impatient and/or meddlesome investors. 8. An infusion of capital often shifts the founding teams focus away from selling to spending money in an effort to placate venture capitalists who often confuse bulkingup staff and assets with real growth. 9. Venture capital brings with it tremendous pressure to create a liquidity event but this frequently results in bad decisions being made to launch products too early or enter into the wrong markets. 10. The venture capitalists knee-jerk response to every problem faced by a portfolio company is to fire the founders and evade any personal responsibility for bad decisions. It is by far the most expensive money an entrepreneur can ever tap into. Lets do the math to see why this is. Suppose you and a venture capitalist agree to a pre-money valuation of Rs.1 million for your start-up, and the venture capitalist then invests Rs.1 million for 50% of the equity. After the investment, the company is said to have a postmoney valuation of Rs. 2 million. Being 50/50 partners sounds acceptable, right? Three years later the company is sold to a Fortune 500 corporation for Rs.5 million. Do you and the venture capitalist each get Rs.2.5 million from the proceeds? Not so. The venture capitalist will have a so-called liquidation preference built into the original investment agreement which allows him to first take out 2 to 5 (or more) times his principal before anyone else sees a penny. So, lets say that in this example he takes out Rs.3 million (i.e., a 3X liquidation preference), plus any accrued dividends on his preferred stock. After exercising the liquidation preference and cashing in his dividends only Rs.1 million is left. You, the founder, and your team, will then split this remaining money on a 50/50 basis with the venture capitalist.
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This is a simplified example of what happens. In real life the founder and her team would probably receive far less than even the Rs.500,000 due to all the fine print clauses. At this point, you really have to ask yourself if its even worth the effort. The good news is that there is a wealth of academic research to support the contention that anyone wishing to build a company for the long term will be better off by not utilizing venture capital. As a result savvy entrepreneurs devise startup strategies that allow them to focus on generating cash flow during the first year instead of chasing venture capital. Conversely, naive entrepreneurial wanna-bees, such as those we observed in the recent dotcom era, have a philosophy which can be summed up as, Give me X million rupees or this idea is dead!. If a parsons entrepreneurial goal is a company built to last its usually best to forgo venture capital. On the other hand, if companys goal is a company built to flip for a fast buck we should use venture capital if it is available to us. Venture capitalists mitigate the risk of investing by developing a portfolio of young companies in a single venture fund. Many times they co-invest with other professional venture capital firms. In addition, many venture partnerships manage multiple funds simultaneously. For decades, venture capitalists have nurtured the growth of Americas high technology and entrepreneurial communities resulting in significant job creation, economic growth and international competitiveness. Companies such as Digital Equipment Corporation, Apple, Federal Express, Compaq, Sun Microsystems, Intel, Microsoft and Genentech are famous examples of companies that received venture capital early in their development. [Source: National Venture Capital Association 1999 Yearbook]. 3.8. CATEGORIZATION OF VC INVESTORS Incubators Angel Investors Venture Capitalists (VCs) Private Equity Player

3.8.1. Incubators An incubator is a hardcore technocrat who works with an entrepreneur to develop a business idea, and prepares a Company for subsequent rounds of growth & funding. eVentures, Infinity are examples of incubators in India.
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Angel Investors: An angel is an experienced industry-bred individual with high net worth. Typically, an angel investor would: invest only his chosen field of technology take active participation in day-to-day running of the Company invest small sums in the range of USD 1 - 3 million not insist on detailed business plans sanction the investment in up to a month help company for second round of funding

NOTES

The IndUS Entrepreneurs (TiE) is a classic group of angels like: Vinod Dham, Sailesh Mehta, Kanwal Rekhi, Prabhu Goel, Suhas Patil, Prakash Agarwal, K.B. Chandrashekhar. In India there is a lack of home grown angels except a few like Saurabh Srivastava & Atul Choksey (ex-Asian Paints). Venture Capitalists (VCs):VCs are organizations raising funds from numerous investors & hiring experienced professional mangers to deploy the same. They typically: Invest at second stage Invest over a spectrum over industry/ies Have hand-holding mentor approach Insist on detailed business plans Invest into proven ideas/businesses Provide brand value to investee

3.8.2. Private Equity Players: They are established investment bankers. Typically: Invest into proven/established businesses Have financial partners approach

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3.9. ORIGIN AND GROWTH OF VENTURE CAPITAL The earliest origins of venture capital can be traced back to the medieval Islamic mudaraba partnership. In terms of protecting the entrepreneur, sharing the risks, losses and profits the two systems of finance are remarkably similar. General Georges Doriot is considered to be the father of the modern venture capital industry. In 1946, Doriot co-founded American Research and Development Corporation (AR&DC) with Ralph Flanders, Karl Compton and others, the biggest success of which was Digital Equipment Corporation. When Digital Equipment went public in 1968 it provided AR&DC with 101% annualized Return on Investment (ROI). AR&DCs $70,000 USD investment in Digital Corporation in 1957 grew in value to $355 million USD. It is commonly accepted that the first venture-backed startup is Fairchild Semiconductor, funded in 1959 by Venrock Associates. Venture capital investments, before World War II, were primarily the sphere of influence of wealthy individuals and families. One of the first steps toward a professionally-managed venture capital industry was the passage of the Small Business Investment Act of 1958. The 1958 Act officially allowed the U.S. Small Business Administration (SBA) to license private Small Business Investment Companies (SBICs) to help the financing and management of the small entrepreneurial businesses in the United States. Passage of the Act addressed concerns raised in a Federal Reserve Board report to Congress that concluded that a major gap existed in the capital markets for long-term funding for growth-oriented small businesses. Facilitating the flow of capital through the economy up to the pioneering small concerns in order to stimulate the U.S. economy was and still is the main goal of the SBIC program today. Generally, venture capital is closely associated with technologically innovative ventures and mostly in the United States. Due to structural restrictions imposed on American banks in the 1930s there was no private merchant banking industry in the United States, a situation that was quite exceptional in developed nations.

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As late as the 1980s Lester Thurow, a noted economist, decried the inability of the USAs financial regulation framework to support any merchant bank other than one that is run by the United States Congress in the form of federally funded projects. These, he argued, were massive in scale, but also politically motivated, too focused on defense, housing and such specialized technologies as space exploration, agriculture, and aerospace. US investment banks were confined to handling large M&A transactions, the issue of equity and debt securities, and, often, the breakup of industrial concerns to access their pension fund surplus or sell off infrastructural capital for big gains. Not only was the lax regulation of this situation very heavily criticized at the time, this industrial policy differed from that of other industrialized rivalsnotably Germany and Japanwhich at that time were gaining ground in automotive and consumer electronics markets globally. However, those nations were also becoming somewhat more dependent on central bank and elite academic judgment, rather than the more diffuse way that priorities were set by government and private investors in the United States. SLOW GROWTH IN 1960S & EARLY 1970S, AND THE FIRST BOOM YEAR IN 1978 During the 1960s and 1970s, venture capital firms focused their investment activity primarily on starting and expanding companies. More often than not, these companies were exploiting breakthroughs in electronic, medical or data-processing technology. As a result, venture capital came to be almost synonymous with technology finance. Venture capital firms suffered a temporary downturn in 1974, when the stock market crashed and investors were naturally wary of this new kind of investment fund. 1978 was the first big year for venture capital. The industry raised approximately $750,000 in 1978. HIGHS & LOWS OF THE 1980S In 1978, the US Labor Department reinterpreted ERISA legislation and thus enabled this major pool of pension fund money to invest in alternative assets classes such as venture capital firms.[1]Venture capital financing took off. 1983 was the boom year the stock market went through the roof and there were over 100 initial public offerings for the first time in U.S. history. That year was also the year that many of todays largest and most prominent VC firms were founded.

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Due to the excess of IPOs and the inexperience of many venture capital fund managers, VC returns were very low through the 1980s. VC firms retrenched, working hard to make their portfolio companies successful. The work paid off and returns began climbing back up. THE DOT COM BOOM The late 1990s were a boom time for the globally-renowned VC firms on Sand Hill Road in the San Francisco Bay Area. A number of large IPOs had taken place, and access to friends and family shares was becoming a major determiner of who would benefit from any such IPO; Common investors would have had no chance to invest at the strike price in this stage. The NASDAQ crash and technology slump that started in March 2000 shook some VC funds significantly by the resulting disastrous losses from overvalued and nonperforming startups. By 2003 many firms were forced to write off companies they had funded just a few years earlier, and many funds were found under water; (the market value of their portfolio companies were less than the invested value) Venture capital investors sought to reduce the large commitments they had made to venture capital funds. By mid2003, the venture capital industry would shrivel to about half its 2001 capacity. Nevertheless, PricewaterhouseCoopers MoneyTree Survey shows that total venture capital investments hold steady at 2003 levels through the second quarter of 2005. The revival of an Internetdriven environment (thanks to deals such as eBays purchase of Skype, the News Corporations purchase of MySpace.com, and the very successful Google.com and Salesforce.com IPOs) have helped to revive the VC environment. The different stages are depicted in the table below:

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3.10. SEED CAPITAL AND STARTUP FINANCING A seed round, sometimes known as a friends and family round, is a securities offering whereby one or more parties that have some connection to a new enterprise invest the funds necessary to start the business. Seed money refers to the money so invested Seed financing is an investment made very early in the development cycle of the business. Typically, little more than a prototype of the product exists at this stage and additional product and market development work remains. Seed financing is provided to foster a concept, develop the initial product or service and carry out the associated marketing. The companies are usually very young (around one year) and have not produced a product or service for commercial sale. The assembly of the key management team is in progress or has just taken place.
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This initial amount is usually quite small because the venture is still in the idea or conceptual stage. Also, theres a high risk that the venture will fail. Seed capital is typically used to pay for such preliminary operations as market research and product development. Investors are often the business founders themselves, using savings, mortgage money, or funds borrowed from family and friends. They may also be outside angel investors, venture capitalists or accredited investors who are acquainted in some way with the founders. Seed capital is not necessarily a large amount of money. Seed capital can be distinguished from venture capital in that venture capital investment tends to involve significantly more money, an arms length transaction, and much greater complexity in the contracts and corporate structure that accompany the investment. Seed capital may come from financial bootstrapping rather than an offering. Bootstrapping in this context means making use of the cash flow of an existing enterprise Startup financing: Start-ups relate to those firms exhibiting few, if any, commercial sales but in which product development and market research are complete. Management is in place and the firm has a business plan. The venture at this point has at least one principal working full time. The search is on for the other key management team members and work is being done on testing and finalizing the prototype for production. 3.11. KEY FACTORS FOR CONSIDERATION FOR APPRAISAL 1. Management: The entire structure of a VC deal depends on the strength of the management and its expertise. Your key people should have experience in the fundamentals of your business and the ability to deal with change and growth. A capable, committed and well-rounded management team brings significant credibility to the company. Never assume the Venture Capitalists will back you because the technology is fantastic, or your product is doing well this can change. 2. Potential for capital gain: The Venture Capitalist needs an above-average rate of return. Most firms would like to see a rate of return in the 30-40% range, depending on the business cycle. The earlier you are
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in the business cycle, the higher the rate of return the Venture Capitalist will need to compensate for the increased risk of investing in a new company. While these rates may seem high, the Venture Capitalist is risking a lot by investing in your business. You might do very well (going public and generating a high rate of return) or you might stagnate, forcing the VC firm to liquidate its position and take a loss. 3. Realistic Financial Requirements and Projections: The Venture Capitalist will probably adopt a very conservative view of your company, so be realistic in your financial assumptions. Emphasize your total financial requirements for this specific stage of growth. By demonstrating a realistic sense of your financial state and your financial requirements, you will be demonstrating your ability to plan properly. 4. Owners Financial Stake: One of the most important indicators of managements commitment to the venture are the financial resources you and the other owners have committed to the company. This includes financing from the friends, contacts, and families of the principals. If the Venture Capitalist is going to commit resources to your company they must be sure that the owner(s) is/are committed. This financial commitment is a strong indicator of your desire to see the business succeed. 3.12. MANGEMENT OF BUY-OUTS A management buyout (MBO) is a form of acquisition where a companys existing managers acquire a large part or all of the company. Management buyouts are similar in all major legal aspects to any other acquisition of a company. The particular nature of the MBO lies in the position of the buyers as managers of the company, and the practical consequences that follow from that. In particular, the due diligence process is likely to be limited as the buyers already have full knowledge of the company available to them. The seller is also unlikely to give any but the most basic warranties to the management, on the basis that the management know more about the company than the sellers do and therefore the sellers should not have to warrant the state of the company.

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In many cases the company will already be a private company, but if it is public then the management will take it private. Some concerns about management buyouts are that the asymmetric information possessed by management may offer them unfair advantage relative to current owners. The impending possibility of an MBO may lead to principal-agent problems, moral hazard, and perhaps even the subtle downward manipulation of the stock price prior to sale via adverse information disclosure - including accelerated and aggressive loss recognition, public launching of questionable projects and adverse earning surprises. Naturally, such corporate governance concerns also exist whenever current senior management is able to benefit personally from the sale of their company or its assets. This would include, for example, large parting bonuses for CEOs after a takeover or management buyout. Since corporate valuation is often subject to considerable uncertainty and ambiguity, and since it can be heavily influenced by asymmetric or inside information, some question the validity of MBOs and consider them to potentially represent a form of insider trading. The mere possibility of an MBO or a substantial parting bonus on sale may create perverse incentives that can reduce the efficiency of a wide range of firms - even if they remain as public companies. This represents a substantial potential negative externality . 3.13. THE PURPOSE OF AN MBO The purpose of such a buyout from the managers point of view may be to save their jobs, either if the business has been scheduled for closure or if an outside purchaser would bring in its own management team. They may also want to maximize the financial benefits they receive from the success they bring to the company by taking the profits for themselves. This is often a way to ward off aggressive buyers. 3.14. FINANCING A MANAGEMENT BUYOUT Debt Financing The management of a company will not usually have the money available to buy the company outright themselves. They would first seek to borrow from a bank, provided the

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bank was willing to accept the risk. Management buyouts are frequently seen as too risky for a bank to finance the purchase through a loan. Private Equity Financing If a bank is unwilling to lend, the management will commonly look to private equity investors to fund the majority of buyout. A high proportion of management buyouts are financed in this way. The private equity investors will invest money in return for a proportion of the shares in the company, though they may also grant a loan to the management. The exact financial structuring will depend on the backers desire to balance the risk with its return, with debt being less risky but less profitable than capital investment. Although the management may not have resources to buy the company, private equity houses will require that the managers each make as large an investment as they can afford in order to ensure that the management are locked in by an overwhelming vested interest in the success of the company. It is common for the management to re-mortgage their houses in order to acquire a small percentage of the company. Private equity backers are likely to have somewhat different goals to the management. They generally aim to maximise their return and make an exit after 3-5 years while minimising risk to themselves, whereas the management rarely look beyond their careers at the company and will take a long-term view. While certain aims do coincide - in particular the primary aim of profitability certain tensions can arise. The backers will invariably impose the same warranties on the management in relation to the company that the sellers will have refused to give the management. This warranty gap means that the management will bear all the risk of any defects in the company that affects its value. As a condition of their investment, the backers will also impose numerous terms on the management concerning the way that the company is run. The purpose is to ensure that the management run the company in a way that will maximise the returns during the term of the backers investment, whereas the management might have hoped to build the company for long-term gains. Though the two aims are not always incompatible, the management may feel restricted.

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It is the purchase of a companys shares in which the acquiring party gains controlling interest of the targeted firm. Incorporating a buyout strategy is a common technique used to gain access to new markets and is one of the most common methods for inorganically growing a business. A leveraged buyout is accomplished by borrowed money or by issuing more stock. Buyout strategies are often seen as a fast way for a company to grow because it allows the acquiring firm to align itself with other companies that have a competitive advantage in a specific area. 3.15. MANGEMENT BUY-IN A management buyin (MBI) occurs when a manager or a management team from outside the company raises the necessary finance, buys it, and becomes the companys new management. A management buy-in team often competes with other purchasers in the search for a suitable business. Usually, the team will be led by a manager with significant experience at managing director level. The difference to a management buy-out is in the position of the purchaser: in the case of a buy-out, they are already working for the company. In the case of a buy-in, however, the manager or management team is from another source. It is a corporate action in which an outside manager or management team purchases an ownership stake in the first company and replaces the existing management team. This type of action can occur due to a company appearing undervalued or having a poor management team. There are a wide range of management teams, such as hedge funds and other companies, that look for undervalued companies to purchase. If they find a company that fits with their investment criteria, they will often purchase the company and make it private to unlock the value. More often than not, they replace the management team with their own, which they feel will do a better job at running the company. 3.16. STAGES OF VENTURE CAPITAL FINANCING These are the typical funding stages that a startup moves through over the course of its life. Post IPO (i.e., Initial Public Offering) financings are not covered here as the focus is on the privately-held phase of the companys life.
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Seed or Concept stage financing: The venture is still in the idea formation stage and its product or service is not fully developed. The usually lone founder/inventor is given a small amount of capital to come up with a working prototype. Monies may also be spent on marketing research, patent application, incorporation, and legal structuring for investors. Its rare for a venture capital firm to fund this stage. In most cases, the money must come from the founders own pocket, from the 3 Fs (Family, Friends, and Fools), and occasionally from angel investors. Startup financing: The venture at this point has at least one principal working full time. The search is on for the other key management team members and work is being done on testing and finalizing the prototype for production. Finding the right financing that fits with a business goals is a continuing challenge for almost every small business. For startup businesses this can be one of the biggest hurdles in getting off the ground. Some entrepreneurs can be incredibly creative in finding ways to fund their ideas. Many work another job as a way to fund their personal business. Others finance their enterprises by going back to school. Business schools often can give you the tools and connections to get a business off the ground. Your classmates may be good business partners or the school may have a business plan competition with a prize of start-up funding for the busines. Most companies, however, find their start-up funding in more conventional ways. The most common sources are: 72% Personal Savings 45% Banks 28% Friends/Relatives 10% Individual Investors 7% Government-guaranteed Loans 1% Venture Capital Firms

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Early stage venture capitalistswho are as rare as hens teethmay fund this stage. But more likely, it will be sophisticated angel investors..
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First -stage financing: The venture has finally launched and achieved initial traction. Sales are trending upwards. .A management team is in place along with employees. The funding from this stage is used to fuel sales, reach the breakeven point., increase productivity, cut unit costs, as well as build the corporate infrastructure and distribution system. At this point the company is two to three years old. Its at this stage that venture capitalists prefer to get involved. How will you get to this stage without venture capital? Second -stage financing: Sales at this point are starting to snowball. The company is also rapidly accumulating accounts receivable and inventory. Capital from this stage is used for funding expansion in all its forms from meeting increasing marketing expenses to entering new markets to financing rapidly increasing accounts receivable. Venture capital firms specializing in later stage funding enter the picture at this point. Third stage financing: At this stage the future is so bright the founders gotta wear shades to borrow a phrase from the old pop tune. Everything looks good. Sales are climbing. Customers are happy. The second level of managers is in place. Money from this financing is used for increasing plant capacity (or other capacity depending on the nature of the business), marketing, working capital, and product improvement or expansion. Mezzanine or Bridge financing: At this point the company is a proven winner and investment bankers have agreed to take it public within 6 months. Mezzanine or bridge financing is a short term form of financing used to prepare a company for its IPO. This includes cleaning up the balance sheet to remove debt that may have accumulated, buy out early investors and founders deemed not strong enough to run a public company, and pay for various other costs stemming from going public. The funding may come from a venture capital firm or bridge financing specialist. They are usually paid back from the proceeds of the IPO. Initial Public Offering (IPO): The company finally achieves liquidity by being allowed to have its stock bought and sold by the public. Founders sell off stock and often go back to square one with another startup.
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Please note that some companies have more financing stages than shown above and others may have fewer. Very few reach the bridge and IPO stages. It all depends on the individual company. Before approaching a venture capital firm one needs to first confirm that it invest in the financing stage your company needs. 3.17. FINANCIAL ANALYSIS Financial analysis will test the economic models sensitivity to key sales and expense assumptions. The primary objectives of this process are to: Understand how management approaches problems, issues and decisions. Confirm managements representations and the investors own perceptions regarding the companys technology and market opportunity. Identify key vulnerabilities and risks so that the risk/reward outlook can be quantified. Gain an intimate understanding of the company and its market so that as a partner, the venture capitalist is prepared to counsel management to anticipate and manage change. Concurrent with the due diligence process, the venture capitalist and management will negotiate terms of a transaction. Valuation expectations should be discussed early in the process in the context of a range. Valuation is not likely to be resolved until the investor has identified all risks and vulnerabilities through due diligence . 3.18. HOW WILL A VENTURE CAPITALIST VALUE A COMPANY? Valuation methods are different depending on your companys stage of development. Early stage companies are valued based on managements investment or contribution in the form of hard dollars, sweat equity, opportunity cost and intellectual value. Prior demonstrable success in a venture backed company will increase managements appeal and negotiating strength considerably.

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Expansion stage companies are ordinarily valued based on comparable company multiples of sales, while late stage companies are valued based on comparable earnings multiples. In all cases, valuation will correlate directly with potential growth and earnings. Venture investors seek to earn between 5 and 10 times their initial investment within a 5-8 year investment horizon. Venture capitalists seldom charge fees or require current income (i.e. interest or dividends) on investments. Capital appreciation is the primary goal and is usually realized through a sale of the company to a strategic buyer or an initial public stock offering. Contrary to popular misconception, an IPO is not necessarily a preferred exit vehicle. A sale or merger may provide a more rapid exit and avoid exposure to unpredictable public market volatility. 3.19. HOW WILL AN INVESTMENT BE STRUCTURED? Convertible preferred stock is the most customary structure used by the venture community. Other equity securities, or combinations of debt and equity (i.e., subordinated notes and warrants) can be structured to mirror the economics of convertible preferred, but may be unnecessarily complex. Investors will require priority (preference) on the value of their principal investment over managements sweat equity in the event of a liquidation or sale of the company. An accruing dividend of 8%-12% is typical, and provides a minimum return on top of the preference on principal. If the company performs well, investors will convert their preferred stock to common stock to participate in capital appreciation. Investors purchasing a minority ownership position will require certain rights and protective covenants to restrict management from taking unilateral action detrimental to investors. 3.20. WHERE DO VENTURE CAPITALISTS GET THEIR MONEY? Venture capitalists draw their investment funds from pools of money raised from public and private investors. There are privately financed funds and labour-sponsored funds that have an investment pool drawn from fees or membership dollars. There are also public funds (held by provincial/regional/federal governments) and hybrid funds, made up of investments from public and private sector corporations.

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3.21. ANGELS AND THEIR ROLES IN THE VENTURE CAPITAL (VC) MARKET Angels are a specific type of Venture Capitalist. They generally are individuals in your community who invest in local businesses. They are generally less formal and less public in their approach to investing. For small businesses seeking more modest equity investment, informal investors known as Angels often fill the gap between love money (money from friends and relatives) and formal VC. In Atlantic Canada, Angels play an important role in providing investment capital to small and medium-sized business. An Angel differs from other venture capitalists in the size of investment (usually under $250,000) and the fact that they are directly involved as an advisor. Angels typically do not invest in several ventures at the same time. Rather, they dedicate their resources and time to helping one company grow. The Angel generally wants and is able to provide more than money. They often have contacts in the financial and business community. They will also usually have some experience within the companys industrial sector. Usually a successful business person in his/her own right, the Angel can offer advice and expertise in areas where your company is having difficulty with expansion. The Angel wants to provide more than money. Sometimes an Angel will invest in a field in which they have not specifically worked; however, they will have broad- based business experience that supplements the specialty or the niche of your company. This personal experience is a tremendous advantage for smaller firms. An Angel is generally a doer( i.e. an entrepreneur who has little time for bureaucracy) and someone who invests in the potential of the company. Angels want to be part of a new venture, to be involved in the thrill of helping another business succeed; something they have most likely experienced with their own company at some point in the past. It would seem the best way to find an Angel is by networking. Some of the best contacts may include local business colleagues, accountants and/or lawyers with wealthy clients, customers or suppliers who periodically invest in small businesses.

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An angel investor or angel (known as a business angel in Europe), is an affluent individual who provides capital for a business start-up, usually in exchange for convertible debt or ownership equity. A small but increasing number of angel investors organize themselves into angel networks or angel groups to share research and pool their investment capital. 3.22. SOURCE AND EXTENT OF FUNDING Angels typically invest their own funds, unlike venture capitalists, who manage the pooled money of others in a professionally-managed fund. Although typically reflecting the investment judgment of an individual, the actual entity that provides the funding may be a trust, business, limited liability company, investment fund, etc. Angel capital fills the gap in start-up financing between friends and family (sometimes humorously called friends, family, and fools) who provide seed funding, and venture capital. Although it is usually difficult to raise more than a few hundred thousand dollars from friends and family, most traditional venture capital funds are usually not able to consider investments under US$12 million. Thus, angel investment is a common second round of financing for high-growth start-ups, and accounts in total for almost as much money invested annually as all venture capital funds combined The term angel originally comes from England where it was used to describe wealthy individuals who provided money for theatrical productions. In 1978, William Wetzel, then a professor at the University of New Hampshire and founder of its Center for Venture Research, completed a pioneering study on how entrepreneurs raised seed capital in the USA, and he began using the term angel to describe the investors that supported them. Angel investors are often retired entrepreneurs or executives, who may be interested in angel investing for reasons that go beyond pure monetary return. These include wanting to keep abreast of current developments in a particular business arena, mentoring another generation of entrepreneurs, and making use of their experience and networks on a lessthan-full-time basis. Thus, in addition to funds, angel investors can often provide valuable management advice and important contacts.

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3.23. RECOMMENDATIONS OF SEBI (CHANDRASEKAR COMMITTEE) 2000: Venture Capital in India - Chandrasekhar Committee on Venture Capital Recommendations Flexibility in Investment and Exit A. Allowing Multiple Flexible Structures: Eligibility for registration as venture capital funds should be neutral to firm structure. The government should consider creating new structures, such as limited partnerships, limited liability partnerships and limited liability corporations. At present, venture capital funds can be structured as trusts or companies in order to be eligible for registration with SEBI. Internationally, limited partnerships, Limited Liability Partnership and limited liability corporations have provided the necessary flexibility in risk-sharing, compensation arrangements amongst investors and tax pass through. Therefore, these structures are commonly used and widely accepted globally specially in USA. Hence, it is necessary to provide for alternative eligible structures. B. Flexibility in the Matter of Investment Ceiling and Sectoral Restrictions: 70% of a venture capital funds investible funds must be invested in unlisted equity or equity-linked instruments, while the rest may be invested in other instruments. Though sectoral restrictions for investment by VCFs are not consistent with the very concept of venture funding, certain restrictions could be put by specifying a negative list which could include areas such as finance companies, real estate, gold-finance, activities not legally permitted and any other sectors which could be notified by SEBI in consultation with the Government. Investments by VCFs in associated companies should also not be permitted. Further, not more than 25% of a funds corpus may be invested in a single firm. The investment ceiling has been recommended in order to increase focus on equity or equity-linked instruments of unlisted startup companies. As the venture capital industry matures, investors in venture capital funds will set their own prudential restrictions. C. Changes in Buy Back Requirements for Unlisted Securities : A venture capital fund incorporated as a company/ venture capital undertaking should be allowed to buyback upto 100% of its paid up capital out of the sale proceeds of investments and assets and not necessarily out of its free reserves and share premium account or proceeds of fresh issue. Such purchases will be exempt from the SEBI takeover
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code. A venture-financed undertaking will be allowed to make an issue of capital within 6 months of buying back its own shares instead of 24 months as at present. Further, negotiated deals may be permitted in Unlisted securities where one of the parties to the transaction is VCF. D. Relaxation in IPO Norms: The IPO norms of 3 year track record or the project being funded by the banks or financial institutions should be relaxed to include the companies funded by the registered VCFs also. The issuer company may float IPO without having three years track record if the project cost to the extent of 10% is funded by the registered VCF. Venture capital holding however shall be subject to lock in period of one year. Further, when shares are acquired by VCF in a preferential allotment after listing or as part of firm allotment in an IPO, the same shall be subject to lock in for a period of one year. Those companies which are funded by Venture capitalists and their securities are listed on the stock exchanges outside the country, these companies should be permitted to list their shares on the Indian stock exchanges. E. E. Relaxation in Takeover Code: The venture capital fund while exercising its call or put option as per the terms of agreement should be exempt from applicability of takeover code and 1969 circular under section 16 of SC(R)A issued by the Government of India. F. Issue of Shares with Differential Right with regard to voting and dividend: In order to facilitate investment by VCF in new enterprises, the Companies Act may be amended so as to permit issue of shares by unlisted public companies with a differential right in regard to voting and dividend. Such a flexibility already exists under the Indian Companies Act in the case of private companies which are not subsidiaries of public limited companies. G. QIB Market for Unlisted Securities: A market for trading in unlisted securities by QIBs be developed. H. NOC Requirement: In the case of transfer of securities by FVCI to any other person, the RBI requirement of obtaining NOC from joint venture partner or other shareholders should be dispensed with. I. RBI Pricing Norms: At present, investment/disinvestment by FVCI is subject to approval of pricing by RBI which curtails operational flexibility and needs to be dispensed with Follow-up Action on the Report of Chandrasekhar Committee [source: Extract from SEBI Annual Report for 2000-01]
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SEBI had set up K B Chandrasekhar Committee to identify the impediments in the development of venture capital industry in India and to suggest suitable measures for its rapid growth. The report of the Committee was submitted to the SEBI Board in January 2000. The recommendations of the Committee were widely discussed. The recommendations were accepted in-principle by the Government also and pursuant to the same, the Finance Minister in the Budget 2000 speech announced that SEBI would be the single point nodal agency for registration and regulation of both domestic and overseas venture capital funds and the SEBI registered Venture Capital Funds would be given total tax pass-through. In the light of the recommendations of the SEBI Committee on Venture Capital and the Budget announcements, the Board of SEBI in its meeting held on September 14, 2000 approved the SEBI (Venture Capital Funds) (Amendment) Regulations, 2000 and also the SEBI (Foreign Venture Capital Investors) Regulations, 2000. The SEBI (Substantial Acquisition of Shares and Takeover) Regulations were amended whereby the acquisition of shares from venture capital funds/foreign venture capital investors either by company or by any promoter/s (on the same footing as that of acquisition from the state level financial institutions) would be exempt from making an open offer to other shareholders. The venture capital funds/foreign venture capital investors are eligible to participate in the IPO through book building route as Qualified Institutional Buyer subject to compliance with the SEBI (Venture Capital Fund) Regulations. Board also approved the amendment in the SEBI (Mutual Fund) Regulations permitting mutual funds to invest in venture capital funds. SEBI notified the Foreign Venture Capital Investors, Regulations, 2000 on September 15, 2000. The SEBI submitted a proposal to the Government to reconsider the condition of exit from investment within one year from the date of listing of shares of venture capital undertaking to seek tax pass-through, Government agreed to remove such condition. Accordingly, the Board at its meeting held on December 22, 2000 amended the regulations removing the clause requiring mandatory exit. The SEBI advised all the registered venture capital funds vide circular no. Cir-12001 dated February 12, 2001 to report every quarter about their resource mobilisation and investments.

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1)

A. The following are the salient features of SEBI (Venture Capital Funds) (Amendment) Regulations, 2000: Definition of Venture Capital Fund : The Venture Capital Fund is now defined as a fund established in the form of a trust, or a company including a body corporate and registered with SEBI which: A. has a dedicated pool of capital; B. raised in the manner specified under the Regulations; and C. to invest in Venture Capital Undertakings in accordance with the Regulations. Definition of Venture Capital Undertaking: venture capital undertaking means a domestic company :a. Whose shares are not listed on a recognised stock exchange in India b. Which is engaged in business including providing services, production or manufacture of articles or things, but does not include such activities or sectors which are specified in the negative list by the Board with the approval of the Central Government by notification in the Official Gazette in this behalf. The negative list includes real estate, non-banking financial services, gold financing, activities not permitted under the Industrial Policy of the Government of India. Minimum Contribution and Fund Size: The minimum investment in a Venture Capital Fund from any investor shall not be less than Rs. 5 lakh and the minimum firm commitment of the fund before the fund can start activities shall be atleast Rs. 5 crores Investment Criteria : The earlier investment criteria has been substituted by a new investment criteria which has the following requirements :_ disclosure of investment strategy; _ maximum investment in single venture capital undertaking not to exceed 25 per cent of the corpus of the fund; _ Investment in the associated companies not permitted; _ atleast 75 per cent of the investible funds to be invested in unlisted equity shares or equity linked instruments._ Not more than 25 per cent of the investible funds may be invested by way of: a. subscription to initial public offer of a venture capital undertaking whose shares are proposed to be listed subject to lock-in period of one year; b. debt or debt instrument of a venture capital undertaking in which the venture capital fund has already made an investment by way of equity. Disclosure and Information to Investors: In order to simplify and expedite the process of fund raising, the requirement of filing the Placement memorandum with
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2)

3)

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SEBI is dispensed with and instead the fund will be required to submit a copy of Placement Memorandum/ copy of contribution agreement entered with the investors along with the details of the fund raised for information to SEBI. Further, the contents of the Placement Memorandum are strengthened to provide adequate disclosure and information to investors. The SEBI will also prescribe suitable reporting requirements for the funds on their investment activity. B. Government of India Guidelines The Government of India (MOF) Guidelines for Overseas Venture Capital Investment in India dated September 20, 1995 have been repealed by the MOF after notification of SEBI Venture Capital Fund Regulations. C. The following are the salient features of SEBI (Foreign Venture Capital Investors) Regulations, 2000 : 1. Definition of Foreign Venture Capital Investor: any entity incorporated and established outside India which proposes to make investment in Venture Capital Fund or Venture Capital Undertaking and registered with SEBI. 2. Eligibility Criteria:entity incorporated and established outside India in the form of investment company, trust, partnership, pension fund, mutual fund, university fund, endowment fund, asset management company, investment manager, investment management company or other investment vehicle incorporated outside India would be eligible for seeking registration from SEBI. The SEBI for the purpose of registration shall consider whether the applicant is regulated by an appropriate foreign regulatory authority; or is an income tax payer; or submits a certificate from its banker or its promoters track record where the applicant is neither a regulated entity nor an income tax payer. 3. Investment Criteria: the same conditions as applicable in case of domestic Venture Capital funds. 4. Hassle Free Entry and Exit: The foreign venture capital investors proposing to make venture capital investment under the Regulations would be granted registration by the SEBI. SEBI registered Foreign Venture Capital Investors shall be permitted to make investment on an automatic route within the overall sectoral ceiling of foreign investment under Annexure III of Statement of Industrial Policy without any approval from FIPB. Further,
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SEBI registered FVCIs shall be granted a general permission from the exchange control angle for inflow and outflow of funds and no prior approval of RBI would be required for pricing. However, there would be ex-post reporting requirement for the amount transacted. 3.24. VC AND THE ENVIRONMENT ROLE OF VC IN THE ECONOMY In the most economies that have VC firms or a VC industry of any sort there is a good deal of brou-haha about the role of VC. Many among those that do not have a VC industry discussed the need for a VC industry. The importance of VC is not on account of the volume of capital provides; it is more on account of its indirect benefits. By providing investment and management support to companies that are engaged in the development/ manufacture of new and innovative products, technologies and services, VC investment enabled the development of entirely new lines of business. Secondly, VC forms typically prefer to invest in knowledge-based industries such as computer software. This in turn has catalysed entrepreneurship amongst professional managers and technologists to a considerable degree. And last but not the least; VC has played an unparalleled role in bringing technologies to the market place. Enabling Environment for VC The growth and development of a healthy VC industry is dependent on the availability of an enabling environment. Enterprise Culture: The general philosophy of the government towards entrepreneurs and private enterprises is among the more fundamental requirements. A strongly supportive attitude towards private enterprise would be manifested in the form of appropriate income and wealth tax policies, economic administration regime by way of liberal or no licensing procedures and limited presence of and reservation for state owned enterprises in business. Tax Policy: Tax policies have been the instruments with the higher impact in promoting the development of a healthy VC industry. The impact of the Tax Reform Acts (TRAs) which increased the capital gains taxation rates in USA had a directly identifiable
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negative impact on flow of funds into VC firms in USA until the TRA of 1978 corrected this position by reducing the tax rate on capital gains resulting in a dramatic impact of the flow of funds into VC firms. In India income from dividends and long-term capital gains from equity investments made by approved venture capital funds or venture capital companies will is exempted from tax. Such venture capital funds or venture capital companies will be required to invest only in unlisted companies engaged in manufacturing. However, income in the hands of share holders will be fully taxable. Capital Market: The issue of exit is as important as that of entry in a VC investment. Public offering of the portfolio companys stock appears to be the most preferred exit route for any VC investor. A vibrant, healthy, stable capital market is therefore an important pre-requisite for VCs to get liquid their investments. Given that most VC portfolio companies could develop into public offering candidates long before they qualify on the main stock exchange of the country, there is a need for an exchange or a market mechanism that addresses the trading of VC portfolio company stocks. The National Association of Securities Dealers Automated Quotation system (NASDAQ) of the US and the Unlisted Securities Market (USM) of the UK provide this exit vehicle for VC investors as well as other companies whose equity base is small. Similar Market mechanisms are known exists in Australia, France, Nigeria, Malaysia, Singapore and Spain (Madrid) which are in various stages of implementing a stock exchange for such a purpose. The Indian counterpart to the NASDAQ of the USA is Over The Counter Exchange of India (OTCEI) .Securities and Exchange Board of India (Venture Capital Funds) Regulations, 1996 prohibit listing of Venture Capital Fund on any stock exchange till the expiry of three years from the date of issuance of securities or units, after case may be by the venture capital fund. It is also equally important to have an efficient capital market in place. The fundamental basis of VC investment is that, while the public market provides risk adjusted rate of return that reflects the cost of capital as determined by free hand and competitive market forces, VC investors post higher rates of return by cashing-in on the imperfections in the equity market. Absence of such efficiency in the main market for whatever reason provides opportunities for realizing super normal rates of return.

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The aforementioned concept assumes great significance in the Indian context. For a Variety of reasons it would be possible to achieve annualized rates of return on the main market that would be fair superior to the return achievable by a VC portfolio through years of patient value addition to the portfolio companies. If this situation persists, it could affect the growth and development of the VC industry. Free Market Forces: It would not be incorrect to say that innovation is the mother of VC investment. The compulsion to innovate results in better and new products/ services and thereby opportunities for VC investments. In a protected economy/business environment, compulsion/incentive to compete through innovation, VC may not find many opportunities to invest. Complementary Financial Institutions: VC investors meet most of the early stage funding requirement of the start-up portfolio companies. However as companies grow in revenue, asset base and profitability they would look increasingly to the complimentary financial institutions, which often credit oriented, in order to leverage their equity share capital. In sophisticated economies, banks have a specialized skills and resource base to appraise and provide the necessary working capital funding to small and medium enterprises. In less developed economies, specialized agencies would need to be setup for the purpose with an appropriate mandate. In India, the DFIs, specialized small scale industries development corporations (SSIDCs) and commercial banks have been fulfilling these needs through their numerous schemes. Professional Entrepreneurship: The ethos of building business for financial gains and the preparedness to sell them off to an acquirer provides as important exit route to the easy investor. In our experience, to the average Indian entrepreneur it is the least preferred alternative for rewarding his financial partner. 3.25. INDIAN VENTURE CAPITAL INDUSTRY Investment Objectives As mentioned earlier, there are more than 13 VC companies and around 10 of them are VCFs in India. Broadly, there are three categories of VC funds/companies going by the agencies that have promoted them. They are the (i) funds promoted by all India

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DFIs/State level DFIs, (ii) funds promoted by commercial banks; and (iii) funds promoted by private sector financial services companies. In Indian context, VC companies have tried to carve out specific niches for themselves by defining their investment objectives in an appropriately distinctive manner. It would appear that at least among public sector VC investors there is a tendency to identify VC quite closely with high/new technology development. It could also be observed from these statements that most of the VC investors in India do not seem to have any stated sectoral preferences. However in the recent past, technological expertise shown by Indian software professionals has encouraged many venture capital funds to devote most of their energy towards the software sector. Software firms like Infosys and computer firms like Mastek owe their present position, to some extent, to the funding Venture Capital. Mastek is a software company providing development services to India and overseas customers. The companys operations have grown rapidly with subsidiaries in Singapore and the USA. TDICI Ltd. Had made its first round of investment in 19889and had helped the company come out with a public issue in December, 1992. TDICI reportedly was able to fetch returns within few years at around 29 times the initial investment. 3.26. INVESTMENT OBJECTIVES OF SOME INDIAN VC FIRMS The following are extracts from published material distributes by some of the typical Indian VC funds/companies: Indus Venture Management Indus plans to invest in certain areas of business; viz, those in which they have some expertise and which provide scope for growth and profits ... such as specialty chemicals healthcare products electronics and computers and consumer products The investment by Indus could be at different stages of the product such as: Seed Stage, Start-up Stage, Early Development Stage, Expansion Stage, Turnaround Stage.

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Industrial Development Bank of India The scheme is designed to provide venture capital fund assistance to new or existing industrial concerns for: a. b. c. Encouraging commercial application of indigenously developed technology; Adapting imported technology to wider domestic applications, and All matters connected with or incidental to the above.

Assistance under the scheme will be available to all industry concerns, existing as well as new units, failing under clause C of Section 2 of the Industrial Development Bank of India Act, 1964. Andhra Pradesh Industrial Development Corporation The objectives of the fund are as follows: a. Commercialization of an innovative product/process based on indigenous or imported technology b. Providing assistance to existing small and medium companies for latter stage investments and follow up on investment in high tech areas aimed at diversification and expansion. c. Providing assistance for management buy-outs specially by the executive(s) working in such firms. The development approach is in sharp contrast to the investment objectives of the professionally managed VC funds in Western Europe and North America where the primary objective is maximizing the return on the portfolio and advancement of technology/ development of an economic by-product or at best a means to achieving financial objectives. The private sector/commercial bank promoted VC funds in India do not appear to have such specific preferences. A common trend that could be noticed though is a professed preference for small/medium companies and first generation entrepreneurs.

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Financing Instruments The Indian VC industry has attempted to maintain the risk-reward sharing nature of the relationship through a variety of innovative instruments for structuring the investments. This have been in response to the: a. b. c. d. Constraints on pricing imposed by the securities pricing regulation; Indian entrepreneur ethos which lays considerable emphasis on ownership and control of the company; and Company law regulation under section no. 43(A), section 370, etc. While the various VC funds /companies have tried to nomenclature instruments differently, essentially these could be classified into three board categories with individual tweaks and twist to the basic forms. These are: Equity investments Quasi equity forms of hybridized debt Normal loan.

NOTES

i. ii. iii.

i. Equity Investments Almost all VC funds/companies appear to prepare a minority position in the investee company. Subscription has almost always been at par so far since the investees have been start-up or early stage companies and a premium would have been difficult to justify under the guidelines issued by the Controller of Capital Issue (CCI). When its risked the equity investments usually carries with it a number of projective covenants (especially in situations where the VC investor is a significant stock holder) including several standard ones such as the right to appoint nominee(s) on the board of directors, authority to examine books of accounts, carry out concurrent audit and sometimes even power to veto decisions on a set of issues that may be agreed upon with the companys management side promoters. The timing of the disinvestment, though, will be at the VC investors option. The VC investor also requires the investee, through the agreement, to have the companys stock listed on one or more stock exchange(s) as desired by the VC investor. The pricing of the saleback of the equity to the promoters /management is often linked either to the market price upon listing of the scrip or some formula. The equity investment also carry a first right of refusal in favour of the promoter. What needs to be noted is that most VC funds/investors provide the buyback comfort. It may not be inaccurate to conclude that this provision is

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also in response to the Indian entrepreneurs tendency to maximize his shareholding in the company over a period of time ii. Quasi Equity Investments Most quasi equity investment, as mentioned earlier, have evolved in response to the regulatory framework as also to the reluctance of the average Indian entrepreneur to permit external participation in his companys equity. The quasi equity loans come in two broad types: i. A loan whose servicing is linked entirely to the companys/projects performance and thus participate totally in the downside and significantly in the upside in a manner agreed upon upfront. A loan on which there is a minimum obligation (be it of interest or principal) contracted at reasonably low levels irrespective of performance and an upside sharing component.

ii.

In the former type the servicing is through a percentage charge on sales that is contracted upfront taking into account the future sales and profitability of the project/company and the servicing capacity available in the companys cash flow. The charge is fixed at a level that would provide a discounted rate of return (on the loan) commensurate with a high-risk equity investment. The charge payment period is normally co-terminus with the maturity of the venture fund. Interestingly these also carry, occasionally, some collateral cover as well such as a charge on the companys assets. The rate of return on a reasonable set of revenue and profitability expectations would be comparable to that achievable on equity investment. Sometimes the charge on sales payable is subject to a cap on the total amount payable. In the latter type again two models obtain. The VC investor either stipulates a fixed repayment schedule for the loan and a variable rate of charge in lieu of interest; or a fixed repayment schedule, a fixed floor rate of interest and a variable premium to share the upside . This type of quasi equity loans also carry collateral. The quasi-equity investments also come with a number of protective covenants including option to appoint nominee(s) and occasionally an option to convert the loan into equity shares in the investee company in the event of consecutive, willful default or nonachievement of some agreed upon performance milestones. The intent in such situations is to be able to obtain control of the company and effect restructuring plans, if any required.
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Quasi-equity instruments such as the above suffer from a number of apparent shortcomings. Firstly, they involve cash pay-outs from the investee company during the growth phase, when the company needs to conserve cash most. A second shortcoming is from the investors standpoint: that of tracking and accounting the payments and ensuring the accuracy of the sales accounting by the investee company. This latter is also a point of potential abuse. The quasi-equity loan will perhaps continue to be a necessary evil till such time as the pricing regime for equity issues permits equity shares to be the instrument for sharing risk and reward equitably and providing financial incentives to the participants that matter. The quasi-equity loan has not found much favour or fancy in Western Europe or North America. However, in some of the newly industrialized countries such as Korea and emerging Asian economies, the conditional loan has been widely applied in structuring VC investments. i. Normal Loans: Of all the financial instruments mentioned above, it may be safely stated that the normal (term) loan is the least preferred alternative. The reason, presumably and understandably, is that it is not ideally suited for VC situations where the cash flows of the firm cannot be predicted with even a reasonable degree of certainty to be able to contract fixed repayment and interest obligations. The limited normal loans that VCs provide appear to be to meet short-term/medium-term requirements of portfolio companies to help them tide over temporary cash shortages. These are short-term maturities (ranging from six to eighteen months) and carry interest at a rate equal to (or slightly higher) then the lending rate of commercial banks. . 3.28. SUMMARY Venture capital, is long-term equity / or equity featured investments in companies with new ideas and new products which offer the potential of high return on investment. European venture capital association defines venture capital as risk finance for entrepreneurial growth oriented companies. The Venture Capital Company (VCC) participates in the management of the Venture Capital Unit (VCU) by assisting in the management, strategic planning, financing, marketing, requirement of key personnel, finding strategic partners etc.,
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SEBI has laid down guidelines for a VCF As the Venture Capital Industry invests in Niche and Sun-rise industries, VC has a significant role in the development of economy. Growth of venture capital industry is dependent on various factors like enterprise culture, tax policy of government, vibrant and stable capital market. Though VC investors meet the initial requirement of VCU, the financial institutes have a complimentary role in meeting the increasing needs of VCUs The venture capital instruments have been broadly classified into three groups: i. Equity investments ii. Quasi equity forms of hybridized debt iii. Normal loan. VC companies prefer to take minority position in the venture capital unit. The timing of the disinvestment will be at the VC investors option. The investee has to get his companys shares listed on a stock exchange as desired by the VC investor and the pricing at the time of sale-back to the promoter will be linked either to the market price of the share or to some formula. The quasi equity investment is of two types: In the first type the servicing is entirely dependent on the performance of the company and thus participates totally in the downside and significantly in the upside as agreed in the beginning. In the second type of loan there is a minimum obligation towards the lender irrespective of performance plus an upside sharing component. Normal loan is an ordinary debt but it is the least preferred alternative from VCUs A venture investment process has the following stages: (i) the generation of the dealflow (ii) due diligence (iii) investment valuation (iv) pricing and structuring the deal (v) value-addition and monitoring and (vi) exit. The two types of VC investment agencies are: (i) Private venture capital firms (ii) The subsidiaries of financial and non-financial corporate The main stages where venture capital financing is needed are early-stage, expansion stage and acquisition stage. The early stage financing is for those firms which are in the nascent stage of their operations. The expansion financing is needed when an existing company is going in for manufacturing another product or expanding its capacity or urgently needs funds when the issue proceeds from a public offering take time. Acquisition / buy-out financing comes into picture when a firm or an entrepreneur need funds to acquire another firm The important venture capital companies / funds in India are the Venture Capital Fund promoted by IDBI, venture capital provide by TDICI, Venture Capital by IFCI, India Investment Fund by ANZ Grindlays Bank and National Equity fund for Small Entrepreneurs set-up by Government of India and administered by IDBI.
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TEST YOUR KNOWLEDGE 3.29. SHORT QUESTIONS 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. Mention the meaning of venture capital. What does a venture capitalist offer? What are the features of venture capital? Mention the benefits of venture capital? What are the drawbacks of venture capital Mention the categories of venture capitalists. What are the different stages involved in venture capital What do you mean by seed capital? What do you mean by management buy-outs? What do you mean by management buy-in?

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3.30. LONG QUESTIONS 1. 2. 3. 4. 5. 6. 7. 8. Mention the growth and origin of venture capital Evaluate the role played by the different categories of venture capitalist. Mention the key factors considered for appraisal of venture capital Mention the different stages of venture capital financing Explain the sources from which venture capitalist get their money Explain the role of VC in economic development of the country. Mention the recommendations of SEBI with respect to Venture capital Explain Venture Capital Investors Regulations 2000.

TEXT BOOKS FOR THE CHAPTER Merchant Banking and Financial Services, Dr. S. Guruswamy, Thomson.

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REFERENCES FOR THE CHAPTER : 1) Raising Venture Capital, Rupert Pearce and Simon Barnety, John Wiley & Sons, Ltd. 2) Corporate Venturing, Zenas Block & Lan.C. Macmillian, Harvard Business School Press. VENTURE CAPITAL IN INDIA - REGULATORY & LEGAL FRAMEWORK\(DOMESTIC VCFS) Definitions of Important Terms Venture Capital Fund: means a fund established in the form of a trust or a company including a body corporate and registered under these regulations whichi. has a dedicated pool of capital, ii. raised in a manner specified in the regulations, and iii. invests in accordance with the regulations. Venture Capital Undertaking; means a domestic company :i. whose shares are not listed on a recognized stock exchange in India; ii. which is engaged in the business for providing services, production or manufacture of article or things or does not include such activities or sectors which are specified in the negative list by the Board with the approval of the Central Government by notification in the Official Gazette in this behalf. Negative List i. Non-banking financial services excluding those Non-Banking Financial companies which are registered with Reserve Bank of India and have been categorized as Equipment Leasing or Hire Purchase companies ii. Gold Financing excluding those companies which are engaged in gold financing for jewellery iii. Activities not permitted under industrial policy of Government of India.
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iv. Any other activity which may be specified by the Board in consultation with Government of India from time to time. Associate Company: means a company in which a director or trustee or sponsor or settlor of the venture capital fund or asset management company holds either individually or collectively, equity shares in excess of 15% of its paid-up equity share capital of venture capital undertaking. Equity Linked Instruments: includes instruments convertible into equity shares or share warrants, preference shares, debentures compulsorily or optionally convertible into equity Investible Funds: means corpus of the fund net of expenditure for administration and management of the fund. Unit : means beneficial interest of the investors in the scheme or fund floated by trust or shares issued by a company including a body corporate Incorporation & Registration of a VCF Application for Grant of Certificate: Any company or trust or body corporate proposing to carry on any activity as a venture capital fund must apply to SEBI for grant of a certificate of carrying out venture capital activity in India. An application for grant of certificate must be made in Form A and must be accompanied by a non-refundable application fee of Rs 25,000/- payable by bank draft in favor of the Securities and Exchange Board of India at Mumbai. Registration fee for grant of certificate is Rs 500,000. Eligibility Criteria For the purpose of grant of certificate by SEBI, the following conditions must be satisfied :A. If the application is made by a company i. The main object of the company as per its Memorandum of Association must be the carrying on of the activity of venture capital fund.

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ii. It is prohibited by its Memorandum and Articles of Association from making an invitation to the public subscribe to its securities. iii. None of its directors or its principal officer or employee is involved in any litigation concerned with the securities market which may have an adverse bearing on the business of the applicant. The directors or the principal officer or employee must not have been at anytime convicted for an offense involving moral turpitude or any economic offense and is a fit and proper person to act as director or principal officer or employee of the company iv. it is a fit and proper person. B. If the application is made by a trust i. ii. iii. The instrument of trust (Trust Deed) is in the form of a deed and has been duly registered under the provisions of the Indian Registration Act, 1908. The main object of the trust is to carry on the activity of a venture capital fund None of its trustees or directors of the trustee company, if any, is involved in any litigation connected with the securities market which may have an adverse bearing in the business of the venture capital fund. The directors of its trustee company or the trustees have not at anytime being convicted of an offense involving moral turpitude or any economic offense. the applicant is a fit and proper person

iv.

v.

C. if the application is made by a body corporate i. it is set up or established under the laws of the Central or State Legislature. ii. the applicant is permitted to carry on the activities of a venture capital fund. iii. the applicant is a fit and proper person. iv. the directors or the trustees, as the case may be, of such body corporate have not been convicted of any offence involving moral turpitude or of any economic offense. v. the directors or the trustees, as the case may be, of such body corporate, if any, is not involved in any litigation connected with the securities market which may have an adverse bearing on the business of the applicant.
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Procedure for Grant of Certificate: If SEBI is satisfied that the applicant is eligible for grant of certificate, it shall send intimation to the applicant of its eligibility. On receipt of intimation, the applicant must pay to SEBI, registration fee of Rs 500,000 and on the receipt of such fees, SEBI shall grant a certificate of registration in Form B Conditions for the Grant of Certificate a. The venture capital fund shall abide by the provisions of the SEBI Act and these regulations. b. The venture capital fund shall not carry on any other activity other than that of a venture capital fund. c. The venture capital fund shall inform SEBI in writing of any information or details previously submitted to SEBI which have changed after grant of the certificate. d. If the information or details submitted are found to be false or are misleading in any particular manner, suitable penal action can be taken Raising Finance A venture capital fund may raise money from any source, whether Indian, foreign or non resident Indian by way of issue of units. No venture capital fund shall accept any investment from any investor less than Rs500,000. However this condition is not applicable to :a. employees or the principal officer or directors of the venture capital fund, or directors of the trustee company or trustees where the venture capital fund has been established as a trust b. the employees of the fund manager or asset management company c. Each scheme launched or fund set up by a venture capital fund shall have firm commitment from the investors for contribution of an amount of at least Rupees five crores before the start of operations by the venture capital fund. Investments Conditions & Restrictions All investment made or to be made by a venture capital fund shall be subject to the following conditions, namely:-

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a. venture capital fund shall disclose the investment strategy at the time of application for registration; b. venture capital fund shall not invest more than 25% corpus of the fund in one venture capital undertaking; c. shall not invest in the associated companies; and d. venture capital fund shall make investment as enumerated below: i. at least 66.67% of the investible funds shall be invested in unlisted equity shares or equity linked instruments of venture capital undertaking . ii. Not more than 33.33% of the investible funds may be invested by way of: a. subscription to initial public offer of a venture capital undertaking whose shares are proposed to be listed ; b. debt or debt instrument of a venture capital undertaking in which the venture capital fund has already made an investment by way of equity c. preferential allotment of equity shares of a listed company subject to lock in period of one year. d. the equity shares or equity linked instruments of a financially weak company or a sick industrial company whose shares are listed. Explanation 1 - For the purpose of these regulations, a financially weak company means a company, which has at the end of the previous financial year accumulated losses, which has resulted in erosion of more than 50% but less than 100% of its networth as at the beginning of the previous financial year. e. Special Purpose Vehicles which are created by a venture capital fund for the purpose of facilitating or promoting investment in accordance with these Regulations Explanation - The investment conditions and restrictions stipulated in clause (d) of regulation 12 shall be achieved by the venture capital fund by the end of its life cycle. f. venture capital fund shall disclose the duration of life cycle of the fund.

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Prohibition on Listing No venture capital fund shall be entitled to get its securities or units listed on any recognized stock exchange upto the expiry of three years from the date of issue of securities or units by the venture capital fund. General Obligations and Responsibilities No venture capital fund shall issue any documents or advertisement inviting offers from the public for the subscription of the purchase of any of its securities or units. Private placement A venture capital fund may raise money only through private placement of its securities or units. The venture capital fund before issuing any securities or units must file with SEBI a placement memorandum. Placement Memorandum or Subscription Agreement: The venture capital fund must :a. issue a placement memorandum which shall contain details of the terms and conditions subject to which monies are proposed to be raised from investors; or b. enter into contribution or subscription agreement with the investors which shall specify the terms and conditions subject to which monies are proposed to be raised. The Venture Capital Fund must file with the Board for information, the copy of the placement memorandum or the copy of the contribution or subscription agreement entered with the investors along with a report of money actually collected from the investor The placement memorandum and /or subscription agreement must give the following details:

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1. Details of the trustee or the trustee company and the directors or chief executives of the venture capital fund. 2. the proposed corpus of the fund and the minimum amount to be raised for the fund to be operational. 3. the minimum amount to be raised for each scheme and the provision for refund of monies to investor in the event of non receipt of minimum amount 4. details of entitlements units of venture capital fund for which subscription is being sought 5. Tax implications that are likely to apply to the investors. 6. Manner of subscription to the units or securities of the Venture Capital Fund 7. Period of maturity of the Fund. 8. Manner in which the fund is to be wound up. 9. Manner in which the benefits accruing to the investors in the units of the trust are to be distributed. 10. Details of the fund manager or asset management company if any, and the fees to be paid to such manager 11. The details about performance of the fund, if any, managed by the Fund Manager 12. investment strategy of the fund. 13. any other information specified by the Board. Maintenance of Books and Records: Every venture capital fund must maintain for a period of 8 years books of accounts, records and documents which must give a true and fair picture of state of affairs of the venture capital fund. Power to Call for Information: SEBI may at anytime call for any information from the venture capital fund in respect to any matter relating to its activity as a venture capital fund. Such information must be submitted within the time specified by days to SEBI. Submission of reports to SEBI: SEBI may at anytime call upon the venture capital fund to file such report as it deems fit with regards to the activity carried out by venture capital fund. Winding -up: A scheme of venture capital fund setup as a trust shall be wound up: i. When the period of the scheme as mentioned in the placement memorandum is over ; or
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ii. If, in the opinion of the trustees or the trustee company, it is in the interest of the investors that be wound-up ; or iii. If 75 % of the investors in the scheme pass a resolution at a meeting of unit holders of the scheme that the scheme be wound up ; or iv. If SEBI so directs, in the interest of investors. The venture capital fund setup as a company shall be wound up according to provision of the Companies Act, 1956. A venture capital fund set up as a body corporate shall be wound up in accordance with the provisions of the statute under which it is constituted. The trustees or trustee company of the venture capital fund set up as a trust or the Board of Directors in the case of the venture capital fund is set up as a company (including body corporate) shall intimate the Board and investors of the circumstances leading to the winding up of the Fund or Scheme. Effect of winding up 1. On and from the date of intimation of the winding up, no further investments shall be made on behalf of the scheme to be wound up. 2. Within three months from the date of intimation, the assets of the scheme shall be liquidated and the proceeds accruing to the investors in the scheme distributed to them after satisfying all liabilities. Notwithstanding anything contained in sub-regulation (2) and subject to the conditions, if any, contained in the placement memorandum or contribution agreement or subscription agreement, as the case may be, in-specie distribution of assets of the scheme, shall be made by the venture capital fund at any time, including on winding up of the scheme, as per the preference of investors, after obtaining approval of at least 75% of the investors of the scheme. Powers of SEBI for Inspection & Investigation: Details covered under Chapter -V of the Regulations Procedure for Action in Case of Default - Offences & Penalties: Details covered under Chapter -VI of the Regulations

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Venture capital funds which desire to claim exemption from income tax are required to follow rules given hereunder: Registration with SEBI Claiming Income tax exemption in respect of dividend and capital gains income. Not more than 40 percent of equity in a venture 80 percent of monies raised for investment are required to be invested in equity shares of domestic companies whose shares are not listed on recognised stock exchange Shares of investee companies are required to be held for a period of at least 3 years. However, these shares can be sold either if they are listed on recognised stock exchange in India

. Venture Capital in India - SEBI (Foreign Venture Capital Investors) Regulations, 2000 SEBI Regulations governing overseas Venture Funds setting thier establishments in India for doing Venture Capital Business are covered by the above Regulations. Definition of Important Terms Designated Bank: means any bank in India which has been permitted by the Reserve Bank of India to act as banker to the Foreign Venture Capital Investor. Domestic Custodian: means a person registered under the Securities and Exchange Board of India (Custodian of Securities) Regulations, 1996. Equity Linked Instruments: includes instruments convertible into equity share or share warrants, preference shares, debentures compulsorily or optionally convertible into equity. Foreign Venture Capital Investor: means an investor incorporated, established outside India, is registered under these Regulations and proposes to make investment in accordance with these Regulations Investible Funds: means the fund committed for investments in India net of expenditure for administration and management of the fund.
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Venture Capital Fund: means a Fund established in the form of a Trust, a company including a body corporate and registered under Securities and Exchange Board of India (Venture Capital Fund) Regulations, 1996, which i. has a dedicated pool of capital; ii. raised in the manner specified under the Regulations; and iii. invests in venture capital undertaking in accordance with the Regulations. venture Capital Undertaking: means a domestic company:i. whose shares are not listed in a recognised stock exchange in India; ii. which is engaged in the business of providing services, production or manufacture of articles or things, but does not include such activities or sectors which are specified in the negative list by the Board, with approval of Central Government, by notification in the Official Gazette in this behalf. Registration of Foreign Venture Capital Investors For the purposes of seeking registration under these regulations, the applicant must make an application to the Board in Form A along with the prescribed application fee (as specified in Part A of the Second Schedule to be paid in the manner specified in Part B thereof). Eligibility Criteria For the purpose of the grant of a certificate to an applicant as a Foreign Venture Capital Investor, the Board shall consider the following conditions for eligibility, namely: a. b. c. the applicants track record, professional competence, financial soundness, experience, general reputation of fairness and integrity. Whether the applicant has been granted necessary approval by the Reserve Bank of India for making investments in India; whether the applicant is an investment company, investment trust, investment partnership, pension fund, mutual fund, endowment fund, university fund, charitable institution or any other entity incorporated outside India; or

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d.

e. f.

g. h.

whether the applicant is an asset management company, investment manager or investment management company or any other investment vehicle incorporated outside India; whether the applicant is authorised to invest in venture capital fund or carry on activity as a 5*[foreign venture capital investors]; whether the applicant is regulated by an appropriate foreign regulatory authority or is an income tax payer; or submits a certificate from its banker of its or its promoters track record where the applicant is neither a regulated entity nor an income tax payer. the applicant has not been refused a certificate by the Board. whether the applicant is a fit and proper person.

Procedure for Grant of Certificate 1. If the Board is satisfied that the applicant is eligible for the grant of certificate, it shall send an intimation to the applicant. 2. On receipt of intimation, the applicant shall pay to the Board, the registration fee specified in Part A of the Second Schedule in the manner specified in Part B thereof. 3. The Board shall on receipt of the registration fee grant a certificate of registration in Form B. Conditions of Certificate The certificate granted to the foreign venture capital investor shall be inter-alia, subject to the following conditions, namely:a. it shall abide by the provisions of the Act, and these regulations; b. it shall appoint a domestic custodian for purpose of custody of securities; c. it shall enter into arrangement with a designated bank for the purpose of operating a special non-resident rupee or foreign currency account. d. it shall forthwith inform the Board in writing if any information or particulars previously submitted to the Board are found to be false or misleading in any material particular or if there is any change in the information already submitted.

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Investment Criteria for a Foreign Venture Capital Investor All investments to be made by a foreign venture capital investors shall be subject to the following conditions: a. it shall disclose to the Board its investment strategy. b. it can invest its total funds committed in one venture capital fund it shall make investments in the Venture Capital Undertaking as enumerated below: i. at least 66.67% of the investible funds shall be invested in unlisted equity shares or equity linked instruments of Venture Capital Undertaking. ii. not more than 33.33% of the investible funds may be invested by way of: a. subscription to initial public offer of a venture capital undertaking whose shares are proposed to be listed subject to lock-in period of one year; b. debt or debt instrument of a venture capital undertaking in which the foreign venture capital investor has already made an investment by way of equity. c. preferential allotment of equity shares of a listed company subject to lock in period of one year. d. the equity shares or equity linked instruments of a financially weak company or a sick industrial company whose shares are listed. Explanation 1: - For the purpose of these regulations, a financially weak company means a company, which has at the end of the previous financial year accumulated losses, which has resulted in erosion of more than 50% but less than 100% of its networth as at the beginning of the previous financial year. e. Special Purpose Vehicles which are created for the purpose of facilitating or promoting investment in accordance with these Regulations. Explanation - The investment conditions and restrictions stipulated in clause (c) of regulation 11 shall be achieved by the Foreign Venture Capital Investor by the end of its life cycle.

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Maintenance of Books and Records 1. Every Foreign Venture Capital Investor shall maintain for a period of eight years, books of accounts, records and documents which shall give a true and fair picture of the state of affairs of the Foreign Venture Capital Investor. > 2. Every Foreign Venture Capital Investor shall intimate to the Board, in writing, the place where the books, records and documents referred to in sub-regulation (1) are being maintained. Power to call for information 1. The Board may at any time call for any information from a Foreign Venture Capital Investor with respect to any matter relating to its activity as a Foreign Venture Capital Investor. 2. Where any information is called for under sub-regulation (1) it shall be furnished within the time specified by the Board. General Obligations and Responsibilities 1. Foreign Venture Capital Investor or a global custodian acting on behalf of the foreign venture capital investor shall enter into an agreement with the domestic custodian to act as a custodian of securities for Foreign Venture Capital Investor. 2. Foreign Venture Capital Investor shall ensure that domestic custodian takes steps for,a. monitoring of investment of Foreign Venture Capital Investors in India b. furnishing of periodic reports to the Board c. furnishing such information as may be called for by the Board. Appointment of designated bank Foreign Venture Capital Investor shall appoint a branch of a bank approved by Reserve Bank of India as designated bank for opening of foreign currency denominated accounts or special non-resident rupee account. Powers of SEBI for Inspection & Investigation Details covered under Chapter -V of the Regulations

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Procedure for Action in Case of Default - Offences & Penalties Details covered under Chapter -VI of the Regulations Venture Capital in India - Chandrasekhar Committee on Venture Capital Its Genesis & Terms of Reference Technology and knowledge based ideas will drive the global economy in the 21st century. Indias recent success story in the area of information technology has shown that there is a tremendous potential for the growth of knowledge based industries. This potential is not only confined to information technology but is equally relevant in several areas such as bio-technology, pharmaceuticals, media and entertainment, agriculture and food processing, telecommunication and other services. Given the inherent strength by way of its human capital, technical skills, cost competitive manpower, research and entrepreneurship, India can unleash a revolution of wealth creation leading to employment generation and rapid economic growth in a sustainable manner. What is needed is risk finance and venture capital environment which can leverage innovation, promote technology and harness knowledge based ideas. In the absence of an organised venture capital industry, individual investors and development financial institutions have hitherto played the role of venture capitalists in India. Entrepreneurs have largely depended upon private placements, public offerings and lending by the financial institutions. In 1973 a committee on Development of Small and Medium Enterprises highlighted the need to foster venture capital as a source of funding new entrepreneurs and technology. Thereafter some public sector funds were set-up but the activity of venture capital did not gather momentum as the thrust was on high-technology projects funded on a purely financial rather than a holistic basis. Later, a study was undertaken by the World Bank to examine the possibility of developing venture capital in the private sector, based on which the Government of India took a policy initiative and announced guidelines for venture capital funds (VCFs) in India in 1988. However, these guidelines restricted setting up of VCFs by the banks or the financial institutions only. Internationally, the trend favored venture capital being supplied by smaller-scale, entrepreneurial venture financiers willing to take high risk in the expectation of high returns, a trend that has continued in this decade. Thereafter, the Government of India issued guidelines in September 1995 for overseas venture capital investment in India. For tax-exemption purposes, guidelines were
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issued by the Central Board of Direct Taxes (CBDT) and the investments and flow of foreign currency into and out of India is governed by the Reserve Bank of India (RBI).Further, as a part of its mandate to regulate and to develop the Indian capital markets, Securities and Exchange Board of India (SEBI) framed SEBI (Venture Capital Funds) Regulations, 1996. Pursuant to the regulatory framework mentioned above, some domestic VCFs were registered with SEBI. Some overseas investment has also come through the Mauritius route. However, the venture capital industry understood globally as independently managed, dedicated pools of capital that focus on equity or equity-linked investments in privately held, high-growth companies (The Venture Capital Cycle, Gompers and Lerner, 1999) is relatively in a nascent stage in India. Figures from the Indian Venture Capital Association (IVCA) show that, till 1998, around Rs.30 billion had been committed by domestic VCFs and offshore funds which are members of IVCA. Not all overseas venture investors and domestic funds are members of the IVCA. Figures available from private sources indicate that overall funds committed are around US$ 1.3 billion. Investible funds are less than 50% of the committed funds and actual investments are lower still. At the same time, due to economic liberalization and increasing global outlook in India, there is increased awareness and interest of domestic as well as foreign investors in venture capital. While only 8 domestic VCFs were registered with SEBI during 1996-1998, an additional 13 funds have already been registered in 1999. Institutional interest is growing and foreign venture investments are also on the increase. Given the proper environment and policy support, there is tremendous potential for venture capital activity in India. SEBI initiated interaction with industry participants and experts in early 1999 to identify the key areas critical for the development of this industry in India. The Finance Minister, in his 1999 budget speech had announced that for boosting high-tech sectors and supporting first generation entrepreneurs, there is an acute need for higher investment in venture capital activities. He also announced that the guidelines for registration of venture capital activity with the Central Board of Direct Taxes would be harmonized with those for registration with the Securities and Exchange Board of India. SEBI, decided to set up a committee on Venture Capital to identify the impediments and suggest suitable measures to facilitate the growth of venture capital activity in India. Keeping in view the need for a global perspective it was decided to associate Indian entrepreneurs from Silicon Valley in the committee. The committee is headed by K.B. Chandrasekhar, Chairman, Exodus

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Communications Inc., California, USA and consist of industry participants, professionals and the representatives from financial institutions and RBI. The setting up of this committee was primarily motivated by the need to play a facilitating role in tune with the mandate of SEBI, to regulate as well as develop the market. The first meeting of the Committee took place on August 5, 1999 and followed by further deliberations by the Working Groups formed by the committee to examine the issues related to Structure and Fund Raising, Investment Process, Exit and Vision for the Venture Capital Industry in India. The draft recommendations of the committee were formulated in the meeting of the committee held on December 8, 1999. The draft recommendations were released for public comments and after considering the feed back, the report was finalised in the meeting of the Committee held on January 8, 2000. VENTURE CAPITAL IN INDIA - CHANDRASEKHAR COMMITTEE ON VENTURE CAPITAL ANALYSIS OF GROUND SITUATION Why Venture Capital The venture capital industry in India is still at a nascent stage. With a view to promote innovation, enterprise and conversion of scientific technology and knowledge based ideas into commercial production, it is very important to promote venture capital activity in India. Indias recent success story in the area of information technology has shown that there is a tremendous potential for growth of knowledge based industries. This potential is not only confined to information technology but is equally relevant in several areas such as bio-technology, pharmaceuticals and drugs, agriculture, food processing, telecommunications, services, etc. Given the inherent strength by way of its skilled and cost competitive manpower, technology, research and entrepreneurship, with proper environment and policy support, India can achieve rapid economic growth and competitive global strength in a sustainable manner. A flourishing venture capital industry in India will fill the gap between the capital requirements of technology and knowledge based startup enterprises and funding available from traditional institutional lenders such as banks. The gap exists because such startups are necessarily based on intangible assets such as human capital and on a technologyenabled mission, often with the hope of changing the world. Very often, they use technology
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developed in university and government research laboratories that would otherwise not be converted to commercial use. However, from the viewpoint of a traditional banker, they have neither physical assets nor a low-risk business plan. Not surprisingly, companies such as Apple, Exodus, Hotmail and Yahoo, to mention a few of the many successful multinational venture-capital funded companies, initially failed to get capital as startups when they approached traditional lenders. However, they were able to obtain finance from independently managed venture capital funds that focus on equity or equity-linked investments in privately held, high-growth companies. Along with this finance came smart advice, handon management support and other skills that helped the entrepreneurial vision to be converted to marketable products. Beginning with a consideration of the wide role of venture capital to encompass not just information technology, but all high-growth technology and knowledge-based enterprises, the endeavor of the Committee has been to make recommendations that will facilitate the growth of a vibrant venture capital industry in India. The report examines1. the vision for venture capital 2. strategies for its growth and 3. how to bridge the gap between traditional means of finance and the capital needs of high growth startups. Critical Factors for Success of Venture Capital Industry While making the recommendations the Committee felt that the following factors are critical for the success of the VC industry in India: A) The regulatory, tax and legal environment should play an enabling role. Internationally, venture funds have evolved in an atmosphere of structural flexibility, fiscal neutrality and operational adaptability. B) Resource raising, investment, management and exit should be as simple and flexible as needed and driven by global trends C) Venture capital should become an institutionalized industry that protects investors and investee firms, operating in an environment suitable for raising the large amounts

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of risk capital needed and for spurring innovation through startup firms in a wide range of high growth areas. D) In view of increasing global integration and mobility of capital it is important that Indian venture capital funds as well as venture finance enterprises are able to have global exposure and investment opportunities. E) Infrastructure in the form of incubators and R&D need to be promoted using Government support and private management as has successfully been done by countries such as the US, Israel and Taiwan. This is necessary for faster conversion of R & D and technological innovation into commercial products. Recommendations Multiplicity of Regulations - Need for Harmonisation and Nodal Regulator Presently there are three set of Regulations dealing with venture capital activity i.e. SEBI (Venture Capital Regulations) 1996, Guidelines for Overseas Venture Capital Investments issued by Department of Economic Affairs in the MOF in the year 1995 and CBDT Guidelines for Venture Capital Companies in 1995 which was modified in 1999. The need is to consolidate and substitute all these with one single regulation of SEBI to provide for uniformity, hassle free single window clearance. There is already a pattern available in this regard; the mutual funds have only one set of regulations and once a mutual fund is registered with SEBI, the tax exemption by CBDT and inflow of funds from abroad is available automatically. Similarly, in the case of FIIs, tax benefits and foreign inflows/ outflows are automatically available once these entities are registered with SEBI. Therefore, SEBI should be the nodal regulator for VCFs to provide uniform, hassle free, single window regulatory framework. On the pattern of FIIs, Foreign Venture Capital Investors (FVCIs) also need to be registered with SEBI. Tax pass through for Venture Capital Funds VCFs are a dedicated pool of capital and therefore operates in fiscal neutrality and are treated as pass through vehicles. In any case, the investors of VCFs are subjected to tax. Similarly, the investee companies pay taxes on their earnings. There is a well established successful precedent in the case of Mutual Funds which once registered with SEBI are automatically entitled to tax exemption at pool level. It is an established principle that taxation should be only at one level and therefore taxation at the level of VCFs as well
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as investors amount to double taxation. Since like mutual funds VCF is also a pool of capital of investors, it needs to be treated as a tax pass through. Once registered with SEBI, it should be entitled to automatic tax pass through at the pool level while maintaining taxation at the investor level without any other requirement under Income Tax Act. Mobilisation of Global and Domestic resources A. Foreign Venture Capital Investors (FVCIs) Presently, FIIs registered with SEBI can freely invest and disinvest without taking FIPB/RBI approvals. This has brought positive investments of more than US $10 billion. At present, foreign venture capital investors can make direct investment in venture capital undertakings or through a domestic venture capital fund by taking FIPB / RBI approvals. This investment being long term and in the nature of risk finance for start-up enterprises, needs to be encouraged. Therefore, atleast on par with FIIs, FVCIs should be registered with SEBI and having once registered, they should have the same facility of hassle free investments and disinvestments without any requirement for approval from FIPB / RBI. This is in line with the present policy of automatic approvals followed by the Government. Further, generally foreign investors invest through the Mauritius-route and do not pay tax in India under a tax treaty. FVCIs therefore should be provided tax exemption. This provision will put all FVCIs, whether investing through the Mauritius route or not, on the same footing. This will help the development of a vibrant India-based venture capital industry with the advantage of best international practices, thus enabling a jump-starting of the process of innovation. The hassle free entry of such FVCIs on the pattern of FIIs is even more necessary because of the following factors: i. Venture capital is a high risk area. In out of 10 projects, 8 either fails or yield negligible returns. It is therefore in the interest of the country that FVCIs bear such a risk. ii. For venture capital activity, high capitalisation of venture capital companies is essential to withstand the losses in 80% of the projects. In India, we do not have such strong companies.

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iii. The FVCIs are also more experienced in providing the needed managerial expertise and other supports. B. Augmenting the Domestic Pool of Resources The present pool of funds available for venture capital is very limited and is predominantly contributed by foreign funds to the extent of 80 percent. The pool of domestic venture capital needs to be augmented by increasing the list of sophisticated institutional investors permitted to invest in venture capital funds. This should include banks, mutual funds and insurance companies upto prudential limits. Later, as expertise grows and the venture capital industry matures, other institutional investors, such as pension funds, should also be permitted. The venture capital funding is high-risk investment and should be restricted to sophisticated investors. However, investing in venture capital funds can be a valuable returnenhancing tool for such investors while the increase in risk at the portfolio level would be minimal. Internationally, over 50% of venture capital comes from pension funds, banks, mutual funds, insurance funds and charitable institutions.

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UNIT - IV

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INVESTMENT PROCESS
4.1 INTRODUCTION VC investments require and permit innovativeness in financial engineering. While VC investments follow no set formula, they attempt to address the needs and concerns of the investor and the investee. 4.2. LEARNING OBJECTIVES After going through this chapter, the reader is expected to : Know the how venture capital investment process is undertaken Know the concept of term sheet Know how selection of investment are made Understand the concept of syndication Understand the process of entry and exit.

4.3. VENTURE INVESTMENT PROCESS The VC investment process has variance/features that are context specific to countries/regions. However, activities in a VC fund follow a typical sequence with a number of commonalities. The typical stages in an investment cycle are as below:

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Generating a Deal flow In generating a deal flow, the VC investor creates a pipeline of deals or investment opportunities that he would consider for investing in. This is achieved primarily through plugging into an appropriate network. The most popular network obviously is the network of VC funds/investors. It is also common for VC funds/investors to develop working relationship with R&D institutions, academia, etc., which could potentially lead to business opportunities. Understandably, the composition of the network would depend on the investment focus of the VC fund/company. Thus VC funds focusing on early stage, technology based deals would develop a network of R&D centers working in those areas. The network is crucial to the success of the VC investor. It i9s almost imperative for the V investor to receive a large number of investment proposal from which he can select a few good investment candidates finally. Successful VC investor in USA examine hundreds of business plans in order to make three or four investments in year. It is important to note the difference between the profile of investment opportunities that a VC would examine and those pursued by a conventional credit oriented agency or
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an investment institution. By definition, as mentioned earlier, the VC investor focuses on opportunities with a high degree of innovativeness. The dealflow composition and the technique of generating a dealflow can vary from country to country. In India, different VC funds/companies have their own methods varying from promotional seminars with R&D institution and industry association to direct advertising companies targeted at various segment. A clear pattern between the investment focus of a fund and the constitution of the deal generation network is discernable even in the Indian context. Due Diligence Due diligence is the industry jargon for all the activities that are associated with evaluating and investment proposal. It includes carrying out reference checks on the proposal related aspect such as management team, products, technology and market. The important feature to not is that VC due diligence focus on the qualitative aspects of an investment opportunity. It is also not unusual for VC funds/ companies to set upon an investment screen. The screen is a set of qualitative (sometimes quantitative criteria such as revenues are also used) criteria that help VC funds/companies to quickly decide on whether an investment opportunity warrants further diligence. Screens can be sometimes elaborate and rigorous and specific and brief. The nature of screen criteria is also a function of the investment focus of the form at the point. VC investors rely extensively on reference checks with leading light in the specific areas of concern being addressed is the due diligence. Investment Valuation The investment valuation process is an exercise aimed at arriving at an acceptable price for the deal. Typically, in countries where free pricing regimes exist the evaluation process goes through the following sequence: 1. 2. Evaluate future events and profitability Forecast likely future value of the firm based on the expected market capitalization or expected acquisition proceeds depending upon the anticipated exit from the investment.

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3.

4.

Target on ownership position in the investee firm so as to achieve desired appreciation on the proposed investment. The appreciation desired should yield a hurdle rate of return on a Discounted Cash Flow Basis. Symbolically the evaluation exercise may be represented as follows: NPV =[(Cash)/(Post)] x [(PAT x PER)] x k; Where,

NPV = Net Present Value of the cash flows relating to the investment comprising outflow by way of investment and inflows by way of interest/dividends (if any) and realization on exit. The rate of return used for discounting is the hurdle rate of return set by the VC investor. Post = Pre + Cash Cash represents the amount cash being brought into the particular round of financing by the VC investor. Pre is the pre-money valuation of the firm estimated by the investor. While technically it is measure by the intrinsic value of the firm at the time of raising capital, it is more often a matter of negotiation driven by the ownership of the company that the VC investor desires and the ownership that the founders/management team is prepared to give away for the required amount of capital. (PAT) is the forecast of Profit After Tax in a year and often agreed upon by the founders and investors. (As opposed to being arrived at unilaterally). It would also be net of preferred dividends, if any. (PER) is the price-earnings multiple that could be expected of a comparable firm in the industry. It is not a always possible to fund such a comparable fit in VC situation. That necessitates therefore, a significant degree of judgment on the part of the VC to arrive at alternate PER scenarios. k is the percent value interest factor (corresponding to a discount rate r) for the investment horizon.

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It is the quite apparent that PER times PAT reference the value of the firm at that time and the complete expression really represents the investors share of the value of the investee firm. The following example illustrates this framework: Example Best Mousetrap Limited (BML) has developed a prototype which needs to be commercialized. BML needs cash of Rs. 2 million to establish production facilities and set up a marketing program. BML expects that the company will go public in the third year and have revenue of Rs.70 million and a PAT margin of 10% on sales. Assume for the sake of convenience, that there would be no further addition to the equity capital of the company. Prudent Fund Managers(PFM) propose to lead a syndicate of like-minded investors with a hurdle rate of return of 75% (discounted) over a five year period based on BMLs sales and profitability expectations. Firms with a comparable sales and profitability and risk profiles trade at 12 times earnings on the stock exchange. The following would be the sequence of computations In order to get a 75% return p.a. the initial investment of Rs.2 m must yield an accumulation of 2 x (1.75)5 =Rs.32.8 m on disinvestment in year 5. BMLs market capitalization in year 5 is likely to be Rs. (70 x 0.1 x 12) m=Rs.84 m. Percentage ownership in BML that is required to yield the desired accumulation will be (32.8 / 84) x 100= 30%. Therefore the post-money valuation of BML at the time of raising capital will be equal to Rs. (2 / 0.39) m= Rs.5.1 m in which implies that a pre-money valuation of Rs.3.1 m for BML Another popular variant of the above method is the First Chicago Method (FCM) developed by Stanley Golder, a leading professional VC manager. FCM assumes three probable scenarios, success, sideways survival and failure. Outcomes under these scenarios are probability weighted to arrive at an expected rate of return.

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In reality the valuation of the firm is driven by a number of factors. The more significant among these are: i. Overall economic conditions: A buoyant economy produces an optimistic longterm outlook for new products/services and therefore, results in more liberal premoney valuation. ii. Demand and supply of capital: When there is a surplus of VC chasing a relatively limited number of VC deals, valuations go up. This can result in unhealthy levels of low return for VC investors. iii. Specifics of the deals: Such as the founders/ management teams track record, innovativeness/unique selling propositions(USPs)the service potential size of product/market, etc. affects valuations in an obvious manner. iv. The degree of popularity: of the industry/technology in question also influences the pre-money. Computer Aided Software Engineering (CASE) tools and Artificial Intelligence were one-time darlings of the VC community that have subsequently given place to biotech and retailing. v. The standing of the individual VC: Well established VC who are sought after by entrepreneurs, for a number of reasons, could get away with tighter valuation than their lesser known counterparts. vi. Investors consideration: could vary significantly. A Study by an American VC, Venture One, showed that large corporations who invest for strategic advantages such as access to technologies, products or markets pay twice as much as a professional VC investor for a given ownership position in a company but only half as much as to investors in a public offering. vii. Valuation offered on comparable deals: around the time investing in the deal. Quite obviously, valuation is one of the most critical activities in the VC investment process. It would not be improper to say, that the success of a fund will be determined by its ability to value/price the investments correctly. Sometimes the valuation process is broadly based on thumb rule metrics such as multiples of revenue. Though such methods would appear rough and ready, they are often based on fairly based well-established industry averages of operating profitability and assets/ capital turnover ratios.

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Such valuation as outlined above, is possible only where complete freedom of pricing is available. In the Indian context, where until recently the pricing of equity issues were heavily regulated unfortunately valuation was heavily constrained. 4.4 THE VENTURE INVESTMENT VALUATION IN INDIA There appears to be no standard approach to investment valuation in India. At one end of the spectrum some of the funds/companies appear to follow the traditional development banking approach with a high degree of emphasis on the project appraisal format and methodology adopted by credit oriented development banks. The similarity in methodology is indeed so close that an appraisal/investment memorandum from one of these investors reads remarkably like that of DFI, in terms of thrust and content. The areas of focus in the appraisal are also quite similar to those addressed by DFI. At the other end, there appears to be the approach of an equity investor emphasis on the earnings potential, broad financial attractiveness of the industry and the promoters track record. While some of the investors have been making a conscious attempt to move towards the American/UK paradigms of investment valuation, there exists a strong local flavor to the valuation process. The Indian approach no doubt will have to take into cognizance the differences in operating ambience prevalent in India. Notable among these are the non-availability of an established market mechanism and related norms, reliable and contemporary information and above everything else pricing regulations on securities offerings. Notwithstanding such differences, the Indian industry will have to evolve a new set of investment valuation techniques and standards in order to be able to handle true VC situations as opposed to the traditional credit appraisal approach. Structuring the Deal VC investments require and permit innovativeness in financial engineering. While VC investments follow no set formula, they attempt to address the needs and concerns of the investor and the investee. The investor tries to ensure the following: Reasonable reward for the given level of risk; Sufficient influence on the management of the company through board representation Minimization of taxes; and Ease in achieving future liquidity on the investment.
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The entrepreneur at the same time seeks to enable: i. The creations of the business that he has conceptualized (operating and strategic control); ii. Financial rewards for creating the business; iii. Adequate resources needs to achieve their goal; and iv. Voting control Common considerations for both sides include: a. Flexibility of structure that will aloe room to enable additional investments later, incentives for future management and retention of stock if management leaves. b. Balance sheet attractiveness to suppliers and debt financiers c. Retention of key employees through adequate equity participation In the Indian context, one of the primary considerations is retention of majority shareholding. Often, the promoters do not even wish to encourage external equity participation. These cultural issues have a significant influence on the structuring of a deal. Value Addition and Monitoring We have seen in our earlier definition of VC that sustained active involvement over an extended period of time is one of the distinguishing characteristics of VC. This process of the VC investors involvement in the portfolio company is often referred to broadly as value addition. The value that the VC brings to the portfolio company can vary from one VC professional to another depending upon the individuals background and approach to VC. There are VC professionals, especially those who invest in very early stage situations, whose involvement can go up to providing operating management support. There are also others, exemplified by LBO specialists and mezzanine investors, whose involvement may not extend beyond lending an avid ear to the proceedings of quarterly or monthly board meetings. The extent of involvement could also depend upon the VC investors stake in the company and his role in the consortium, when the investment has been syndicated among a number of investors. In a consortium, it is not an uncommon practice for one of the investors to play the role of the lead investor taking upon himself significant responsibilities with respect to the portfolio company, on behalf of himself as well as the co-investors in the

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syndicate. Investment exposure and/or specific ability to add value and/or geographic presence are some of the usual criteria for a VC investor being designated lead investor. The nature of involvement is situation-specific as mentioned earlier. However, some generalizations have been attempted based on empirical research. One such study revealed the following general patterns: i. ii. iii. iv. The most intense involvement occurs at the tender early stages of the venture; Openness of communications and chemistry are crucial; Venture capitalists add value in a variety of ways, especially through strategic and supportive roles; and Most of the venture capitalists key role become increasingly important as the venture develops.

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If valuable addition represents the pro-active stance of a VC investor to maximize the value of his portfolio company, monitoring represents the reactive obverse of avoiding losses by seeing red flags in advance that warn impending danger. Monitoring portfolio companies is a straightforward, yet delicate task. The straightforwardness lies in the well established tools and techniques that are used for the purpose: Period reports, Board of Directory meetings, review sessions and so forth. The delicacy arises, out of the need to draw a line between policing in distrust and monitoring out of caution. Exit The process of exiting from a VC investment is an important as in any other process in the investment cycle. The two exit options are: Sale of the VCs position either along with or subsequent to a public offering; and Acquisition of the company.

A Public offering is the preferred route of exit for VCs. In North America and Western Europe, a well developed second tier market serves as a convenient vehicle for such an exit. Public offerings result in higher multiples in the case of a successful venture backed company. Secondly, the acquisition market in these countries is a well developed mechanism. Over the years building companies for acquisition by a larger corporate for strategic consideration has become a popular trend.
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In India, the main market for capital issues has cut off criteria which most venture backed companies may not be able to achieve over a five or seven year horizon. In response, the Over The Counter Exchange of India (OTCEI) has emerged. The effectiveness of this market mechanism as an exit vehicle remains to be established yet. Acquisition of companies again is likely to take a few years to emerge as an acceptable route in view of the current entrepreneurial ethos in our country. The issue of exit in remains to be addressed by many of the Indian VC funds/companies. The current Indian practices are to redeem the hybridized debt through a cash pay-out or enter into a buy-back arrangement for the equity investment with the promoters. As mentioned earlier, from an economic stand emergence of a stable second tier capital market, growth in number of venture capital investment and evolving entrepreneurial ethos, it would be reasonable to expect that the exit options available to the Indian VC investors would improve in efficiency and ease. Most Indian VC investors are still in the process of evolving their own approaches to value addition and monitoring. Some of the VC investors that invest in relatively large enterprises promoted by entrepreneurs from an industrial family or possessing well established credential tend to prepare a hands-off approach to value addition and be content monitoring there investment . Some of the other who have been investing in small/ medium entrepreneurial start-up with considerable management gaps have been trying to add value to their portfolio companies, apart from just monitoring. Similarly, there are no known instances of VC taking over operating managements of portfolio companies in India. Given that most investments are in the early stages still, it may be premature to draw any firm conclusion on the effectiveness of those professionals in complementing/ supplementing operating managements. Some VC investors argue, that they (investors) have had a role to play in some of the early portfolio success that manifested in recent times.

4.5. ORGANIZATION OF VC BUSINESSES In the early days, venture investment was primarily the activity of wealthy individuals, syndicates organized by investment bankers or by a few family organizations employing

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professional managers. The first formal VC institution is the now legendary. American Research and Development Corporation. During the fifties and the sixties, the Small Business Investment Corporation, (SBIC), engaged in financing young, entrepreneurial companies, got involved albeit unintentionally, in funding some risky ventures as well. For numerous reasons however the SBIC program as a whole is reported to have met with limited success. The two other types of VC investment agencies are: i. ii. Private venture capital firms The subsidiaries of financial and non-financial corporate

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Most private VC firms are organized as limited partnerships and a few as corporations with restricted shareholding. A limited partnership (LP, hereafter), a concept alien to Indian business organizations, is one where investors have limited financial liability, but are subject to the other governing aspects of a partnership. Typical investors in such funds could be pension funds, large corporates, state/municipal funds, family trusts and banks. Pension funds new venture investments as an alternate asset class while large corporate invest in venture funds with the strategic objective of obtaining a window into emerging technologies being developed by young, venture backed start-up companies. State/municipal government funds use investment in venture funds for promoting local economic/industrial development through venture capital-led investment formation. A LP is managed by general partners (GPs). GPs are usually professional from diverse backgrounds who have made mid-career changes into venture investment management. Thus, there are technologists, scientists, managers, lawyers and bankers, to name a few categories, who have made a mark in venture investment management in the USA. Most of them have a track record of excellence in the previous vocations. The GPs are compensated through a management fee which is a percentage of the assets/funds managed by them. The fee most often is 2% - 2.5%. (Some successful GPs manage to negotiate fees linked to the Net Asset Value (NAV), thus incentivize to providing the GP to maximize the NAV of the fund). In addition, the GPs also retain a part of the appreciation in the fund value. This share of the appreciation is also known as carried interest and is usually 20% of all pay-outs to the investor beyond the principal amount of the fund. LPs have attained popularity for the following reasons: i. The partnership itself is not taxed. ii. The partners liability is limited to interest in the partnership, and iii. The partnership process is fixed at the time of formation and is fitted to match the duration of extended investment holding periods
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It would be relevant to point out at this juncture that corporate venture fund managers met with limited success in USA. The requirement of specialized skills to succeed in venture investing is cited as one of the reasons. Corporate and banks seem to have discovered that it is not easy to convert their executive/credit officers and analyst into effective venture investment managers. David Silver suggest that this could also be due to the inability of corporate to provide for the managers to participate in the profitability of the investment with in the corporate framework. This led to many of the successful investment managers setting up their independent fund management partnership. Among private venture capital firms several early venture capital firms started by wealthy families/individuals such as the Rockefellers (Venrock), the Phipps (Bessemer Securities) and the Whitneys (Whitney & co.) who were the fore runners to modern venture funds continue to be active and possess considerable venture investment experience and savvy. In India, most VC firms are private corporate or institutional spin offs. While corporate bring the investible fund into their books as share capital, some fund managers such as Indus Venture Fund Managers from funds into a trust and manage the same through an Asset Management Company (AMC). TDICI and Risk Capital and Technology Finance Corporation (RCTC) have constituted the funds into a scheme under the UTI Act- Venture Capital Units Scheme (VECAUS). TDICI manages two of these funds under a management contract, while RCTC manages the third VECAUS fund in a similar manner. This approach provides all the tax benefits available under a UTI scheme to the fund investor. In all these instances the fund manager is provided a management fee on the funds invested and a share of profits. It would be pertinent to highlight here that the Indian industry is yet to adopt the American approach towards management of venture capital funds. Most VC funds appear to have adopted corporate/institutional framework and thereby do not seem to provide a mechanism for expression of individual styles in investing or value addition and correspondingly for a financial compensation package that is linked to the value that the manager creates out of the funds investment portfolio.

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4.6. UNDERSTANDING THE PROCESS- TARGET A VENTURE CAPITAL PARTNER Choosing the right venture capital firms is an important part of the fundraising process. An entrepreneur that has not researched and targeted venture firms runs the risk of lengthening the search and over-shopping the plan. Venture capitalists readily exchange information, so rejection from one firm may influence others. The criteria for selecting the right venture capitalists to approach include their geographic, industry specialization, stage of development, and size of investment preferences. Also important are whether the fund will act as a lead investor and whether there are complementary or competing ventures within the funds portfolio. The research of a funds preferences can be done by obtaining literature from the funds directly, talking to venture-backed entrepreneurs, or by asking us. Elsewhere on our site, we have a listing of the primary venture funds in the Boston area or funds that have strong ties to Boston. We list each of their websites so click on and study where your business best fits. You can also send us an email with an outline of your business idea and where you are in the process and we will provide you with a few names. You can also visiting the PricewaterhouseCoopers MoneyTree TM web site at www.pwcmoneytree.com which is an excellent source of industry data. 4.7. PROFILE OF A TYPICAL VENTURE CAPITAL FUND Professionally managed venture capital funds provide seed, startup and expansion financing as well as management/leveraged buyout financing. In addition to these distinctions, funds may also specialize in technology sectors such as life sciences, while others invest in a wide array of technology and non-technology arenas. Venture capital firms are typically established as partnerships that invest the money of their limited partners. The limitedS are usually corporate pension funds, governments, private individuals, foreign investors, corporations, insurance companies, endowment funds, and even other venture capital funds. When venture capital firms raise money from these sources, they group the money committed into a fund. A typical fund might close at Rs.50Rs.150 million and actively invest for three to five years. Since investors in venture capital
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funds have specific return-on-investment requirements, a venture capitalist must evaluate potential investments with a similar return-on-investment consideration. Since the return on investment is critical, venture capitalists invest with certain criteria in mind. Many funds invest between Rs.4-Rs.8 million in any one venture over a three- to five-year period and look for companies with market potential of Rs.75-Rs.200 million. Since a venture fund typically invests in only 20-30 companies, each investment must be screened carefully. Venture capitalists will be looking for a 30 percent to 40 percent, or more, annual return on investment and for total return of 5 to 20 times their investment. Venture capitalists are not passive investors and become involved as advisors to management, usually as members of the companys board of directors. By actively participating in investments, venture capitalists seek to maximize their return. Just as venture capitalists perform due diligence, an entrepreneur must evaluate the benefits that a particular venture firm can provide the company.

Do the venture capitalists have experience with similar types of investments? Do they take a highly active or passive management role? Are there competing companies in their portfolio? Are the personalities on both sides of the table compatible? Does the firm have strong syndication ties with other venture firms for additional rounds of financing? Can they help provide contacts for distribution channels and executive search?

The Valuation Process It is critical for an entrepreneur seeking venture capital to assess the value of the company from the perspective of the venture capitalist and to appreciate the dynamics of the entrepreneur/ venture capitalist relationship. This relationship revolves around a tradeoff. Funds for growth are exchanged for a share of ownership. The entrepreneur will be asked to give up a large share of ownership of the company, possibly a majority stake. The venture capitalist seeks to value the venture to provide a return on investment commensurate with the risk taken.

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Entrepreneurs seek to raise as much money as they can while giving up as little ownership as possible. Venture capitalists strive to maximize their return on investment by putting in as little money as possible for the largest share of ownership. Through the negotiation process, the two parties come to agreement. Entrepreneurs understand that excess funding costs them equity. Venture capitalists must leave company founders with enough ownership to provide incentive to make the business succeed. To balance their individual goals, both parties should agree on one mutual goal-to grow a successful enterprise. The first step in the negotiation process is to determine the current value of the company. The most important factor in determining this premoney valuation, or the value of the venture prior to funding, is the stage of development of the company. A business with no product revenues, little expense history, and an incomplete management team will usually receive a lower valuation than a company with revenue that is operating at a loss. This is because the absence of one or more of these elements increases the risk of the ventures not succeeding. Each successive stage commands higher valuations as the business achieves milestones, confirms the ability of the management team, and progresses in reducing fundamental risks. \ Stage I Ventures have no product revenues to date and little or no expense history, usually indicating an incomplete team with an idea, plan, and possibly some initial product development. Stage II Ventures still have no product revenues, but some expense history suggesting product development is underway. Stage III Ventures show product revenues, but they are still operating at a loss. Stage IV Companies have product revenues and are operating profitably.

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The best way to build value in a company is to achieve the goals and milestones within the timeframes designated in the business plan. As milestones are achieved, risk is reduced and subsequent rounds of financing can usually be raised at more attractive valuations. 4.8. PRICING AND CONTROL: THE INVESTORS PERSPECTIVE Pricing venture capital deals involves the estimated future values of the entity being financed and is highly subjective. Theoretical approaches can be used to estimate the companys future value and the corresponding percentage ownership that the investor requires-in other words, estimated future value based on the ventures expected profitability and estimated earnings multiples. The estimated percentage ownership the investor must receive can then be calculated to derive the desired return on investment. As noted, venture capital investors expect an annual rate of return of 30 percent to 40 percent or more. An example would be that to realize a 30 percent return on an investment of Rs.4 million, a venture capitalist would need to own 32 percent of a company with an estimated future market value of Rs.60 million after six years. If the estimated future market value is higher, Rs.100 million for example, a smaller percentage ownership (19 percent) will provide the required rate of return. Writing the Business Plan Often the first step in dealing with venture capitalists is to forward them a copy of the business plan. And, because venture capitalists have to deal with so many business plans, the plan must immediately grab the readers attention. The executive summary will either entice venture capitalists to read the entire proposal or convince them not to invest further time. A good plan is crucial for two reasons: first, as a management tool, and second, as a means to obtain financing. While the plan is an essential element in securing financing, it should also be an operating guide to the business, with the goals, objectives, milestones and strategies clearly defined and well-written. This is the best way to demonstrate the viability and growth potential of the business and to showcase the entrepreneurs knowledge and understanding of what is needed to meet the companys objectives. The first reading of

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a plan is the venture capitalists initial opportunity to evaluate the individuals who will manage the business and to measure the potential for return on this investment. The plan should also address the following business issues from the perspective of the venture capitalist:

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Is the management team capable of growing the business rapidly and successfully? Have they done it before? Is the technology fully developed? Is the product unique, and what value does it create so that buyers will want to purchase the product or service? Is the market potential large enough? Does the team understand how to penetrate the market? Do significant barriers to entry exist? How much money is required and how will it be utilized? What exit strategies are possible?

If the plan is of interest, the entrepreneur will be contacted for the first of what will generally be several meetings, and the venture capitalist may begin the due diligence process. Since venture firms are in the business of making risk investments, one can be certain a thorough analysis of the companys business prospects, management team, industry, and financial forecasts will precede any investment. Why Is a Business Plan Needed? A quality business plan is an important first step in convincing investors that the management team has the experience to build a successful enterprise. The plan also provides measurable operating and financial objectives for management and potential investors to measure the companys progress. Executive Summary Business plans should be summarized into a short two- to three-page synopsis called the executive summary. The summary is used to capture the essence of the plan and generate interest so the reader further studies the full proposal. It is the most important

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section of the business plan and should be written last, ensuring that only vital information is included. At many of the largest venture capital firms, fewer than 5 percent of the hundreds of plans received are reviewed beyond the executive summary. While sometimes this is because the business does not fit the type of investment favored by that firm, more often it is because the executive summary is not written convincingly or clearly enough. The summary must stand out and be noticed, and to do this it must be of the highest quality. The summary must be persuasive in conveying the companys growth and profit potential and managements prior relevant experience. The effort taken in researching investor preferences and preparing a quality summary will set the plan apart and assure that it receives further consideration by venture capital firms. Executive Summary Outline Company Overview Generally, the investor wants to know-in a hurry-what product the company is developing, the market/industry it serves, a brief history, milestones completed (with dates), and a statement on the companys future plans. If the company is an ongoing business seeking expansion capital, the entrepreneur must summarize the companys financial and market performance to date. Management Team List the key members of the management team and technical advisors, including their age, qualifications, and work history. It is important to emphasize the teams relevant, proven track record. Note key open positions and how you intend to fill them. Products and Services Provide a short description of the product or service and highlight why it is unique. Discuss any barriers to entry that prevent further competition (e.g., patents). Mention the products direct or indirect competition. If possible, briefly mention future product development plans such as upgrades or product line extensions in order to show the investor that the venture is not a one-product/service company.
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Market Analysis Define the target market to be served using recent market data and analysts estimates of current and projected size and growth rates. Also note what percent of the market the company plans to capture. Mention the names of your largest current, wellknown customers who have either purchased your product or given you letters of intent. It is important to discuss who will buy the product and why. Briefly note the distribution/ selling strategies used in the industry and explain which one(s) you plan to use to penetrate the market. Funds Requested and Uses State the amount of money required and be specific in the description of the uses of the funds sought. Avoid such general terms as working capital. Summary of Five-Year Financial Projections This section should summarize key financial projections through breakeven. Only projected revenues, net income, assets and liabilities should be listed. It is also useful to note additional expected rounds of financing needed. Body of the Plan Company Overview In this section one should fully describe the reason for founding the company and the general nature of the business. The investor must be convinced of the uniqueness of the business and gain a clear idea of the market in which the company will compete. The entrepreneurs vision for the companys future production and operations strategy should also be described. An investor needs to be assured that the company is built around more than a product idea. The entrepreneur needs to demonstrate that a profitable business can be built based on the strategies detailed in the plan. Products and Services The business plan must convey to the reader that the company and product truly fill an unmet need in the marketplace. The characteristics that set the product/ service and company apart from the competition need to be defined. It is also important to describe each of the end-user segments that will be targeted. A full profile of the end-users and the key potential applications of the product will demonstrate to an investor that the entrepreneur has done his/her marketing homework.
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A description of the status of patents, copyrights and trade secrets is very important. It is equally imperative to describe barriers to entry. Keep in mind that patents are only as good as they are defensible. The plan should list all the major product accomplishments achieved to date as well as remaining milestones. This will give an investor a comfort level, knowing that the entrepreneur has tackled several hurdles and is aware of remaining hurdles and how to surmount them. Specific mention should be made of the results of alpha (internal) and beta (external with potential customers) product testing. If alpha or beta tests are upcoming, mention how these tests will be conducted. Single product companies can be a concern for investors. It is always beneficial to include ideas and plans for future products/services. If the plan demonstrates the viability of several products, an investor will see an opportunity to grow a successful business. Market Analysis The analysis of market potential separates the inventors from entrepreneurs. Many good products are never successfully commercialized because their inventors dont stop to understand the market or assemble the management team necessary to capitalize on the opportunity. This section of the business plan will be scrutinized carefully; market analysis should therefore be as specific as possible, focusing on believable, verifiable data. Market Research should contain a thorough analysis of the companys industry and potential customers. Industry Data should include growth rates, size of the market, recent technical advances, government regulations and future trends. Customer Research should include the number of potential customers, the purchase rate per customer, and a profile of the decision-maker. This research drives the sales forecast and pricing strategy, which relates to all other strategies in marketing, sales and distribution. Finally, comment on the percentage of the target market the company plans to capture.

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Management and Ownership Venture capitalists invest in people-people who have run or who are likely to run successful operations. Potential investors will look closely at the members of the companys management team. The team should have experience and talents in the key disciplines: technological development, marketing, sales, manufacturing, and finance. This section of the plan should therefore introduce the members of your management team and what they bring to the business. The management team in most start-up companies includes only a few founders with varied backgrounds and an idea. If there are gaps in the team it is important to mention them and comment on how the positions will be filled. Glossing over a key unfilled position will raise red flags. Often, because venture capital investors have access to networks of management talent, they can provide a list of proven candidates appropriate for these crucial positions. Include a list of the board of directors or advisors: key outside industry or technology experts who lend guidance and credibility. This is another area where empty positions may be filled from suggestions of a well-net-worked investor. Marketing Plan The primary purpose of the marketing section of a business plan is to convince the venture capitalist that the market can be developed and penetrated. The sales projections made in the marketing section will drive the rest of the business plan by estimating the rate of growth of operations and the financing required. The plan should include an outline of plans for:

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Pricing, Distribution channels, and Promotion.

Pricing The strategy used to price a product or service provides an investor with insight for evaluating the strategic plan. Explain the key components of the pricing decision,
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i.e., image, competitive issues, gross margins, and the discount structure for each distribution channel. Pricing strategy should also involve consideration of future product releases and future products. Distribution Channels A manufacturers business plan should clearly identify the distribution channels that will get the product to the end user. For a service provider, the distribution channels are not as important as are the means of promotion. Distribution options for a manufacturer may include: Direct Sales, such as mail order, direct contact through salespeople, and telemarketing; Original Equipment Manufacturers (OEM), integration of the product into other manufacturers products; Distributors or Wholesalers; or Retailers. Each of these methods has its own advantages and disadvantages and financial impact, and these should be clarified in the business plan. For example, assume the company decided to use direct sales because of the expertise required in selling the product. A direct salesforce increases control, but it requires a significant investment. A venture capitalist will look to the entrepreneurs expertise as a salesperson, or to the plans to hire, train and compensate an expert salesforce. If more than one distribution channel is used, they should all be compatible. For example, using both direct sales and wholesalers can create channel conflict if not managed well. Fully explain the reasons for selecting these distribution approaches and the financial benefits they will provide. The explanation should include a schedule of projected prices, with appropriate discounts and commissions as part of the projected sales estimates. These estimates of profit margin and pricing policy will provide support for the decision.

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Promotion The marketing promotion section of the business plan should include plans for product sheets, potential advertising plans, Internet strategy, trade show schedules, and any other promotional materials. The venture capitalist must be convinced that the company has the expertise to move the product to market. A well-thought-out promotional approach will set the business plan apart from the competition. It is important to explain the thought process behind the selected sources of promotion and the reasons for those not selected. Competition A discussion of the competition is an essential part of the business plan. Every product or service has competition; even if the company is first-to-market, the entrepreneur must explain how the markets need is currently being met and how the new product will compete against the existing solution. The venture capitalist will be looking to see how and why the firm will beat the competition. The business plan should analyze the competition, giving strengths and weaknesses relative to the product. Attempt to anticipate competitive response to the product. Include, if possible, a direct product comparison based on price, quality, warranties, product updates, features, distribution strategies, and other means of comparison. Document the sources used in the analysis. Operations The operations section of the business plan should discuss the location and size of the facility. If one location is selected over another, be sure to include justification. Factors such as the availability of labor, accessibility of materials, proximity to distribution channels, and tax considerations should be mentioned. Describe the equipment and the facilities. If more equipment is required in response to production demands, include plans for financing. If the company needs international distribution, mention whether the operations facility will provide adequate support. If work will be outsourced to subcontractors, eliminating the need to expand facilities, state that, too. The investor will be looking to see if there are inconsistencies in the business plan.
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If a prototype has not been developed or there is other uncertainty concerning production, include a budget and timetable for product development. The venture capitalist will be looking to see how flexible and efficient the facility plans are. The venture capitalist will also ask such questions as:

If sales projections predict a growth rate of 25 percent per year, does the current site allow for expansion? Are there suppliers who can provide the materials required? Is there an educated labor force in the area?

These and any other factors that might be important to the investor should be included. The sales projections will determine the size of the operation and thereby the funds required both now and in the future. Include the sources and uses of financing in the business plan, and be certain the assumptions are realistic. The timing and the amount of funds will be derived from the sales estimates. Business Plan DOs and Donts

Do be brief. Begin with a two- to three-page executive summary. Then, limit the body of the plan to seven to ten typewritten pages. Note that internal business plans and budgets are normally more detailed than those presented to external investors. Include everything important to the business and financing decision, but leave secondary issues and information, such as detailed financial information, for discussion at a later meeting. DO let the reader know, early on, what type of business the company is in. While this may seem obvious, many plans tell the reader this information on page 20, for example, and with other plans, the reader is never certain. DO state the companys objectives. DO describe the strategy and tactics that will enable the company to reach those objectives. DO cite clearly how much money the company will need, over what period of time, and how the funds will be used. DO have a clear and logical explanation about the investors exit strategy. DONT use highly technical descriptions of products, processes and operations. Use common terms. Keep it simple and complete.
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DO be realistic in making estimates and assessing market and other potentials. DO discuss the companys business risks. Credibility can be seriously damaged if existing risks and problems are discovered by outside parties. DONT make vague or unsubstantiated statements. For example, dont just say that sales will double in the next two years or that new product lines will be added without supporting details. DO be specific. Substantiate statements with underlying data and market information. DO summarize and properly structure internal budgets and plans to facilitate review by outside parties. DO enclose the proposal/ business plan in an attractive but not overdone cover. DO provide extra copies of the plan to speed the review process. Preparing the Financial

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Preparing the Financials Prepare the Financials Realistic financial forecasts within the business plan are important to attract investors and retain their interest to participate in future rounds of financing. The financials must accurately reflect the various product development, marketing and manufacturing strategies described in each section of the plan. The Purpose of Financial Forecasts Developing a detailed set of financial forecasts demonstrates to the investor that the entrepreneur has thought out the financial implications of the companys growth plans. Good financial forecasts integrate the performance goals outlined in the plan into financial goals so that return on investment, profitability and cash-flow milestones can be clearly stated. Investors use these forecasts to determine if (a) the company offers enough growth potential to deliver the type of return on investment that the investor is seeking, and (b) the projections are realistic enough to give the company a reasonable chance of attaining them.

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Content of Financial Forecasts Investors expect to see a full set of cohesive financial statements, including a balance sheet, income statement and cash-flows statement, for a period of three to five years. It is customary to show monthly statements until the breakeven point or profitability is reached. Thereafter, quarterly statements should be prepared for two years, followed by yearly data for the remaining timeframe. It is also imperative that the forecasts include a footnote section that explains the major assumptions used to develop revenue and expense items. It is not advisable to ramp up sales and expenses in sequential fashion-this gives the impression that the financial implications of the plan have not been fully thought out. Prepare the financial projections as the final step in putting together the plan. The following section contains some helpful hints on how to develop sound assumptions from which to base projections. Assumptions to Use in Forecasts Sales Preparing the sales forecasts can be a difficult process, especially in a developing or niche market. Typically, the plan should state an average selling price per unit along with the projected number of units to be sold each reporting period. Sales prices should be competitive with similar offerings in the market and should take into consideration the cost to produce and distribute the product. Cost of Sales Investors will expect accurate unit cost data, taking into consideration the labor, material, and overhead costs to produce each unit. Have a good grasp on initial product costing so it is protected against price pressure from competitors. This data will also be important for strategic make versus buy decisions. Product Development Product development expenses should be closely tied to product introduction timetables elsewhere in the plan. These expenses are typically higher in the early years and taper off because product line extensions are less costly to develop. Investors will focus on

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these assumptions because further rounds of financing may be needed if major products are not introduced on time. Other Expenses A detailed set of expense assumptions should take into consideration headcount, selling and administrative costs, space, and major promotions. It is useful to compare final expense projections with industry norms. All expense categories should be considered. Balance Sheet The balance sheet should agree with the income and cash flows statement. Consideration should be given to the level of inventory and capital expenditures required to support the projected sales level. It is important to limit capital expenditures at the outset to current requirements because cash will be harder to come by if fiscal restraint is not demonstrated to investors. It is generally better to rent or lease capital equipment in the first few years in order to conserve cash for marketing and selling expenses that will generate sales. Cash Flows The cash-flows statement must correlate to the balance sheet and income statement and should mirror the timing of the funding requirements stated in the plan. Investors will study the cash-flows statement to determine when cash-flow breakeven is expected and when periodic needs are anticipated. Venture capital firms set aside a certain percentage of their funds for follow-on financing to address these periods of need by their portfolio companies, but the cost in lower valuations for unanticipated financings can be high. This is why it is important to set realistic forecasts so that the initial request covers the capital needs until the business can complete milestones leading to higher valuations in future rounds. Examples of Financial Forecasts The financial forecasts illustrated on the next page represent a fast-growth, technology-oriented manufacturing company. The forecasts are shown on a yearly basis. An actual business plan, however, should show monthly figures until breakeven and then
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quarterly statements for subsequent years. The assumptions are included as a guide and may not apply to all start-up companies. Be sure to consult your financial advisor. Prepare for the Negotiation Process Following due diligence, the successful venture will then enter into the negotiation process, where the structure and terms of financing will be determined. The entrepreneur must carefully prepare for this next step by becoming familiar with the various structures of venture capital financing and preparing a bargaining position after consulting with an attorney who has extensive venture capital experience. Attorneys will give guidance on the issues worth fighting for. Issues to consider are: vesting, salary, stock restrictions, commitment to the venture, debt conversion, dilution protection, downstream liquidity and directors. The negotiation will involve most or all of these issues in addition to price per share. However, price-per-share concerns should not be the overriding interest; the end result of this process must be a win/win situation in order for the relationship to progress successfully. The last step is to document and close the transaction, resulting in a term sheet, investment agreement(s) and, finally, the closing.

4.10. WHAT IS INVOLVED IN THE INVESTMENT PROCESS?

The investment process, from reviewing the business plan to actually investing in a proposition, can take a venture capitalist anything from one month to one year but typically it takes between 3 and 6 months. There are always exceptions to the rule and deals can be done in extremely short time frames. Much depends on the quality of information provided and made available. The key stage of the investment process is the initial evaluation of a business plan. Most approaches to venture capitalists are rejected at this stage. In considering the business plan, the venture capitalist will consider several principal aspects: Is the product or service commercially viable? Does the company have potential for sustained growth? Does management have the ability to exploit this potential and control the company through the growth phases? Does the possible reward justify the risk? Does the potential financial return on the investment meet their investment criteria?
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In structuring its investment, the venture capitalist may use one or more of the following types of share capital:

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Ordinary shares

These are equity shares that are entitled to all income and capital after the rights of all other classes of capital and creditors have been satisfied. Ordinary shares have votes. In a venture capital deal these are the shares typically held by the management and family shareholders rather than the venture capital firm.

Preferred ordinary shares

These are equity shares with special rights.For example, they may be entitled to a fixed dividend or share of the profits. Preferred ordinary shares have votes.

Preference shares

These are non-equity shares. They rank ahead of all classes of ordinary shares for both income and capital. Their income rights are defined and they are usually entitled to a fixed dividend (eg. 10% fixed). The shares may be redeemable on fixed dates or they may be irredeemable. Sometimes they may be redeemable at a fixed premium (eg. at 120% of cost). They may be convertible into a class of ordinary shares.

Loan capital

Venture capital loans typically are entitled to interest and are usually, though not necessarily repayable. Loans may be secured on the companys assets or may be unsecured. A secured loan will rank ahead of unsecured loans and certain other creditors of the company. A loan may be convertible into equity shares. Alternatively, it may have a warrant attached which gives the loan holder the option to subscribe for new equity shares on terms fixed in the warrant. They typically carry a higher rate of interest than bank term loans and rank behind the bank for payment of interest and repayment of capital.
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Venture capital investments are often accompanied by additional financing at the point of investment. This is nearly always the case where the business in which the investment is being made is relatively mature or well-established. In this case, it is appropriate for a business to have a financing structure that includes both equity and debt. Other forms of finance provided in addition to venture capitalist equity include: Clearing banks - principally provide overdrafts and short to medium-term loans at fixed or, more usually, variable rates of interest. Merchant banks - organise the provision of medium to longer-term loans, usually for larger amounts than clearing banks. Later they can play an important role in the process of going public by advising on the terms and price of public issues and by arranging underwriting when necessary. Finance houses - provide various forms of installment credit, ranging from hire purchase to leasing, often asset based and usually for a fixed term and at fixed interest rates. Factoring companies - provide finance by buying trade debts at a discount, either on a recourse basis (you retain the credit risk on the debts) or on a non-recourse basis (the factoring company takes over the credit risk). Government and European Commission sources - provide financial aid to UK companies, ranging from project grants (related to jobs created and safeguarded) to enterprise loans in selective areas. Mezzanine firms - provide loan finance that is halfway between equity and secured debt. These facilities require either a second charge on the companys assets or are unsecured. Because the risk is consequently higher than senior debt, the interest charged by the mezzanine debt provider will be higher than that from the principal lenders and sometimes a modest equity up-side will be required through options or warrants. It is generally most appropriate for larger transactions.

Making the Investment - Due Diligence To support an initial positive assessment of your business proposition, the venture capitalist will want to assess the technical and financial feasibility in detail. External consultants are often used to assess market prospects and the technical feasibility of the proposition, unless the venture capital firm has the appropriately qualified people in-house. Chartered accountants are often called on to do much of the due diligence,
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such as to report on the financial projections and other financial aspects of the plan. These reports often follow a detailed study, or a one or two day overview may be all that is required by the venture capital firm. They will assess and review the following points concerning the company and its management:

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Management information systems Forecasting techniques and accuracy of past forecasting Assumptions on which financial assumptions are based The latest available management accounts, including the companys cash/debtor positions Bank facilities and leasing agreements Pensions funding Employee contracts, etc.

The due diligence review aims to support or contradict the venture capital firms own initial impressions of the business plan formed during the initial stage. References may also be taken up on the company (eg. with suppliers, customers, and bankers).

4.11. CHOOSING THE VENTURE CAPITAL FIRM Identifying the most appropriate group of venture capitalists to approach is critical. It is surprising how little research many entrepreneurs conduct before they begin the timeconsuming task of raising capital. Two problems can result from approaching venture capitalists unprepared. First, once an investment opportunity is rejected, it is very difficult to get it reconsidered, even with a proper introduction. Second, if an investment opportunity is rejected by a number of firms, it may get an over-shopped reputation.

Venture capitalists frequently share investment information and a turndown by one firm may influence others. Gathering preliminary information to narrow the field of potential VC firms is essential. The internet makes collecting background information on venture firms quite easy. Information on a VCs website is a good starting place. Specifically, an entrepreneur should set out to gather information on VCs based on five factors:
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Geographical location, Stage of development preference, Investment level parameters, Industry focus and Whether the firm prefers to lead investments.

This information is important as it provides five ways for choosing venture capital firms that are most likely to respond to the business plan. The first filter one should apply is geography. If one is based in an area well served by Venture capital, a local lead investor is critical. If one cannot attract a local lead, one will have a more difficult time raising capital elsewhere. Although there are many firms investing nationwide, the closer the venture capitalist is to the investment, the easier it is to add value and to monitor the investment, especially in early-stage companies. Today, virtually every region of the country has experienced venture capitalists. Secondly, many venture capitalists have a stage of development bias. There are some who prefer the seed capital arena while others are only interested in later-stage investing. One has to make certain that the companys stage of development matches the stage preferred by the venture firm, which one is approaching. One word of caution: many in the venture capital industry invest in startups but definitions vary between firms. A start-up for one firm can actually be a later-stage investment for another. So beware of inconsistent uses of stage of development terms. The third criterion is amount of capital needed. There are many firms that have an upper and lower limit to the size of an investment. If the project falls far outside a firms range, it is better not to approach them. Also, it is unwise to inflate the amount of capital needed to meet the minimum. Some venture capitalists shy away from very large rupee syndications and prefer to invest a smaller amount to give them a meaningful position in an emerging company. These firms may be more appropriate for initial requirements. The venture capital industry is witnessing greater industry specialization than ever before. This is the fourth filter to apply to in the search. There are venture capital firms and individual venture capitalists that specialize in medical technology, communications, consumer products and distribution, for instance. Clearly, if a venture capital firm has a stated investment preference in an industry, not only is it more likely to understand the opportunity, but it will
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also be in a position to add value to the company. This industry expertise is often acknowledged and respected by other VCs that may provide additional funding. In addition, a number of venture capital firms have excluded certain investment categories such as real estate or oil and gas. Finally, in every successful venture capital financing, there is a need for venture capital leadership. There are a number of funds who are active investors and are willing to lead a financing while others serve as passive investors. In order to complete syndication, one will need venture capital leadership. It is unwise to approach passive investors until after a lead investor is identified. Therefore, one should try to identify venture capitalists that take early leadership roles in syndications similar to the opportunity. Using these five criteria as a basis, one could prepare a target group of venture capitalists. One has to make certain that this target group is a reasonable size. (No one likes to receive a business plan that is number 128, knowing it has been sent to a broad audience.) A simple matrix may assist this effort. For example, subjectively one could rate a venture firms investment orientation as it relates to the firms needs. The VCs with the highest ratings should be the initial targets. Provisions relating to Share capital Type of Security Investors typically receive convertible preferred stock in exchange for making the investment in a new venture. This type of stock has priority over common stock if the company is acquired or liquidated and assets are distributed. The higher priority of the preferred stock justifies a higher price, compared to the price paid by founders for common stock. Convertible means that the shares may be exchanged for a fixed number of common shares. Liquidation Preference When the company is sold or liquidated, the preferred stockholders will receive a certain fixed amount before any assets are distributed to the common stockholders. A participating preferred stockholder will not only receive the fixed amount, but will also share in any additional amounts distributed to common stock.

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Dividend Preference Dividends are paid first to preferred stock, and then common stock. This dividend may be cumulative so that it accrues from year to year until paid in full, or non-cumulative and discretionary. Redemption Preferred stock may be redeemed or retired, either at the option of the company or the investors, or on a mandatory basis, frequently at some premium over the initial purchase price of the stock. One reason why venture firms want this right is due to the finite life of each investment partnership managed by the firm Conversion Rights Preferred stock may be converted into common stock at a certain conversion price, generally whenever the stockholder chooses. Conversion may also happen automatically in response to certain events, such as when the company goes public. Anti-dilution Protection The conversion price of the preferred stock is subject to adjustment for certain diluting events, such as stock splits or stock dividends. The conversion price is typically subject to price protection, which is an adjustment based on future sales of stock at prices below the conversion price. Price protection can take many forms. One form is called ratchet protection, which lowers the conversion price to the price at which any new stock is sold no matter the number of shares. Another form is broad-based weighted average protection, which adjusts the conversion price according to a formula that incorporates the number of new shares being issued, and their price. In many cases, a certain number of shares are exempted from this protection to cover anticipated assurances to key employees, consultants, and directors. Voting Rights Preferred stock has a number of votes equal to the number of shares of common stock into which it is convertible. Preferred stock usually has special voting rights, such as the right to
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elect one or more of the companys directors, or to approve certain types of corporate actions, such as amending the articles of incorporation, or creating a new series of preferred stock. Right of First Refusal Holders of preferred stock typically have the right to purchase additional shares when issued by the company, up to their current aggregate ownership percentage. Co-Sale Right Founders will often enter into a co-sale agreement with investors. A co-sale right gives investors some protection for investors against founders selling their interest to a third party by giving investors the right to sell part of their stock as part of such a sale. Registration Rights Registration rights are generally given to preferred investors as part of their investment. These rights provide investors liquidity by allowing them to require the company to register their shares for sale to the public either as part of an offering already planned by the company (called piggyback rights), or in a separate offering initiated at the investors request (called demand rights). Vesting on Founders Stock A percentage of founders stock, which decreases over time, can be purchased by the company at cost if a founder leaves the company. This is a protection for the investors against founders leaving the company after it gets funded. SUMMARY VENTURE INVESTMENT PROCESS The VC investment process has variance/features that are context specific to countries/regions. However, activities in a VC fund follow a typical sequence with a number of commonalities.

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In generating a deal flow, the VC investor creates a pipeline of deals or investment opportunities that he would consider for investing in. This is achieved primarily through plugging into an appropriate network. Due diligence is the industry jargon for all the activities that are associated with evaluating and investment proposal. It includes carrying out reference checks on the proposal related aspect such as management team, products, technology and market. The investment valuation process is an exercise aimed at arriving at an acceptable price for the deal. Typically, in countries where free pricing regimes exist the evaluation process goes through the following sequence: Evaluate future events and profitability Forecast likely future value of the firm based on the expected market capitalization or expected acquisition proceeds depending upon the anticipated exit from the investment. Target on ownership position in the investee firm so as to achieve desired appreciation on the proposed investment. The appreciation desired should yield a hurdle rate of return on a Discounted Cash Flow Basis. Symbolically the evaluation exercise may be represented as follows: Choosing the right venture capital firms is an important part of the fundraising process. An entrepreneur that has not researched and targeted venture firms runs the risk of lengthening the search and over-shopping the plan. Venture capitalists readily exchange information, so rejection from one firm may influence others. The criteria for selecting the right venture capitalists to approach include their geographic, industry specialization, stage of development, and size of investment preferences. Also important are whether the fund will act as a lead investor and whether there are complementary or competing ventures within the funds portfolio. Professionally managed venture capital funds provide seed, startup and expansion financing as well as management/leveraged buyout financing. In addition to these distinctions, funds may also specialize in technology sectors such as life sciences, while others invest in a wide array of technology and non-technology arenas. It is critical for an entrepreneur seeking venture capital to assess the value of the company from the perspective of the venture capitalist and to appreciate the dynamics of the entrepreneur/ venture capitalist relationship. This relationship revolves around a trade-off. Funds for growth are exchanged for a share of ownership. The entrepreneur will be asked to give up a large share of ownership of

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the company, possibly a majority stake. The venture capitalist seeks to value the venture to provide a return on investment commensurate with the risk taken. Pricing venture capital deals involves the estimated future values of the entity being financed and is highly subjective. A quality business plan is an important first step in convincing investors that the management team has the experience to build a successful enterprise. The plan also provides measurable operating and financial objectives for management and potential investors to measure the companys progress. Realistic financial forecasts within the business plan are important to attract investors and retain their interest to participate in future rounds of financing. The financials must accurately reflect the various product development, marketing and manufacturing strategies described in each section of the plan.

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TEST YOUR KNOWLEDGE 4.13. SHORT QUESTIONS 1. 2. 3. 4. 5. 6. 7. 8. Mention the typical stages in an investment cycle How can a deal flow be generated? What do you mean by due diligence How is the investment valuation made? Mention the factors which drive investment valuation. What do you mean by value addition? How would you target a venture capital partner? What is the profile of a typical venture capital fund

4.14. LONG QUESTIONS 1. 2. 3. 4. 5. Explain the venture capital investment process. Critically evaluate the factors which drive investment valuation. Explain the concept of pricing and control from the : the investors perspective Write a detailed note on the contents of a business plan. Examine the factors to be considered in choosing a venture capital partner.

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UNIT - V

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CORPORATE VENTURING
5.1 CORPORATE VENTURING Every ten years or so there is a surge of interest in internally generated new businesses i.e.. Corporate Ventures. Is this merely a recurring fad or has it had a real impact on organizational performance? The track record is mixed a combination of dramatic failures, success and mediocre results. Although many companies have been discouraged other have demonstrated the power of venturing by using it as a strategy for propelling themselves into dynamic profitability and growth. This record leaves little doubt about whether organizations can venture successfully. The real challenges involve are how to do so. 5.1.1 What is Corporate Venture? A project is considered as a venture when it : Involves an activity new to the organization Is initiated or conducted internally Involves significantly higher risk of failure or large losses than the organizations base business Will be managed separately at some time during its life Is undertaken for the purpose of increasing sales, profit, productivity or quality.

Although a venture may originate externally and may be augmented with a foothold acquisition, the venturing activity is originally part of the parent company. Internal corporate ventures (ICVs) may include major new products, development of new markets, commercialization of new technology and major innovative projects. They can involve a
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marked diversification r be closely related to companys other businesses. The key differentiating qualities are risk, uncertainty, newness and significance. The dividing line between a new venture and an extension of normal business activities is not always clear but it is important to determine this. From an operational standpoint, deciding that the business is in fact a new venture helps an organization define the kind f management the project will need. That decision is critical to the projects success. Creating a new business is different from modifying an old one to meet new challenges, because new ventures require a fundamentally different approach to management one consisting of integrating entrepreneurial management and leadership. This contrast sharply with traditional approach to management I which activities are separated into functional departments and a new project passes through an interminable process of interdepartmental head offs and signoffs as it wends its flow, weary and excessively expensive way to commercialization. 5.1.2 Why do Companies Venture Companies venture primarily to grow and to respond to competitive pressures. The following are the reasons for venturing: 1. 2. 3. 4. 5. 6. Maturity of base business To meet strategic gals To provide challenges to managers To develop future organizations To survive To provide employment

An organizations very survival depends on constant growth and defense against competition. From a defensive standpoint, run-run competitiveness cannot be maintained without innovation and the generation of new ventures.

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As shown in the figure above, growth can be achieved by increasing market penetration within existing markets with existing products; by introducing new products into existing markets, by entering new markets with existing products; or by introducing new products to new markets. The more mature a market the more difficult and expensive it gets for a company to grow by increasing its market share (penetration). Defending share also gets more expensive. Thus it becomes imperative for the company to innovate and develop new products and new markets. If familiar markets and products are in decline, the company may be force to sell out or to buy or develop new businesses in order to survive or grow. Productivity, quality and service must be improved simultaneously if an organization is to remain competitive. In an era of dynamic technological change, the organization must also remain technologically competitive; either though internal research and development or through alliances. But technology-driven R&D often produces new knowledge that has no practical utility unless a new business is created to make use of it. 5.1.3 Should all companies ventures? All companies should venture at least, if the timing and level of investment are right. Venturing is an absolute necessity if business and strategic goals require innovation and the transformation of innovation into new businesses, related or otherwise. Furthermore, venturing is probably called for if desired growth cannot be achieved with a current less risky activity, and it is also a must if opportunities in an industry are nt to be ceded to the competition.
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Companies that are achieving all their goals and have ample opportunity to continue doing so by expanding their efforts to new geographical areas or extending their product lines might best choose a venturing strategy focused on enhancing quality, service and productivity by means of technical development and process improvement. Companies that are not prepared to commit to internal venturing as an absolute necessity to ensure either the achievement of their strategic goals or their survival probably should not undertake a venturing effort until they make such a commitment. It is clear that all organizations must innovate and venture in order to survive competitively, but not every organization must at all times be prepared to mount a programme to start new businesses internally. These options include creating spin-offs and venturing with corporate venture capital. Creating spin-Offs; When an innovation occurs, especially one involving the development of new technology, a company may perceive a new business opportunity. But suppose the opportunity would entail bringing new products to new markets, particularly unrelated markets, and the company is not ready to support venturing activity in any form. Does this mean the opportunity should be ignored? Not necessarily. In such case, the company can choose the spin-offs option, which has proved very effective in Japan. (Toyota was a spinoff). Using this option, the existing company invests (and not necessarily as a controlling investor) in a new company organized for and dedicated to the development of the new business. This approach is based on the existing companys recognition that it cannot be a supportive host for the new business and that he new business will do much better as a separate organization. It is also based on the unstated premise that the existing companys culture cannot or should not be changed in order to create a supportive base for the new business.

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SELECTING OPPORTUNITIES 5.2 LOCATING THE VENTURE IN THE ORGANISATION The crucial decision of where to locate a venture in the parent organization should be related with the key issue of the extent to which he venture should be separated from the organizations ongoing operations. Six major location options, involving progressive degrees of separation are being described below with their pros and cons. These options range from simply assigning the venture to a line managers as part of his or her normal job to having the venture manager report to a new business division or even directly to the CEO. Thus it is clear from the above that there is no ideal pace to locate a venture. 5.2.1 Selecting the Ventures Format Before discussing the issues of venture location, however, we should point out that there are alternatives to simply creating a fully controlled internal corporate venture. A wide variety of format options are available including selling an innovation off outright, licensing others to exploit it, starting an internal venture as a project team, forming a subsidiary to build the business, creating a joint venture (in which the parent companys ownership could range from minority holding to 50/50 to majority holding), acting solely as a venture capital source (either for an internally developed innovation or as a participant in a venture capital pool), or making an acquisition (either a foothold acquisition or a major acquisition). 5.2.2 Why would a company choosing give up full ownership of a venture? The parent firm may be unable to provide the required expertise, principally involving technology or market, or it may need to obtain capital or share the risk. Other reasons include: financing capacity (current and projected), an aversion to risk, timing needs, risk or reward potential, and fit factors. The shared ownership option may be rejected, however, if the parent company feels it must retain 100% ownership or is convinced it can meet all the ventures needs by itself. Acquisition is used primarily to collapse time or sometimes to get the kind of management required and reduce the risk. The separate subsidiary approach can help the parent obtain and retain talented management and enable it to use innovative incentives and compensation arrangements without alienating people in the core business. The joint

NOTES

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venture, possibly with the minority holding might be appropriate for a corporation that has low capacity for risk, an urgent need for accelerating the venture process, and a significant culture gap between the parent firm and the venture. Of course, whatever the ventures starting format, it is unlikely to remain in that format permanently, particularly if strategic alliances or joint ventures are involved. Such agreement such contain exit provisions, specifying the conditions under which the parties cane exit, the pricing formula to be used in the event of buyout, and the process for handling unresolvable disagreement (e.g., arbitration). 5.2.3 Venture location options Venture location options range from totally embedding the venture in the parent companys ongoing operations to creating a completely separate new-venture division reporting directly to the top most level of the organization. The degree to which a venture is separated from main stream corporate operations significantly influences a number of issues that are important for the ventures progress : Focus: The more embedded a venture, the less its chances of being the focus of attention in that location. Ventures placed in line operations tend to struggle to attract attention because line managers are distracted by day-to-day problems. So if focus of attention is important for the ventures success, a higher degree of separation will be needed. Priority: The more embedded a venture, the less likely it is to receive top priority in so far as the allocation of resources is concerned. This is because the venture must compete for resources against established, large, and often much more profitable sub-units in the organization within which it is embedded. Increasing the degree of separation therefore increases th ventures chances of receiving top priority. Reliability of funding: The more embedded a venture, the more unpredictable the availability of funds, since there is a tendency to respond to contingencies by preempting the ventures funding and diverting it to established operating units, Increasing the ventures separation increases the probability that needed funds will be forthcoming. Copying with growth: The greater the ventures separation from ongoing operations, the less built-in infrastructure and staff will be available to cope with
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the ventures growth. When a venture deeply embedded in existing operations needs to grow, the required systems, facilities and staff are already in place. When a highly separated venue needs to grow, these resources must either be created or recruited, since they simply do not exist in that location. (the fact that resources are available in embedded locations does not necessarily mean that those resources will be forthcoming, only that they need not be created from scratch.) In the light of the preceding issues, an organization seeking to determine the initial location of a venture should ask itself where the venture can best be placed in order to ensure that: The venture is protected politically The venture gets the necessary guidance, commitment, and attention The venture gains optimal access to the target market The venture enjoys nurturing and supportive environment that includes appropriate controls. The parent firm is protected against major losses and hazards.

NOTES

In the following subsections the six major levels of location together with their major pros and cons. Note that each higher level represents a higher degree of separation from the ongoing operations of the firm. Level 1 : Assigning the project to a Line Manager The venture project is assigned to a line manager to execute as all parts of his or her ongoing managerial responsibilities, with the line manager reporting to the operating division management. Pros : The venture enjoys maximum exposure to operations expertise. Cons : This location maximizes the ventures intrusion into and disruption of the units present business, while minimizing the attention it receives from the line management.
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It also leave the venture highly vulnerable to turf brawling. Level 2 : Creating a separate section in an operating division The venture is assigned full time to a line manager who reports to an operating division, and he or she assembles a team of full and part time people to get the venture going. Pros : The venture gains political support, enjoys maximum exposure to corporate knowhow and has greater access to the organizations expertise in the business if it involves a familiar market. Subsequent integration into the division is facilitated (assuming that is the ultimate objective) Cons : The venture has a low priority in terms of commitment and it losses detract from divisional performance. It may be the first to suffer during periods of cost reduction; it faces the dangers of turf drawling and intrusion from the parent division; and it is susceptive to red tape. Level 3 : Having the venture report to R&D The venture is assigned full time to a venture manager who reports to R&D and he or she assembles a team of full and part time people to get the venture going. Pros. : The venture remains close to evolving technology and technical information that would prove crucial to success.

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Cons : The R&D division may become infatuated with the technology and be oblivious to market needs and timing especially if it lacks business and marketing experience, orientation and knowledge and the evaluation of technical alternatives may be hampered by a not invented here attitude. This location also leads the venture susceptive be red tape. Level 4 : Having the venture report to a Senior Staff Function The person in charge of the venture reports to a senior staff position (such as R&D or Corporate Development), either individually or as a venture manager in charge of a team of full or part-timers. Pros. This approach ensures dedication to addresses the key challenges of the venturing operations, intrusion into existing operations is minimized, as is vulnerability to turf brawling Cons: The venture has little exposure to operations expertise and may suffer if the parent unit lacks business and marketing experience. Level 5 : Having the venture report to a new venture division The venture manager reports to a separate new venture division, which interacts directly with top management. Pros This approach ensures sympathetic nurturing of the venture, protection from corporate red tape and a high level of attention focused on the key challenges facing the venture. Intrusion into the parent firms operations is minimized, as is the ventures vulnerability to turf brawling.

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Cons The venture is removed from the corporates main stream. Level 6 : Having the venture report to the CEO 5.3 FACTORS INFLUENCING HOW SEPARATED THE VENTURE SHOULD BE FROM THE PARENT COMPANY. The factors that influence how separated the venture should be depend on the circumstances in which the parent company finds itself. They are as follows : 1. Acceptance of venturing and of the venture : The level of acceptance within an organisation, both of venturing as an activity and of a particular venture, varies from one firm to another. If most to the established organisation is indifferent or hostile to the venture or to venturing in general, or simply does not believe in venturing, then the venture has a very great change of failing prey to lack of support or deliberate obstructionism or getting chewed up as powerful vested interests engaged in turf brawling. Clearly, when organisational acceptance is poor, there is a need to safeguard the venture, either by placing it in what is termed a reservation (a level 3 or 4 location, described above) or by creating a safeguarding mechanism. 2. Experience with venturing: An organizations experience with venturing can range from nonexistent to extensive. Even if the organisation welcomes venturing, it may simply lack the expertise base required to venture successfully, in this case, it is probably better to locate the venture where it can be protected from constantly having to account for differences between plans and results. Once again, it may become necessary to place the venture in a reservation (i.e., a level 3 or level 4 location). 3. The ventures criticality: The ventures importance to the firm and the urgency of its success must be considered in making the location decision. Highly critical ventures tend to need a location that reports to senior level of th parent organisation. 4. Current organization and divisional performance: If the organisation is performing poorly or is subject to great stress the venture will whither on the vine unless it can command organizational attention, which means level 3 or level 4 location. It is totally inappropriate to place a venture in any dividing that is under stress because of environmental turbulence or internal performance disappointments.
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5. Organisational Structure: The organizations current structure also affects where a venture can be located. There are 5 basic types of organisational structure: Functional Geographic Product Divisional Hybrid

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Highly functionalized firms tend to have extensive policies and procedures by which to coordinate cross functional activities, whereas geographically dispersed firms tend to have similar policies and procedures to coordinate activities in various areas. In geographically dispersed firms, ventures placed in lower level locations tend to get strangled by homogenizing staff groups whose task is to ensure that all units comply with corporate policies. In firms with such homogenizing bureaucracies, venture should be placed in location with a high degree of separation. 6. Scale of the Venture: The venture size is an important consideration in making the location decision. A major venture involving significant commitment of organisational resources and significant organisational effort will obvious require large multifunctional team, which will probably be separated from the companys ongoing operations. The smaller the scale of the venture, the more likely it is to be located as a group or an individual embedded in some part of the organization. 7. Stage of venture Evolution: There is no location that would fit all the stages through which a venture passes as it evolves. The location needs of a venture in its very early stages differ significantly from those of a successful venture that is about to become a large component of the parent organisation. It is quite conceivable for a venture to start as an one person investigation in the development department, perhaps liaising with one or two scales and production contracts, and then evolve into a large, separate operation as it grows. The key is for senior management to set back and reassess the location decision as the venture progresses , changing the location if it no longer fits the ventures current needs. 8. The ventures anticipated future location within the firm : If the new business will ultimately become part of one of the firms existing operations, the initial location decision should be made in such a way as to minimize later integration problems

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5.4 SAFEGUARDING THE VENTURE FROM ORGANISATIONAL ANTAGONISM It should be clear that the 8 factors discussed in the preceding section are significant determinants of a ventures outcome and that certain combinations of these factors can lead to political and bureaucratic conditions that will guarantee the failure of a poorly located venture, no mater how great its intrinsic potential. Although all 8 of the above factors are important, senior managements top priority in making the venture location decision should be first and foremost, to place the venture where it will be safeguarded from corporate antagonism (i.e., political and bureaucratic interferences). There is no way a venture can survive simultaneously internal and external competition, so unless the venture can be proceed from internal attack, at least in its early stages, it is doomed. The most effective way to seal a venture from organizational antagonism is to separate it form ongoing operations, but his is not necessarily the only way to proect the venture that faces opposition. Here are some safeguarding mechanism the parent firm can use as alternatives to separation: Venture Advisory Board : A signification measure of protection from organisational politics and bureaucratic attacks can be achieved by creating a board comprised of important internal and even external advisors whose task is not only to provide the venture with technical and managerial advise but also to protect it. Particularly, if one or more of the boards members are very senior executives of the parent firm, they will be in a position to overrule policies and procedures that may be obstructing the venture or discourage political moves against the venture manager. Executive Champion: In addition to a venture advisory board, the organisation should appoint a very senior manager as executive champion, with explicit part or full-time responsibility for defending any ventures that come under political or bureaucratic attack. The challenge in filling such an assignment is to find a senior manger who is widely respected in all functional areas and possesses and entrepreneurial attitude and mindset. And if the assignment is a
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part time one, there is a question of whether the executive champion will devote enough attention to the ventures which or she is supposed to protect. On the other hand, appointing such an individual sends the rest of the organisation a powerful signal regarding the seriousness of the firms commitment to venturing. Right of Direct Appeal: The final and least costly safeguarding mechanism is to give the venture manager the right to appeal directly to the senior management team or policy committee whenever he or she feels that organisational issues are compromising the venture. In theory, this should work fine. The question is whether the venture manager will risk challenging powerful senior executives when the ventures needs conflict with the executives wishes. The effectiveness of this mechanism depends to a great extent on the organizations experience with and acceptance of venturing as well as how critical the particular venture is for the organisation. In short, if a venture faces any danger of organisation antagonism, safeguarding it should take top priority in making the location decisions. No matter how compelling a particular location may seem, a venture facing hostility may require protecting through the use of such safeguarding mechanisms as separation, a venture advisory board, an executive champion or some right of appeal to top management. Conclusion : When the issue of venture location, is first raised, senior managers may wonder what all the fuss is about. Why not simply create a new venture division of have the various venture mangers report directly to the CEO. However, separating the venture from the rest of eh organisation, could deny it access to viable know-how, which, in turn could significantly increase the ventures cost and reduce its chances for success. Thus there is always a basic trade-off that must be made; if the venture is separated, it will be poected from antagonism and/or byuracratic interferences but its access to valuable know-how will be restricted, threby compromising its success in one way; if the venture is embeeded, it will be able to avail itself of that know-hw but I will be exposed to rgnsiainal antagonism and/or buracractic interferences thereby comprsoing its success in a different way.
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In the absence of antagonism, there is no reason why any partiicular venture location is superior to one all have their shortcomings. What matters is whether the shortcomings of he particular location have been recognized and offset through the use of appropriate mechanisms. Finally as with every other design decision, lthe location decision must be reexamined on an ongoing basis and may require change as he venture evolves though its various developmental stages (startup, survival, expansion, maturity). Guidelines : 1. Exercise great car in positing a venture in the firm. This decision is a critical determinant of the ventures success. 2. Since safeguarding the venture from corporate antagonism is essential, take appropriate prorective measure if need be. These include, having the venture report directly to senior management, providing for an executive champion, creating a venture advisory board, or establishing the venture managers right of direct appeal to the highest levels of management. 3. In determining the ventures degree of embeededness or separation, consider the ventures needs in terms of priority in securing management attention, reliability of funding, and coping with growth. 4. Revisit and reassess the location decision as the venture evoleves.

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