Acknowledgement

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

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

We express our sincere thanks to Mr. Prem Sibbal, Faculty- Management of Financial
Services at Lal Bahadur Shastri Institute of Management, for his encouragement and support
in pursuing this project.

1
 Table of Contents
Serial Number Particulars Page Number

1 Acknowledgement

2 Concept of Venture Capital

3 The Venture Capital Spectrum

4 Current Industry Trends

5 VC Industry in India

6 Factors Affecting Venture Capital

7 Venture Capitalists: Scenario 2010

8 Case Study

2
 Concept of Venture Capital

The term venture capital comprises of two words that is, “Venture” and “Capital”. Venture is
a course of processing, the outcome of which is uncertain but to which is attended the risk or
danger of “loss”. “Capital” means recourses to start an enterprise. To connote the risk and
adventure of such a fund, the generic name Venture Capital was coined.

Venture capital is considered as financing of high and new technology based enterprises. It is
said that Venture capital involves investment in new or relatively untried technology,
initiated by relatively new and professionally or technically qualified entrepreneurs with
inadequate funds. The conventional financiers, unlike Venture capitals, mainly finance
proven technologies and established markets. However, high technology need not be pre-
requisite for venture capital.

Venture capital has also been described as ‘unsecured risk financing’. The relatively high risk
of venture capital is compensated by the possibility of high returns usually through
substantial capital gains in the medium term. Venture capital in broader sense is not solely an
injection of funds into a new firm, it is also an input of skills needed to set up the firm, design
its marketing strategy, organize and manage it. Thus it is a long term association with
successive stages of company’s development under highly risk investment conditions, with
distinctive type of financing appropriate to each stage of development. Investors join the
entrepreneurs as co-partners and support the project with finance and business skills to
exploit the market opportunities.

Venture capital is not a passive finance. It may be at any stage of business/production cycle,
that is, start up, expansion or to improve a product or process, which are associated with both
risk and reward. The Venture capital makes higher capital gains through appreciation in the
value of such investments when the new technology succeeds. Thus the primary return sought
by the investor is essentially capital gain rather than steady interest income or dividend yield.

The most flexible definition of Venture capital is-

3
 “The support by investors of entrepreneurial talent with finance and business
skills to exploit market opportunities and thus obtain capital gains.”

Venture capital commonly describes not only the provision of start up finance or ‘seed corn’
capital but also development capital for later stages of business. A long term commitment of
funds is involved in the form of equity investments, with the aim of eventual capital gains
rather than income and active involvement in the management of customer’s business.

Features of Venture Capital

2.2.1 High Risk

By definition the Venture capital financing is highly risky and chances of failure are high as it
provides long term start up capital to high risk-high reward ventures. Venture capital assumes
four types of risks, these are:

 Management risk - Inability of management teams to work together.

 Market risk - Product may fail in the market.

 Product risk - Product may not be commercially viable.

 Operation risk - Operations may not be cost effective resulting in

increased cost decreased gross margins.

2.2.2 High Tech

As opportunities in the low technology area tend to be few of lower order, and hi-tech
projects generally offer higher returns than projects in more traditional areas, venture capital
investments are made in high tech. areas using new technologies or producing innovative
goods by using new technology. Not just high technology, any high risk ventures where the
entrepreneur has conviction but little capital gets venture finance. Venture capital is available

4
for expansion of existing business or diversification to a high risk area. Thus technology
financing had never been the primary objective but incidental to venture capital.

2.2.3 Equity Participation & Capital Gains

Investments are generally in equity and quasi equity participation through direct purchase of
shares, options, convertible debentures where the debt holder has the option to convert the
loan instruments into stock of the borrower or a debt with warrants to equity investment. The
funds in the form of equity help to raise term loans that are cheaper source of funds. In the
early stage of business, because dividends can be delayed, equity investment implies that
investors bear the risk of venture and would earn a return commensurate with success in the
form of capital gains.

2.2.4 Participation In Management

Venture capital provides value addition by managerial support, monitoring and follow up
assistance. It monitors physical and financial progress as well as market development
initiative. It helps by identifying key resource person. They want one seat on the company’s
board of directors and involvement, for better or worse, in the major decision affecting the
direction of company. This is a unique philosophy of “hands on management” where Venture
capitalist acts as complementary to the entrepreneurs. Based upon the experience other
companies, a venture capitalist advise the promoters on project planning, monitoring,
financial management, including working capital and public issue. Venture capital investor
cannot interfere in day today management of the enterprise but keeps a close contact with the
promoters or entrepreneurs to protect his investment.

2.2.5 Length of Investment

Venture capitalist help companies grow, but they eventually seek to exit the investment in
three to seven years. An early stage investment may take seven to ten years to mature, while
most of the later stage investment takes only a few years. The process of having significant

5
returns takes several years and calls on the capacity and talent of venture capitalist and
entrepreneurs to reach fruition.

2.2.6 Illiquid Investment

Venture capital investments are illiquid, that is, not subject to repayment on demand or
following a repayment schedule. Investors seek return ultimately by means of capital gains
when the investment is sold at market place. The investment is realized only on enlistment of
security or it is lost if enterprise is liquidated for unsuccessful working. It may take several
years before the first investment starts to locked for seven to ten years. Venture capitalist
understands this illiquidity and factors this in his investment decisions.

Difference between Venture Capital & Other Funds

2.3.1 Venture Capital Vs Development Funds

Venture capital differs from Development funds as latter means putting up of industries
without much consideration of use of new technology or new entrepreneurial venture but
having a focus on underdeveloped areas (locations). In majority of cases it is in the form of
loan capital and proportion of equity is very thin. Development finance is security oriented
and liquidity prone. The criteria for investment are proven track record of company and its
promoters, and sufficient cash generation to provide for returns (principal and interest). The
development bank safeguards its interest through collateral.

They have no say in working of the enterprise except safeguarding their interest by having a
nominee director. They do not play any active role in the enterprise except ensuring flow of
information and proper management information system, regular board meetings, adherence
to statutory requirements for effective management control where as Venture capitalist
remain interested if the overall management of the project o account of high risk involved I
the project till its completion, entering into production and making available proper exit route
for liquidation of the investment. As against this fixed payments in the form of installment of
principal and interest are to be made to development banks.

6
2.3.2 Venture Capital Vs Seed Capital & Risk Capital

It is difficult to make a distinction between venture capital, seed capital, and risk capital as
the latter two form part of broader meaning of Venture capital. Difference between them
arises on account of application of funds and terms and conditions applicable. The seed
capital and risk funds in India are being provided basically to arrange promoter’s contribution
to the project. The objective is to provide finance and encourage professionals to become
promoters of industrial projects. The seed capital is provided to conventional projects on the
consideration of low risk and security and use conventional techniques for appraisal. Seed
capital is normally in the form of low interest deferred loan as against equity investment by
Venture capital. Unlike Venture capital, Seed capital providers neither provide any value
addition nor participate in the management of the project. Unlike Venture capital Seed capital
provider is satisfied with low risk-normal returns and lacks any flexibility in its approach.

Risk capital is also provided to established companies for adapting new technologies. Herein
the approach is not business oriented but developmental. As a result on one hand the success
rate of units assisted by Seed capital/Risk
Finance has been lower than those provided with venture capital. On the other hand the return
to the seed/risk capital financier had been very low as compared to venture capitalist.

Seed Capital Scheme Venture capital Scheme

Basis Income or aid Commercial viability
Beneficiaries Very small entrepreneurs Medium and large
entrepreneurs are also
covered
Size of assistance Rs. 15 Lac (Max) Up to 40 percent of
promoters’ equity
Appraisal process Normal Skilled and specialized
Estimates returns 20 percent 30 percent plus
Flexibility Nil Highly flexible
Value addition Nil Multiple ways
Exit option Sell back to promoters Several ,including Public
offer
Funding sources Owner funds Outside contribution
allowed
Syndication Not done Possible

7
 Tax concession Nil Exempted
Success rate Not good Very satisfactory

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

2.3.3 Venture Capital Vs Bought Out Deals

The important difference between the Venture capital and bought out deals is that bought-
outs are not based upon high risk- high reward principal. Further unlike Venture capital they
do not provide equity finance at different stages of the enterprise. However both have a
common expectation of capital gains yet their objectives and intents are totally different.

8
 The Venture Capital Spectrum

The requirements of funds vary with the life cycle stage of the enterprise. Even before a
business plan is prepared the entrepreneur invests his time and resources in surveying the
market, finding and understanding the target customers and their needs. At the seed stage the
entrepreneur continue to fund the venture with his own or family funds. At this stage the
funds are needed to solicit the consultant’s services in formulation of business plans, meeting
potential customers and technology partners. Next the funds would be required for
development of the product/process and producing prototypes, hiring key people and building
up the managerial team. This is followed by funds for assembling the manufacturing and
marketing facilities in that order. Finally the funds are needed to expand the business and
attaint the critical mass for profit generation. Venture capitalists cater to the needs of the
entrepreneurs at different stages of their enterprises. Depending upon the stage they finance,
venture capitalists are called angel investors, venture capitalist or private equity
supplier/investor.

Venture capital was started as early stage financing of relatively small but rapidly growing
companies. However various reasons forced venture capitalists to be more and more involved
in expansion financing to support the development of existing portfolio companies. With
increasing demand of capital from newer business, Venture capitalists began to operate
across a broader spectrum of investment interest. This diversity of opportunities enabled
Venture capitalists to balance their activities in term of time involvement, risk acceptance and
reward potential, while providing on going assistance to developing business.

Different venture capital firms have different attributes and aptitudes for different types of
Venture capital investments. Hence there are different stages of entry for different Venture
capitalists and they can identify and differentiate between types of Venture capital
investments, each appropriate for the given stage of the investee company, These are:-

1. Early Stage Finance

 Seed Capital
 Start up Capital

9
 Early/First Stage Capital
 Later/Third Stage Capital

2. Later Stage Finance

 Expansion/Development Stage Capital
 Replacement Finance
 Management Buy Out and Buy ins
 Turnarounds
 Mezzanine/Bridge Finance

Not all business firms pass through each of these stages in a sequential manner. For instance
seed capital is normally not required by service based ventures. It applies largely to
manufacturing or research based activities. Similarly second round finance does not always
follow early stage finance. If the business grows successfully it is likely to develop sufficient
cash to fund its own growth, so does not require venture capital for growth.

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

Financing Stage Period (funds Risk perception Activity to be financed

locked in years)
Early stage finance 7-10 Extreme For supporting a concept or
Seed idea or R & D for product
development
Start up 5-9 Very high Initializing operations or
developing prototypes
First stage 3-7 High Start commercial production
and marketing
Second stage 3-5 Sufficiently Expand market & growing
high working capital need
Later stage finance 1-3 Medium Market expansion,
acquisition & product
development for profit
making company

10
 Buy out-in 1-3 Medium Acquisition financing

Turnaround 3-5 Medium to high Turning around a sick

company
Mezzanine 1-3 Low Facilitating public issue

Table 2.2: Venture Capital- Financing Stages

2.4.1 Seed Capital

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

defines seed capital as “The financing of the initial product development or capital provided
to an entrepreneur to prove the feasibility of a project and to qualify for start up capital”.

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

 Absence of ready product market

 Absence of complete management team
 Product/ process still in R & D stage
 Initial period / licensing stage of technology transfer

Broadly speaking seed capital investment may take 7 to 10 years to achieve realization. It is
the earliest and therefore riskiest stage of Venture capital investment. The new technology
and innovations being attempted have equal chance of success and failure. Such projects,
particularly hi-tech, projects sink a lot of cash and need a strong financial support for their
adaptation, commencement and eventual success. However, while the earliest stage of
financing is fraught with risk, it also provides greater potential for realizing significant gains
in long term. Typically seed enterprises lack asset base or track record to obtain finance from
conventional sources and are largely dependent upon entrepreneur’s personal resources. Seed
capital is provided after being satisfied that the entrepreneur has used up his own resources
and carried out his idea to a stage of acceptance and has initiated research. The asset
underlying the seed capital is often technology or an idea as opposed to human assets (a good
management team) so often sought by venture capitalists.

Volume of Investment Activity

11
It has been observed that Venture capitalist seldom make seed capital investment and these
are relatively small by comparison to other forms of venture finance. The absence of interest
in providing a significant amount of seed capital can be attributed to the following three
factors: -

a) Seed capital projects by their very nature require a relatively small amount of capital. The
success or failure of an individual seed capital investment will have little impact on the
performance of all but the smallest venture capitalist’s portfolio. Larger venture
capitalists avoid seed capital investments. This is because the small investments are seen
to be cost inefficient in terms of time required to analyze, structure and manage them.

b) The time horizon to realization for most seed capital investments is typically 7-10 years
which is longer than all but most long-term oriented investors will desire.

c) The risk of product and technology obsolescence increases as the time to realization is
extended. These types of obsolescence are particularly likely to occur with high
technology investments particularly in the fields related to Information Technology.

2.4.2 Start up Capital

It is stage 2 in the venture capital cycle and is distinguishable from seed capital investments.
An entrepreneur often needs finance when the business is just starting. The start up stage
involves starting a new business. Here in the entrepreneur has moved closer towards
establishment of a going concern. Here in the business concept has been fully investigated
and the business risk now becomes that of turning the concept into product.

Start up capital is defined as: “Capital needed to finance the product development, initial
marketing and establishment of product facility. “

The characteristics of start-up capital are:-

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i. Establishment of company or business. The company is either being organized or is
established recently. New business activity could be based on experts, experience or a spin-
off from R & D.

ii. Establishment of most but not all the members of the team. The skills and fitness to the
job and situation of the entrepreneur’s team is an important factor for start up finance.

iii. Development of business plan or idea. The business plan should be fully developed yet
the acceptability of the product by the market is uncertain. The company has not yet started
trading.

In the start up preposition venture capitalists’ investment criteria shifts from idea to people
involved in the venture and the market opportunity. Before committing any finance at this
stage, Venture capitalist however, assesses the managerial ability and the capacity of the
entrepreneur, besides the skills, suitability and competence of the managerial team are also
evaluated. If required they supply managerial skills and supervision for implementation. The
time horizon for start up capital will be typically 6 or 8 years. Failure rate for start up is 2 out
of 3. Start up needs funds by way of both first round investment and subsequent follow-up
investments. The risk tends t be lower relative to seed capital situation. The risk is controlled
by initially investing a smaller amount of capital in start-ups. The decision on additional
financing is based upon the successful performance of the company. However, the term to
realization of a start up investment remains longer than the term of finance normally provided
by the majority of financial institutions. Longer time scale for using exit route demands
continued watch on start up projects.

Volume of Investment Activity

Despite potential for specular returns most venture firms avoid investing in start-ups. One
reason for the paucity of start up financing may be high discount rate that venture capitalist
applies to venture proposals at this level of risk and maturity. They often prefer to spread
their risk by sharing the financing. Thus syndicates of investor’s often participate in start up
finance.
13
2.4.3 Early Stage Finance

It is also called first stage capital is provided to entrepreneur who has a proven product, to
start commercial production and marketing, not covering market expansion, de-risking and
acquisition costs.

At this stage the company passed into early success stage of its life cycle. A proven
management team is put into this stage, a product is established and an identifiable market is
being targeted.

British Venture Capital Association has vividly defined early stage finance as: “Finance
provided to companies that have completed the product development stage and require
further funds to initiate commercial manufacturing and sales but may not be generating
profits.”

The characteristics of early stage finance may be: -

 Little or no sales revenue.

 Cash flow and profit still negative.
 A small but enthusiastic management team which consists of people
with technical and specialist background and with little experience in the management
of growing business.
 Short term prospective for dramatic growth in revenue and profits.

The early stage finance usually takes 4 to 6 years time horizon to realization. Early stage
finance is the earliest in which two of the fundamentals of business are in place i.e. fully
assembled management team and a marketable product. A company needs this round of
finance because of any of the following reasons: -

 Project overruns on product development.

 Initial loss after start up phase.

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The firm needs additional equity funds, which are not available from other sources thus
prompting venture capitalist that, have financed the start up stage to provide further
financing. The management risk is shifted from factors internal to the firm (lack of
management, lack of product etc.) to factors external to the firm (competitive pressures, in
sufficient will of financial institutions to provide adequate capital, risk of product
obsolescence etc.)

At this stage, capital needs, both fixed and working capital needs are greatest. Further, since
firms do not have foundation of a trading record, finance will be difficult to obtain and so
Venture capital particularly equity investment without associated debt burden is key to
survival of the business.

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

a) The early stage firms may have drawn the attention of and
incurred the challenge of a larger competition.

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

firm is involved in high-tech business like computer,
information technology etc.

2.4.4 Second Stage Finance

It is the capital provided for marketing and meeting the growing working capital needs of an
enterprise that has commenced the production but does not have positive cash flows
sufficient to take care of its growing needs. Second stage finance, the second trench of Early
State Finance is also referred to as follow on finance and can be defined as the provision of
capital to the firm which has previously been in receipt of external capital but whose financial
needs have subsequently exploded. This may be second or even third injection of capital.

The characteristics of a second stage finance are:

 A developed product on the market

 A full management team in place
15
 Sales revenue being generated from one or more products
 There are losses in the firm or at best there may be a break even but the surplus generated
is insufficient to meet the firm’s needs.

Second round financing typically comes in after start up and early stage funding and so have
shorter time to maturity, generally ranging from 3 to 7 years. This stage of financing has both
positive and negative reasons.

Negative reasons include:

I Cost overruns in market development.

II Failure of new product to live up to sales forecast.
III Need to re-position products through a new marketing campaign.
IV Need to re-define the product in the market place once the
product deficiency is revealed.

Positive reasons include:

I Sales appear to be exceeding forecasts and the enterprise needs to acquire assets to gear
up for production volumes greater than forecasts.
II High growth enterprises expand faster than their working capital permit, thus
needing additional finance. Aim is to provide working capital for initial expansion of an
enterprise to meet needs of increasing stocks and receivables.

It is additional injection of funds and is an acceptable part of venture capital. Often provision
for such additional finance can be included in the original financing package as an option,
subject to certain management performance targets.

2.4.5 Later Stage Finance

It is called third stage capital is provided to an enterprise that has established commercial
production and basic marketing set-up, typically for market expansion, acquisition, product
development etc. It is provided for market expansion of the enterprise. The enterprises
eligible for this round of finance have following characteristics.
16
I. Established business, having already passed the risky early stage.
II. Expanding high yield, capital growth and good profitability.
III. Reputed market position and an established formal organization structure.

“Funds are utilized for further plant expansion, marketing, working capital or development of
improved products.” Third stage financing is a mix of equity with debt or subordinate debt.
As it is half way between equity and debt in US it is called “mezzanine” finance. It is also
called last round of finance in run up to the trade sale or public offer.

Venture capitalist s prefer later stage investment vis a vis early stage investments, as the rate
of failure in later stage financing is low. It is because firms at this stage have a past
performance data, track record of management, established procedures of financial control.
The time horizon for realization is shorter, ranging from 3 to 5 years. This helps the venture
capitalists to balance their own portfolio of investment as it provides a running yield to
venture capitalists. Further the loan component in third stage finance provides tax advantage
and superior return to the investors.

There are four sub divisions of later stage finance.

 Expansion / Development Finance

 Replacement Finance
 Buyout Financing
 Turnaround Finance

Expansion / Development Finance

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

the economies of scale. This expansion can be achieved either through an organic growth,
that is by expanding production capacity and setting up proper distribution system or by way
of acquisitions. Anyhow, expansion needs finance and venture capitalists support both
organic growth as well as acquisitions for expansion.

17
At this stage the real market feedback is used to analyze competition. It may be found that the
entrepreneur needs to develop his managerial team for handling growth and managing a
larger business.

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

favored by venture capitalist as it offers higher rewards in shorter period with lower risk.
Funds are needed for new or larger factories and warehouses, production capacities,
developing improved or new products, developing new markets or entering exports by
enterprise with established business that has already achieved break even and has started
making profits.

Replacement Finance

It means substituting one shareholder for another, rather than raising new capital resulting in
the change of ownership pattern. Venture capitalist purchase shares from the entrepreneurs
and their associates enabling them to reduce their shareholding in unlisted companies. They
also buy ordinary shares from non-promoters and convert them to preference shares with
fixed dividend coupon. Later, on sale of the company or its listing on stock exchange, these
are re-converted to ordinary shares. Thus Venture capitalist makes a capital gain in a period
of 1 to 5 years.

Buy - out / Buy - in Financing

It is a recent development and a new form of investment by venture capitalist. The funds
provided to the current operating management to acquire or purchase a significant share
holding in the business they manage are called management buyout.

Management Buy-in refers to the funds provided to enable a manager or a group of managers
from outside the company to buy into it.

It is the most popular form of venture capital amongst later stage financing. It is less risky as
venture capitalist in invests in solid, ongoing and more mature business. The funds are
provided for acquiring and revitalizing an existing product line or division of a major
business. MBO (Management buyout) has low risk as enterprise to be bought have existed for
18
some time besides having positive cash flow to provide regular returns to the venture
capitalist, who structure their investment by judicious combination of debt and equity. Of late
there has been a gradual shift away from start up and early finance to wards MBO
opportunities. This shift is because of lower risk than start up investments.

Turnaround Finance

It is rare form later stage finance which most of the venture capitalist avoid because of higher
degree of risk. When an established enterprise becomes sick, it needs finance as well as
management assistance foe a major restructuring to revitalize growth of profits. Unquoted
company at an early stage of development often has higher debt than equity; its cash flows
are slowing down due to lack of managerial skill and inability to exploit the market potential.
The sick companies at the later stages of development do not normally have high debt burden
but lack competent staff at various levels. Such enterprises are compelled to relinquish
control to new management. The venture capitalist has to carry out the recovery process
using hands on management in 2 to 5 years. The risk profile and anticipated rewards are akin
to early stage investment.

Bridge Finance

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

round of financing before the planned exit. Venture capitalist help in building a stable and
experienced management team that will help the company in its initial public offer. Most of
the time bridge finance helps improves the valuation of the company. Bridge finance often
has a realization period of 6 months to one year and hence the risk involved is low. The
bridge finance is paid back from the proceeds of the public issue.

Venture Capital Investment Process

19
Venture capital investment process is different from normal project financing. In order to
understand the investment process a review of the available literature on venture capital
finance is carried out. Tyebjee and Bruno in 1984 gave a model of venture capital investment
activity which with some variations is commonly used presently.

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

1. Deal Organization
2. Screening
3. Evaluation or due Diligence
4. Deal Structuring
5. Post Investment Activity and Exit

20
Figure 2.2: Venture Capital Investment Process

21
Deal origination:

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

opportunities that he would consider for investing in. Deal may originate in various ways.
referral system, active search system, and intermediaries. Referral system is an important
source of deals. Deals may be referred to VCFs by their parent organisaions, trade partners,
industry associations, friends etc. Another deal flow is active search through networks, trade
fairs, conferences, seminars, foreign visits etc. Intermediaries is used by venture capitalists in
developed countries like USA, is certain intermediaries who match VCFs and the potential
entrepreneurs.

Screening:

VCFs, before going for an in-depth analysis, carry out initial screening of all projects on the
basis of some broad criteria. For example, the screening process may limit projects to areas in
which the venture capitalist is familiar in terms of technology, or product, or market scope.
The size of investment, geographical location and stage of financing could also be used as the
broad screening criteria.

Due Diligence:

Due diligence is the industry jargon for all the activities that are associated with evaluating an
investment proposal. The venture capitalists evaluate the quality of entrepreneur before
appraising the characteristics of the product, market or technology. Most venture capitalists
ask for a business plan to make an assessment of the possible risk and return on the venture.
Business plan contains detailed information about the proposed venture. The evaluation of
ventures by VCFs in India includes;

Preliminary evaluation: The applicant required to provide a brief profile of the proposed
venture to establish prima facie eligibility.

22
Detailed evaluation: Once the preliminary evaluation is over, the proposal is evaluated in
greater detail. VCFs in India expect the entrepreneur to have:-  Integrity, long-term vision,
urge to grow, managerial skills, commercial orientation.

VCFs in India also make the risk analysis of the proposed projects which includes: Product
risk, Market risk, Technological risk and Entrepreneurial risk. The final decision is taken in
terms of the expected risk-return trade-off as shown in Figure.

Deal Structuring:

In this process, the venture capitalist and the venture company negotiate the terms of the
deals, that is, the amount, form and price of the investment. This process is termed as deal
structuring. The agreement also include the venture capitalist's right to control the venture
company and to change its management if needed, buyback arrangements, acquisition,
making initial public offerings (IPOs), etc. Earned out arrangements specify the
entrepreneur's equity share and the objectives to be achieved.

Post Investment Activities:

Once the deal has been structured and agreement finalised, the venture capitalist generally
assumes the role of a partner and collaborator. He also gets involved in shaping of the
direction of the venture. The degree of the venture capitalist's involvement depends on his
policy. It may not, however, be desirable for a venture capitalist to get involved in the day-to-
day operation of the venture. If a financial or managerial crisis occurs, the venture capitalist
may intervene, and even install a new management team.

Exit:

Venture capitalists generally want to cash-out their gains in five to ten years after the initial
investment. They play a positive role in directing the company towards particular exit routes.
A venture may exit in one of the following ways:

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

23
 Initial Public Offer (IPO)
 Acquisition by another company
 Re-purchase of venture capitalist’s share by the investee company
 Purchase of venture capitalist’s share by a third party

Promoter’s Buy-back

The most popular disinvestments route in India is promoter’s buy-back. This route is suited to
Indian conditions because it keeps the ownership and control of the promoter intact. The
obvious limitation, however, is that in a majority of cases the market value of the shares of
the venture firm would have appreciated so much after some years that the promoter would
not be in a financial position to buy them back.

In India, the promoters are invariably given the first option to buy back equity of their
enterprises. For example, RCTC participates in the assisted firm’s equity with suitable
agreement for the promoter to repurchase it. Similarly, Canfina-VCF offers an opportunity to
the promoters to buy back the shares of the assisted firm within an agreed period at a
predetermined price. If the promoter fails to buy back the shares within the stipulated period,
Canfina-VCF would have the discretion to divest them in any manner it deemed appropriate.
SBI capital Markets ensures through examining the personal assets of the promoters and their
associates, which buy back, would be a feasible option. GVFL would make disinvestments,
in consultation with the promoter, usually after the project has settled down, to a profitable
level and the entrepreneur is in a position to avail of finance under conventional schemes of
assistance from banks or other financial institutions.

Initial Public Offers (IPOs)

The benefits of disinvestments via the public issue route are, improved marketability and
liquidity, better prospects for capital gains and widely known status of the venture as well as
market control through public share participation. This option has certain limitations in the
Indian context. The promotion of the public issue would be difficult and expensive since the
first generation entrepreneurs are not known in the capital markets. Further, difficulties will
be caused if the entrepreneur’s business is perceived to be an unattractive investment
proposition by investors. Also, the emphasis by the Indian investors on short-term profits and
24
dividends may tend to make the market price unattractive. Yet another difficulty in India until
recently was that the Controller of Capital Issues (CCI) guidelines for determining the
premium on shares took into account the book value and the cumulative average EPS till the
date of the new issue. This formula failed to give due weight age to the expected stream of
earning of the venture firm. Thus, the formula would underestimate the premium. The
Government has now abolished the Capital Issues Control Act, 1947 and consequently, the
office of the controller of Capital Issues. The existing companies are now free to fix the
premium on their shares. The initial public issue for disinvestments of VCFs’ holding can
involve high transaction costs because of the inefficiency of the secondary market in a
country like India. Also, this option has become far less feasible for small ventures on
account of the higher listing requirement of the stock exchanges. In February 1989, the
Government of India raised the minimum capital for listing on the stock exchanges from Rs
10 million to Rs 30 million and the minimum public offer from Rs 6 million to Rs 18 million.

Sale on the OTC Market

An active secondary capital market provides the necessary impetus to the success of the
venture capital. VCFs should be able to sell their holdings, and investors should be able to
trade shares conveniently and freely. In the USA, there exist well-developed OTC markets
where dealers trade in shares on telephone/terminal and not on an exchange floor. This
mechanism enables new, small companies which are not otherwise eligible to be listed on the
stock exchange, to enlist on the OTC markets and provides liquidity to investors. The
National Association of Securities Dealers Automated Quotation System (NASDAQ) in the
USA daily quotes over 8000 stock prices of companies backed by venture capital.

The OTC Exchange in India was established in June 1992. The Government of India had
approved the creation for the Exchange under the Securities Contracts (Regulations) Act in
1989. It has been promoted jointly by UTI, ICICI, SBI Capital Markets, Can bank Financial
Services, GIC, LIC and IDBI. Since this list of market-makers (who will decide daily prices
and appoint dealers for trading) includes most of the public sector venture financiers, it
should pick up fast, and it should be possible for investors to trade in the securities of new
small and medium size enterprises.

25
The other disinvestments mechanisms such as the management buyouts or sale to other
venture funds are not considered to be appropriate by VCFs in India.

The growth of an enterprise follows a life cycle as shown in the diagram below. The
requirements of funds vary with the life cycle stage of the enterprise. Even before a business
plan is prepared the entrepreneur invests his time and resources in surveying the market,
finding and understanding the target customers and their needs. At the seed stage the
entrepreneur continue to fund the venture with his own or family funds. At this stage the
funds are needed to solicit the consultant’s services in formulation of business plans, meeting
potential customers and technology partners. Next the funds would be required for
development of the product/process and producing prototypes, hiring key people and building
up the managerial team. This is followed by funds for assembling the manufacturing and
marketing facilities in that order. Finally the funds are needed to expand the business and
attaint the critical mass for profit generation. Venture capitalists cater to the needs of the
entrepreneurs at different stages of their enterprises. Depending upon the stage they finance,
venture capitalists are called angel investors, venture capitalist or private equity
supplier/investor.

The players

There are following groups of players:

· Angels and angel clubs

· Venture Capital funds
- Small
- Medium
- Large
· Corporate venture funds
· Financial service venture groups

26
 Angels and angel clubs

Angels are wealthy individuals who invest directly into companies. They can form angel
clubs to coordinate and bundle their activities. Besides the money, angels often provide their
personal knowledge, experience and contacts to support their investees. With average deals
sizes from USD 100,000 to USD 500,000 they finance companies in their early stages.
Examples for angel clubs are · Media Club, Dinner Club ,· Angel's Forum

 Small and Upstart Venture Capital Funds

These are smaller Venture Capital Companies that mostly provide seed and start-up capital.
The so called "Boutique firms" are often specialised in certain industries or market segments.
Their capitalization is about USD 20 to USD 50 million (is this deals size or total money
under management or money under management per fund?). As for the small and medium
Venture Capital funds strong competition will clear the marketplace. There will be mergers
and acquisitions leading to a concentration of capital. Funds specialised in different business
areas will form strategic partnerships. Only the more successful funds will be able to attract
new money. Examples are:

· Artemis Comaford
· Abbell Venture Fund
· Acacia Venture Partners

 Medium Venture Funds

The medium venture funds finance all stages after seed stage and operate in all business
segments. They provide money for deals up to USD 250 million. Single funds have up to
USD 5 billion under management. An example is Accel Partners

 Large Venture Funds

As the medium funds, large funds operate in all business sectors and provide all types of
capital for companies after seed stage. They often operate internationally and finance deals up
to USD 500 million The large funds will try to improve their position by mergers and
acquisitions with other funds to improve size, reputation and their financial muscle. In
27
addition they will to diversify. Possible areas to enter are other financial services by means of
M&As with financial services corporations and the consulting business. For the latter one the
funds have a rich resource of expertise and contacts in house. In a declining market for their
core activity and with lots of tumbling companies out there is no reason why Venture Capital
funds should offer advice and consulting only to their investees.

Examples are:
· AIG American International Group
· Cap Vest Man
· 3i

 Corporate Venture Funds

These Venture Capital funds are set up and owned by technology companies. Their aim is to
widen the parent company's technology base in an win-win-situation for both, the investor
and the investee. In general, corporate funds invest in growing or maturing companies, often
when the investee wishes to make additional investments in echnology or product
development. The average deals size is between USD 2 million and USD 5 million. The
large funds will try to improve their position by mergers and acquisitions with other funds to
improve size, reputation and their financial muscle. In addition they will to diversify. Possible
areas to enter are other financial services by means of M&As with financial services
corporations and the consulting business. For the latter one the funds have a rich resource of
expertise and contacts in house. In a declining market for their core activity and with lots of
tumbling companies out there is no reason why Venture Capital funds should offer advice
and consulting only to their investees. Examples are:
· Oracle
· Adobe
· Dell
· Kyocera

As an example, Adobe systems launched a $40m venture fund in 1994 to invest in companies
strategic to its core business, such as Cascade Systems Inc and Lantana Research
28
Corporation.- has been successfully boosting demand for its core products, so that Adobe
recently launched a second $40m fund.

 Financial funds:

A solution for financial funds could be a shift to a higher securisation of Venture Capital
activities. That means that the parent companies shift the risk to their customers by creating
new products such as stakes in an Venture Capital fund. However, the success of such
products will depend on the overall climate and expectations in the economy. As long as the
sownturn continues without any sign of recovery customers might prefer less risky
alternatives.

29
 Current Industry Trends

Round Class Distribution

The distribution of financing rounds by round class in mature markets is typically 30-40% in
the early stage rounds, 20-25% in second round, and 35-40% in later rounds. In emerging
market like China, the round distribution is very different as 68% in early stage round and
25% in second round. In mature countries, the investments are made at early start up or
product development phase.

Industry shifts

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

and the business, consumer and retail industries, give the huge number of companies financed
in the technology and Internet boom of 1999-2000, and the subsequent downturn. The
healthcare pool, driven by investment in biopharmaceuticals and medical devices, has
actually grown to some degree in the different geographies .In United States, the healthcare
pool has grown consistently over the last several years, both in terms of number of companies
and cumulative dollars invested.

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

 The information and technology pool has declined by just 6% since 2002; particularly
due to increasing Interest in WEB 2.0 innovations.

 Since 2003, the IT pool has decreased by 27% in Europe and since 2004 17% in Israel.
Cumulative investment has declined in similar amounts.

 The business, consumer and retail category has faced the steepest declines across the
board. In US the number had fallen 54% since 2002 and 54% in Europe since 2003 .In
Israel; it dropped 67% since 2004.

30
 The number of healthcare companies has grown in U.S. since 2002 by 27% and the
capital risen 30% in last five years. Capital investment to the pool of healthcare
companies in Europe and Israel has also climbed, although the number of companies
dropped by 9%in Europe since 2003 and 9% in Israel since 2004.

 Clean technology is a small but increasing element of the pool. There were 262 clean
technology companies with a cumulative invested venture capital of US $38 billion in
2007.

Mega trends

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

 Beyond the BRICs: - A new wave of fast growing economies is joining the global growth
leaders like Brazil, China, India, and Russia. The beginning of venture capital activity has
been seen in others countries such as Indonesia, Korea, Turkey and Vietnam.

 The new multinationals: - A new breed of global company is emerging from developing
countries and redefining industries through low-cost advantage, modern infrastructure,
and vast customer databases in their home countries. These companies are potential
acquirers of developed market companies at all stages of growth.

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

significant regional shifts in IPO activity. These changes have also sparked global
consolidation alliances among stock exchanges.

 Transformation of the CFO’s role and function:- With the globalization and increasingly
complex regulatory environment, CFOs have a wider range of responsibilities and finance
function has been transformed to face broader mandates.

 Clean Technology: - Clean technology is poised to become the first break through sector
of 21st century. Encompassing energy, air and water treatment, industrial efficiency

31
 improvements, new material and waste management etc are playing very vital role
globally because of which VC investors are enjoying rewards.

The 2007 Global Venture Capital Survey was sponsored by Deloitte & Touche LLP in
conjunction with the National Venture Capital Association and other venture capital
associations* throughout the world. It was administered in April and May 2007 to venture
capitalists (VCs) in the Americas, Asia Pacific, Europe, the Middle East, and Africa.

There were 528 responses from general partners, with 45 percent of respondents from the
United States and 31 percent from Europe. A complete geographic breakdown of respondents
is as follows:

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

The breadth of assets under management by these respondents was varied. The highest
number of respondents—42 percent—had managed assets totaling less than $100 million; 35
percent managed assets between $100 million and $499 million; 12 percent managed assets
between $500 million to $1 billion; and 11 percent more than $1 billion in assets under
management

32
There are 13 % respondents from APAC in which China, India, Japan, South Korea, other
Asia. 45% respondents from Middle East include Israel and other area of Middle East.

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

We may live in a global economy, but the venture capital community is not broadly
embracing global investment. Rather, roughly half of the venture community has made a
commitment to a global investment strategy and those firms are implementing that strategy
slowly and cautiously. The intentions for growth of foreign investment, as demonstrated by
this year’s survey data, are modest at best.

% OF VENTURE CAPITALISTCURRENTLY INVESTING OUTSIDE

HOME COUNTRY(U.S. RESPONDENTS)

46
54

YES NO

Figure: 3.2 Percentage of venture capitalist currently investing outside home country
(U.S. respondents)

33
Figure: 3.3 Percentage of venture capitalist currently investing outside home country
(Non U.S. respondents)

Among U.S. investors, 54 percent indicated that they would be expanding their investment
focus outside of their home country or region in the next five years. Adequate deal flow in
their home country was the reason indicated most for not wanting to expand globally.

Some venture investors are certainly taking advantage of opportunities outside their home
countries, actual growth in terms of percentage of venture investors investing globally is
occurring much more slowly than is commonly believed. And, for a lot of firms, they’re not
diving deep into investing in other countries, but dipping a toe in with one or two deals. This
cautious approach allows the venture firms to further assess the investment environment,
evaluate how their strategy may need to be adjusted and how critical challenges, such as tax
and intellectual property issues impact overall performance.

3.5 Current strategies

Among those VCs who are currently investing abroad, 48 percent of them have developed
strategic alliances with a foreign-based firm and 51 percent invest only with other investors
who have a local presence. This underscores the need in venture capital to be physically close
to the portfolio companies in order to work with management. Firms also indicated that to
succeed, they need to understand local culture, and to do so they must have a local presence
in their target countries to take advantage of in-country expertise. To this end, they also are

34
hiring investment staff with expertise in target countries (41 percent) and requiring their
partners to travel more (58 percent).

Current business practises used by venture capitalist to manage foreign investment

focus
glo bal US No n US

70 63
58 58
60 55
50 51 52
48
50 44
40 40 41 41
40 34 36
33 33
29
30

20 14
11 12
7 7 8 6 8 6
10

0
strategic invest only acquire require require relocate HQ open new hire im vest in
alliances w ith other foreign partners to partners to of portfolio offices in investm ent local
w ith foreign investors based firm s travel m ore transfer to co.to be foreign staff w ith portfolio co.
firm s that have a foreign near our location expertise in w ith
local location firm target significant
presence countries operations
outside
country

China, India, Israel and Canada are primary target countries for
U.S. venture capitalists

There continues to be a consensus among U.S. venture capitalists regarding where the most
opportunities exists globally. Most of the U.S. firms who have invested globally are making
investments in China, India, Israel, and Canada. However, even in these countries, the
majority of U.S. respondents are essentially dabbling, making only one to two investments
thus far.

35
 FOREIGN INVESTMENT CURRENTLY HELD BY FIRMS

12% 1-2 investment

4%
3-5 investment
8%

53% 6-10 investment

23% 11-15 investment

16+ investment

Figure: 3.5 Foreign investment currently held by firms

Allocations by U.S. and non-U.S. firms alike for the most part represent less than 5 percent of
capital invested overseas in fewer than three to five deals. Survey results indicate that there
will not be significant change during the next five years.

36
RESPONSE FROM U.S. RESPONDENTS

Primary locations where investors would like to expand

investment focus (U.S. respondents)

china
5% India
7%
4% canda
6% 34%
UK & Ireland

9% Israel

other Asia
11% other Europe
24% others

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

Here from the above chart we can see that the highest percent of respondents are interested in
China for setting up their businesses. India is the second choice for the global investors.

37
RESPONSE FROM (APAC) RESPONDENTS

PRIMARY LOCATION WHERE INVESTOR WOULD LIKE TO EXPAND

INVESTMENT FOCUS (APAC) RESPONDENTS

3
3 3
CHINA

9 OTHER ASIA
37 U.S.

INDIA
18
MIDDLE EAST

SOUTH KOREA

JAPAN
27

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

While China, India, Israel, and Canada are by far the most seductive target markets for
investment by U.S. firms, venture capitalists in non-US countries have a different focus. By
far the greatest contrast is among European respondents, who indicated a strong preference
for investing in other parts of Europe (67 percent) and the United States (17 percent), with the
remainder focused on Asia. Asian respondents had a similar level of interest in the United
States (18 percent), but looked primarily inward to other Asian countries (78 percent), with
the remainder focused on the Middle East. This data shows that while non-U.S. investors are
interested in making deals outside of their home countries, there’s still a desire to remain
somewhat close to home and do business with cultures close to theirs. Most of APAC

38
respondents like to investment china and other Asia. There is 3% ready to invest in South
Korea, Japan and South Korea.

39
 VC Industry in India

The first major analysis on risk capital for India was reported in 1983. It indicated that new
companies often confront serious barriers to entry into capital market for raising equity
finance which undermines their future prospects of expansion and diversification. It also
indicated that on the whole there is a need to revive the equity cult among the masses by
ensuring competitive return on equity investment. This brought out the institutional
inadequacies with respect to the evolution of venture capital.

In India, the Industrial finance Corporation of India (IFCI) initiated the idea of VC when it
established the Risk Capital Foundation in 1975 to provide seed capital to small and risky
projects. However the concept of VC financing got statutory recognition for the first time in
the fiscal budget for the year 1986-87.

The Venture Capital companies operating at present can be divided into four groups:
 Promoted by All – India Development Financial Institutions
 Promoted by State Level Financial Institutions
 Promoted by Commercial banks
 Private venture Capitalists.

 Promoted by all India development financial institutions

The IDBI started a VC fund in 19876 as per the long term fiscal policy of government of
India, with an initial capital of Rs. 10 cr which raised by imposing a cess of 5% on all
payments made for the import of technology know- how projects requiring funds from rs.5
lacs to rs 2.5 cr were considered for financing. Promoter’s contribution ranged from this fund
was available at a concessional interest rate of 9% ( during gestation period) which could be
increased at later stages.

The ICICI provided the required impetus to VC activities in India, 1986, it started providing
VC finance in 1998 it promoted, along with the Unit Trust of India (UTI) Technology
Development and Information Company of India (TDICI) as the first VC company registered
under the companies act, 1956. The TDICI may provide financial assistance to venture

40
capital undertakings which are set up by technocrat entrepreneurs, or technology information
and guidance services.

The risk capital foundation established by the industrial finance corporation of India (IFCI) in
1975, was converted in 1988 into the Risk Capital and Technology Finance company (RCTC)
as a subsidiary company of the ifci the rctc provides assistance in the form of conventional
loans, interest –free conditional loans on profit and risk sharing basis or equity participation
in extends financial supoort to high technology projects for technological upgradations. The
RCTC has been renamed as IFCI Venture Capital Funds Ltd.(IVCF)

 Promoted by State Level Financial Institutions

In India, the State Level financial institutions in some states such as Madhya Pradesh,
Gujarat, Uttar Prades, etc., have done an excellent job and have provided VC to a small scale
enterprises. Several successful entrepreneurs have been the beneficiaries of the liberal
funding environment. In 1990, the Gujarat Industrial Investment Corporation, promoted the
Gujarat Venture Financial Ltd.(GVFL) along with other promoters such as the IDBI, the
World Bank, etc. The GVFL provides financial assistance to businesses in the form of equity,
conditional loans or income notes for technologies development and innovative products. It
also provides finance assistance to entrepreneurs.

The government of Andhra Pradesh has also promoted the Andhra Pradesh Industrial
Development Corporation (APIDC) venture capital ltd. To provide VC financing in Andhra
Pradesh.

 Promoted by commercial banks

Canbank Venture Capital Fund, State Bank Venture Capital Fund and Grindlays bank
Venture Capital Fund have been set up by the respective commercial banks to undertake vc
activities.

41
The State Bank Venture Capital Funds provides financial assistance for bought –out deal as
well as new companies in the form of equity which it disinvests after the commercialization
of the project.

Canbank Venture Capital Fund provides financial assistance for proven but yet to b
commercially exploited technologies. It provides assistance both in the form of equity and
conditional loans.

 Private Venture Capital Funds

Several private sector venture capital funds have been established in India such as the 20 th
Centure Venture Capital Company, Indus Venture Capital Fund, Infrastructure Leasing and
Financial Services Ltd.

Some of the companies that have received funding through this route include:
 Mastek, on of the oldest softwear house in India
 Ruskan software, Pune based software consultancy
 SQL Star, Hyderabad-based training and software development consultancy
 Satyam infoway, the first private ISP in India
 Hinditron, makers of embedded software
 Selectia, provider of interactive software selectior
 Yantra, ITLInfosy’s US subsidiary, solution for supply chain management
 Rediff on the Net, Indian website featuring electronic shopping, news,chat etc.

42
4.2 INDUSTRY LIFE CYCLE:

From the industry life cyle we can know in which stage we are standing. On the basis of
this management can make future strategies of their business.

INTRODUCTION GROWTH

Figure: 4.1 Industry life cycle

The growth of VC in India has four separate phases:

4.2.1 Phase I - Formation of TDICI in the 80’s and regional funds as GVFL & APIDC in the
early 90s.

The first origins of modern venture capital in India can be traced to the setting up of a
Technology Development Fund in the year 1987-88, through the levy of access on all
technology import payments. Technology Development Fund was started to provide financial
support to innovative and high risk technological programmes through the Industrial
Development Bank of India.

The first phase was the initial phase in which the concept of VC got wider acceptance. The
first period did not really experience any substantial growth of VCs’. The 1980’s were
marked by an increasing disillusionment with the trajectory of the economic system and a

43
belief that liberalization was needed. The liberalization process started in 1985 in a limited
way. The concept of venture capital received official recognition in 1988 with the
announcement of the venture capital guidelines.

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

Though the venture capital funds should operate as open entities, Government of India
controlled them rigidly. One of the major forces that induced Government of India to start
venture funding was the World Bank. The initial funding has been provided by World Bank.
The most important feature of the 1988 rules was that venture capital funds received the
benefit of a relatively low capital gains tax rate which was lower than the corporate rate. The
1988 guidelines stipulated that VC funding firms should meet the following criteria:

 Technology involved should be new, relatively untried, very closely held, in the process
of being taken from pilot to commercial stage or incorporate some significant
improvement over the existing ones in India

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

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

Between 1988 and 1994 about 11 VC funds became operational either through reorganizing
the businesses or through new entities.

All these followed the Government of India guidelines for venture capital activities and have
primarily supported technology oriented innovative businesses started by first generation
entrepreneurs. Most of these were operated more like a financing operation. The main feature
of this phase was that the concept got accepted. VCs became operational in India before the
liberalization process started. The context was not fully ripe for the growth of VCs. Till 1995;
the VCs operated like any bank but provided funds without collateral. The first stage of the
venture capital industry in India was plagued by in experienced management, mandates to
invest in certain states and sectors and general regulatory problems. Many public issues by
small and medium companies have shown that the Indian investor is becoming increasingly
wary of investing in the projects of new and unknown promoters.

44
The liberation of the economy and toning up of the capital market changed the economic
landscape. The decisions relating to issue of stocks and shares was handled by an office
namely: Controller of Capital Issues (CCI). According to 1988 VC guideline, any
organization requiring to start venture funds have to forward an application to CCI.
Subsequent to the liberalization of the economy in 1991, the office of CCI was abolished in
May 1992 and the powers were vested in Securities and Exchange Board of India. The
Securities and Exchange Board of India Act, 1992 empowers SEBI under section 11(2)
thereof to register and regulate the working of venture capital funds. This was done in 1996,
through a government notification. The power to control venture funds has been given to
SEBI only in 1995 and the notification came out in 1996. Till this time, venture funds were
dominated by Indian firms. The new regulations became the harbinger of the second phase of
the VC growth.

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

The second phase of VC growth attracted many foreign institutional investors.During this
period overseas and private domestic venture capitalists began investing in VCF. The new
regulations in 1996 helped in this. Though the changes proposed in 1996 had a salutary
effect, the development of venture capital continued to be inhibited because of the regulatory
regime and restricted the FDI environment. To facilitate the growth of venture funds, SEBI
appointed a committee to recommend the changes needed in the VC funding context. This
coincided with the IT boom as well as the success of Silicon Valley start-ups. In other words,
VC growth and IT growth co-evolved in India

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

Not surprisingly, the investing in India came “crashing down” when NASDAQ lost 60% of
its value during the second quarter of 2000 and other public markets (including those in
India) also declined substantially. Consequently, during 2001-2003, the VCs started investing
less money and in more mature companies in an effort to minimize the risks. This decline
broadly continued until 2003.

4.2.4 Phase IV – 2004 onwards - Global VCs firms actively investing in India
45
Since India’s economy has been growing at 7%-8% a year, and since some sectors, including
the services sector and the high-end manufacturing sector, have been growing at 12%-14% a
year, investors renewed their interest and started investing again in 2004. The number of
deals and the total dollars invested in India has been increasing substantially.

4.3 Growth of venture capital in India

Growth of VC in India
USD Million No. of Deals
16000 450
14234
14000 387 400

350
12000
299 300
10000 280
250
8000 7500
6390
200
6000 170
146 150
4000 110 71
100
78 2200
56
2000 1160 937 1650 50
591 470
0 0
2000 2001 2002 2003 2004 2005 2006 2007 1st half
of 2008
Value of deals No.of deals

Figure: 4.2 Growth of Venture capital in india

The venture capital is growing 43% CAGR. However, in spite of the venture capital scenario
improving, several specific VC funds are setting up shop in India, with the year 2006 having
been a landmark year for VC funding in India. The total deal value in 2007 is 14234 USD
Million. The NO. of deals are increasing year by year. The no. of deals in 2006 only 56 and
now in 2007 it touch the 387 deals. The introduction stage of venture capital industry in India
is completed in 2003 after that growing stage of Indian venture capital industry is started.

46
There are 160 venture capital firms/funds in India. In 2006 it is only but in 2007 the number
of venture capital firms are 146. The reason is good position of capital market. But in 2008
no. of venture capital firms increase by only 14. the reason is crashdown of capital market by
51% from January to November 2008. The No. of venture capital funds are increasing year
by year.

2000 2001 2002 2003 2004 2005 2006 2007 2008

841 77 78 81 86 89 105 146 160

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

and Service Companies)

Venture capital growth and industrial clustering have a strong positive correlation. Foreign
direct investment, starting of R&D centres, availability of venture capital and growth of
entrepreneurial firms are getting concentrated into five clusters. The cost of monitoring and
the cost of skill acquisition are lower in clusters, especially for innovation. Entry costs are
also lower in clusters. Creating entrepreneurship and stimulating innovation in clusters have
to become a major concern of public policy makers. This is essential because only when the
cultural context is conducive for risk management venture capital will take-of. Clusters
support innovation and facilitates risk bearing. VCs prefer clusters because the information
costs are lower. Policies for promoting dispersion of industries are becoming redundant after
the economic liberalization.

The venture capital firm invest their money in most developing sectors like health care, IT-
ITes,, telecom, Bio-technology, Media& Entretainment, shipping & ligistics etc.

47
 2007 VC INVESTMENTS BY INDUSTRY TOTAL
US$14.2Bn
1284 988
1638
1839

685

616
3979
1101
478
1628
IT&ITES Manufacturing
BFSI Eng & Construction
Healthcare & lifesciences Energy
Media&Entertinment Shipping&Logistics
Telecom Others

Source : TSJ Venture Intelligence India

Figure: 4.3 Total sector wise venture capital investment-2007

Now venture capital is nascent stage in india. Now due to growth of this sector, the venture
capital industry is also grow. The top most player in the industries are ICICI venture capital
fund, Avishhkar venture capital fund, IL&FS venture capital fund, Canbank.

48
Venture Capital investment Q3, 2008.

Venture Capital firms invested $274 million over 49 deals in India during the three months
ending September 2008. The VC investment activity during the period was significantly
higher compared to the same quarter last year (which had witnessed 36 investments worth
$252 million) as well as the immediate previous quarter ($165 million invested across 28
deals).

The latest numbers take the total VC investments in the first nine months of 2008 to $661
million (across 108 deals) as against the $648 million (across 97 deals) during the
corresponding period in 2007.

4.4.1 Top Investments

The largest investment reported during Q3 2008 was the $18 million raised by online tutoring
services provider TutorVista from existing investors Sequoia Capital India and LightSpeed
Ventures.

4.4.2 Investments by Industry

Information Technology and IT-Enabled Services (IT & ITES) industry retained its status as
the favorite among VC investors during Q3 ’08.

VC Investments by Industry

49
 Industry Volume No. of Deals Value (US $ M)
Q3 ‘ 08 Q3’ 08 YTD
YTD**
IT & ITES 25 58 147 361

BFSI 5 8 34 54
Engg & Construction 3 4 23 33
Healthcare & Life 6 12 4 52
Sciences
Education 2 3 17 23
Other Services 1 6 15 29
Manufacturing 2 2 13 13
Media 2 5 11 19
Energy 2 6 6 48
Travel & Transport 1 2 4 14
Retail - 1 - 10
Telecom - 1 - 5

Table: 4.2 Venture capital investment by industry

Led by the $12 million investment by Bellwether and others into Chennai-based microfinance
firm Equitas, BFSI emerged as the second largest (in value terms) for VC investments during
the period. Other microfinance firms that attracted investments during Q3 ’08 included
Kolkata-based Arohan Financial Services (which raised funding from Lok Capital and others)
and Guwahati-based Asomi Finance (IFC and Aavishkaar Goodwell).

50
 INVESTMENT BY INDUSTRY (Q3 ' 08)

5% 4% 2%1%
6%
6%

2% 54%
8%
12%
IT & ITES BFSI
Engg & Construction Healthcare & Life Sciences
Education Other Services
Manufacturing Media
Energy Travel & Transport

Figure: 4.4 investment by industry Q3,2008

51
4.4.3 Investment by Stage

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

VC Investments by Stage
Stage of Company Volume Value
Development
Q3 '08 YTD Q3 '08 YTD
Early 33 67 172 339
Growth 16 41 102 322

Table: 4.3 Venture investment by stage

STAGE WISE INVESTMENT

33%

67%

EARLY LATER

52
 Figure: 4.5 Stage wise investment

4.5 Need for growth of venture capital in India

In India, a revolution is ushering in a new economy, wherein entrepreneurs mind set is taking
a shift from risk averse business to investment in new ideas which involve high risk. The
conventional industrial finance in India is not of much help to these new emerging
enterprises. Therefore there is a need of financing mechanism that will fit with the
requirement of entrepreneurs and thus it needs venture capital industry to grow in India.

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

 Innovation : needs risk capital in a largely regulated,

conservative, legacy financial system

 Job creation: large pool of skilled graduates in the first

and second tier cities

 Patient capital: Not flighty, unlike FIIs

 Creating new industry clusters: Media, Retail, Call Centers and back office
processing, trickling down to organized effort of support services like office services,
catering, transportation

53
 Factors Affecting Venture Capital
ECONOMIC FACTORS:

 MERGER & ACQUISITION :

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

Quarter/Y Total M&A Deals Total Average

ear M&A with Disclosed M&AsDeal
Deals Disclosed M&A Value Size($M)
Values ($M)
2002 318 152 7,916.4 52.1
2003 290 122 7,721.1 63.3
2004 339 186 15,440.6 83.0
2005-1 81 45 4,351.9 96.7
2005-2 81 34 4,725.0 139.0
2005-3 101 48 18,056.0 376.2
2005-4 87 39 2,594.0 66.5
2005 350 166 29,727.0 179.1
2006-1 107 52 5,607.5 107.8
2006-2 105 40 4,018.5 100.5
2006-3 94 42 3,894.8 92.7
2006-4 62 26 5,616.8 216.0
2006 368 160 19,137.6 119.6
2007-1 82 29 4,540.3 156.6
2007-2 87 36 3,972.3 110.3
2007-3 100 52 10,810.0 207.9
2007-4 86 43 9,084.1 211.3
2007 355 160 28,406.7 177.5
2008-1 70 28 3,602.4 128.7
2008-2 50 14 2,397.3 171.2
2008 120 42 5,999.7 142.9

www.thomsonreuters.com

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

54
 VENTURE BACKED LIQUIDITY BY EVENTS
9000 8512.6 180
169
VALUE OF DEALS 8000 160
7000 5999.7 140

No.OF DEALS
6000 120
120
5000 100
4000 80
3000 60
2000 40
1000 20
0 0
FIRST TWO QUARTER OF FIRST TWO QUARTER OF
2007 2008

Value of Deals No. of Deals

Figure: 5.3 Venture backed M & A deals

 MERGERS AND ACQUISITIONS VOLUME DECLINES

In the second quarter of 2008, 50 venture-backed M&A deals were completed, 14 of which
had an aggregate deal value of $2.4 billion. M&A volume of 120 transactions in the first half
of 2008 was down 28 percent from the first half of 2007 when 169 transactions were
completed. The average disclosed deal value for the quarter was $171.2 million. Due to this
V/C is directly affected negatively because M&A is the exit route for Venture capital
industry. The reason behind decreasing No. of M&A deals is crashdown of SENSEX by 51%

55
 No.of Total Offer Average IPO
IPO's Amount Offer
Amount

Quarter/Year
($M) ($M)
 
2002 22 2,109.10 95.9
2003 29 2,022.70 69.8
2004 93 11,014.90 118.4
2005-1 10 720.7 72.1
2005-2 10 714.1 71.4
2005-3 19 1,458.10 76.7
2005-4 18 1,592.10 92.2
2005 57 4,485.00 78.7
2006-1 10 540.8 54.1
2006-2 19 2,011.00 105.8
2006-3 8 934.2 116.8
2006-4 20 1,631.10 81.6
2006 57 5,117.10 89.8
2007-1 18 2,190.60 121.7
2007-2 25 4,146.80 165.9
2007-3 12 945.2 78.8
2007-4 31 3,043.80 98.2
2007 86 10,326.30 120.1
2008-1 5 282.7 56.5

56
 2008-2 0 0 n/a
2008 5 282.7 56.5
www.thomsonreuters.com

Table: 5.2 Number of IPOs during 2002-2008

Here the No. of IPO is decreased in first two quarter of 2008 as compared to first two quarter
of previous two years. The no. of IPO in 1st two quarter of 2007 are 43 and in first two quarter
of 2008 are only 5 IPO. Because due to crash down of IPO nobody like to bring IPO. IPO is
the exist route for venture capital company. It comes a barrier for venture capital to exist
from a venture capital.

 INFLATION RATE

INFLATION v/s VC GROWTH RATE

8 7.4 300

7
V C G RO W T H R AT E

251.06 250
INF L AT IO N RAT E

5.8
6 240.91
200
5 4.5

4 150
3.2
3
100
89.79
2
50
1 33.33
0 0
2004 2005 2006 2007

INFLATION RATE VC GROWTH RATE

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

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

57
 Figure: 5.4 Inflation V/S Venture capital growth rate

IMPACT

In above chart the inflation rate is decreased to 4.5 in 2005 from 7.4 in 2004. At same time
the growth of VC is also declining to 33.33% in 2005 from 251.06% in 2004. From the above
chart we can conclude that inflation and VC has positive relationship. Now in June 2008 the
inflation rate was 11.9 and the NO. of deal in first two quarter in 2008 was 170 and value of
deal was 6390 US$mn and in third quarter of 2008 there was only four deals. And in October
the inflation touch the 13.01%. Due to increase in inflation rate the people will going to spend
more. Thus, their savings will decrease. So more money will come into the market and
demand of the products will increase continuously. now due to growth of any sector will
attract new entrepreneur to enter in the industry. For that they must need funds. So there is a
great opportunity for venture capital industry to attract this new entrepreneur.

 GDP GROWTH RATE

GDP V/S VC GROWTH RATE

12 300
GDP GROWTH RATE(%)

VC GROWTH RATE(%)

251.06 9.4 9.6

10 8.5 240.91 250
7.5
8 200

6 150

4 89.79 100
2 33.33 50

0 0
2004 2005 2006 2007

GDP GROWTH RATE VC GROWTH RATE

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

58
 Figure: 5.5 GDP V/S Venture capital growth rate

IMPACT

In above chart there was a positive relation ship there was between GDP growth rate. But in
2007 the growth of VC was decline to 89.79% from 240.91% in 2006 but here the value of
deal was increasing. In 2008 the growth rate is 9% and project the next year GDP 8% to 9%.
So there is a hope, the growth of VC industry can be increased.

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

Taking Indian Purchasing Power Parity (PPP) into consideration, this would be equivalent to
$22 billion worth of investment in the US. Since about $1.75 billion (or approximately 40%
of $4.4 billion) has been already raised, even if only $2.2 billion is raised by December 2006.

Evalueserve cautions that there will be a glut of VC money for earlystage investments in
India. This will be especially true if the VCs continue to invest only in currently favourite
sectors such as IT, BPO, software and hardware products, telecom, and consumer Internet.

 CONTRIBUTION OF SECTOR IN GDP:

59
 GDP COM POSITION

19%

54%
27%

AGRICULTURE INDUSTRY SERVICES

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

Figure: 5.6 Contribution of sector in GDP

In Indian GDP growth rate the contribution of service and manufacturing sectors are
increasing. In 1991 the contribution of service and industry sectors are 41% and 27% and
now in 2008 it is 54% and 27% respectively.

IMPRESSIVE GROWTH IN INDUSTRY SECTOR :

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

Industry 9.8 10.15 11 8.1
Mining and Quarrying 7.5 4.87 5.7 4.7
Manufacturing 8.7 8.98 12 8.8
Electricitym gas water supply 7.5 4.68 6 6.3
Construction 14.1 16.46 12 9.8

60
 Items 2005-06 2006-07 2007-08(AE)
Services 10.34 11.9 10.7
Trade, hotels, transport & 11.51 11.8 12.0
communication
Financial, real estate & 11.41 13.9 11.8
business services
Community, social and 7.21 6.9 7.3
personal services
IMPRESSIVE GROWTH IN SERVICES SECTOR :

Source : Confederation of Indian Industry, July 2008

Most of the venture capital industry invest their money in IT companies, hotels, transport,
communication, bio-technology, BIFS etc. This shows an impressive growth year by year.
This are emerging sectors for venture capital industry.

 SENSEX CRASHDOWN

61
 SENSEX IN 2008
20000
17578.72 17287.31
18000
16000 17648.71 16415.57 14355.75
14000 15644.44 12860.43
12000 13461.6 14564.53
9092.72
10000
8000 9788.06
6000
4000
2000
0
N B H IL AY E LY G PT T V
JA FE C
PR
N
JU
U E C O
AR A
M JU A S O N
M

www.bseindia.com
Figure: 5.7 SENSEX in 2008

IMPACT

The SENSEX is down by 51% from January 2008 to Nov 2008. So one company is try to
come up with IPO. IPO in first two quarter of 2007 is 43 and value of IPO is 6337.4 and in
first two quarter of 2008 there is only 5 IPO and value is only 282.7 through VC company go
for exit. Because IPO is one of the exit route for Venture capitalist from the company. It is
also favorable for venture capital company because no one try to come up with IPO so they
must go to the venture capital for money

 SMALL SCALE INDUSTRIES

62
 No. deals V/S No. of SMEs

450 128.44 130

400 387
123.42 125
350
299
300 120
118.59
250
115
200 113.95
146
150 109.49 110
100 71
56 105
50
0 100
2003 2004 2005 2006 2007

No. of deals No. of SMEs

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

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

IMPACT
VC, to be able to contribute to developing entrepreneurship in India, needs to concentrate its
investment in small and medium enterprises. A “Package for Promotion of Micro and
Small Enterprises” was announced in February 2007. This includes measures addressing
concerns of credit, fiscal support, cluster-based development, infrastructure, technology, and
marketing. Capacity building of MSME Associations and support to women entrepreneurs
are the other important features of this package. SMEs have been allowed to manage their
direct/indirect exposure to foreign exchange risk by booking/canceling/roll over of forward
contracts without prior permission of RBI.

To boost the micro and small enterprise sector, the bank has decided to refinance an amount
of 7000 crore to the Small Industries Development Bank of India, which will be available up
to March 31, 2010. The Central Bank said that it is also working on a similar refinance
facility for the National Housing Bank (NHB) of an amount of Rs 4, 000 crore.

 INTEREST RATE :

63
 INTEREST RATE

PERCENTAG E
10 8.73 9.11
7.98
8 7.23
6.11
6
4
2
0
MA MA MA JUNE-- JULY--
RCH--06 RCH--07 RCH--08 08 08

Sources:- The Macro economic and monetary development annual statement on monetary
policy, First Quarter Review 2008-09

Figure: 5.9 Interest Rate

IMPACT :

The interest rate increase year by year. It is 6.11% in March-2006 and now in July 2008 it is
9.11%. venture capital firms generally borrow from banks now if interest rates are increasing
interest cost of venture capital firms will also increase which led reduce the profitability of
Venture Capital firms. Because if anyone is investing in any option he will look for good
return, so here if they will maintain their own profits they will have to give less return to
investors then investors will go for other options. Here increase in bank rates affect Venture
Capital firms in both ways from the suppliers as well as buyers side.

64
 CURRENCY RISK :

Exchange Rate(INR/US$)
60
EXCHANG E RATE

45.75 47.73 48.42 45.95 44.87 44.09 45.11

50
40.01
40
30
20
10
0
2000- 2001- 2002- 2003- 2004- 2005- 2006- 2007-
01 02 03 04 05 06 07 08

Figure: 5.10 Exchange Rate(INR/US$)

IMPACT

From the above chart we can see that exchange rate is highly fluctuated. Nowadays the
exchange rate touches to 50 Rs. Per dollar. Now due to globalization venture capital firms are
entering at global level. Nowa for a particular country currency risk can be defined in two
ways.

 Indian venture capital are concentrated on global level due to increasing opportunity
in global level. They make a deal with global company. So there is directly affect the
movement of exchange rate.

 In second way , Foreign institutional investor incest their money Indian stock market
and nowadays due to crash down of market the investment of FII is decreasing. Due
to this nobody like to bring IPO. It is directly affected to venture capital company
because IPO is one way for exist.

65
  EXPORT AND IMPORT

VALUE OF EXPORT AND IMPORT

200 185.7 185.7

180
149.2 155.5
US dollars in billions

160
140 126.4
120 111.5
103.1
100 83.6
78.1
80 61.4 63.8
52.7
60
40
20
0
2002-03 2003-04 2004-05 2005-06 2006-07 2007-08

EXPORT IMPORT

Figure: 5.11 Value of export and import

IMPACT :

The value of Import and export are increasing year by year. In 2002-03 the value of import
and export are 52.7 and 61.4 US$bn respectively and in 2007-08 the value of import and
export are 155.7 and 185.7 US$bn. It means industry need more money for import and
export. So it is an opportunity for venture capital. On the other side when company going to
export the company must have good contact with other country’s company. So for that
venture capital industry is useful because they have good contact and affiliation network with
other country’s company.

66
 REPO RATE

The Repo Rate is now reduced to 6.5 from 8.5 in july 2008. It is directly affect the home loan
rate. The rate of home loan is reduced so it is very helpful for real estate sector. And most of
the Venture Capital companies invest their money in real estate sector. There is an improve
the flow of credit to productive sectors of the economy.

 LACK OF FINANCIAL TRANSPERANCY AND OTHER PROCESSES :

Again, partly because the Indian economy was a “socialistic and closed” economy and
partly because Indian entrepreneurs are not as proficient at business development as their
counterparts in the US, Indian start-ups lack financial transparency and often have limited
experience in implementing effective financial processes. This usually makes the task of
the Venture Capital much more difficult not only during the due-diligence phase, but also
in helping the start-up grow rapidly.

FACTOR FAVOURABLE UNFAVOURABLE BOTH

MERGER& √
ACQUISITION,IPO
INFLATION RATE √

GDP GROWTH √
RATE
SENSEX √
CRASHDOWN
SMALL SCALE √
INDUSTRIES
INTEREST RATE √
CURRENCY RISK : √

EXPORT & IMPORT √

67
 REPO RATE √

Table: 5.3 Result of Economic factors

5.2.3 SOCIAL FACTORS:

 Demographic factor:

 AGE:

Population Demographic Shift

Age % of population 1997 2002 2007
Under 15 years 37.20% 33.50% 30.00%
Between 15-59 years 56.10% 59.30% 62.30%
Above 60 years 06.60% 06.90% 07.50%

Table: 5.4 Population Demographic Shift

68
 AGE BETWEEN 15-59 YEARS
64 62.3

P E RCE NTAGE
62
60 59.3

58
56.1
56
54
52
1997 2002 2007

(Source: Planning Commission Projection data)

Figure: 5.12 population demographic shift between 15-59 years

In above chart we can see young working people in India is increasing rapidly. Earlier the
young working peoples are 56.1% out of total population and nowadays it is 62.3%. Young
people out of total population. The average young age in India is 25 upto year 2025.

 UNEMPLOYMENT RATE:

UNEMPLOYMENT RATE

9.5 9.2
10 8.8 8.8 8.9
7.8
PERCENTAGE

8 7.2

6
4
2
0
2002 2003 2004 2005 2006 2007 2008

www.indexmundi.com

Figure: 5.13 Unemployment rate

In India the unemployment rate is very high. No doubt it is decreasing year by year. It is
9.5% in 2004 and now it is 7.2% in 2008. Here there is a great opportunity for Venture
capital firm because there is a huge untapped market and they require amount fr strting the
business.

69
According to one survey by National Entrepreneurship Development Board (NEBD),
Ministry of SSI & ARI, Govt. of India, on ‘Entry barriers to entrepreneurship as
perceived by youth’. In this survey out of 1625 respondents 19.2% people have future plan
to become entrepreneur for starting the business and 80.8% persons are not ready for
business. But out of this 80.8% persons 58.3% person are ready for becoming
entrepreneurship if they get help in finance, project idea, and training for business and
management. So here there is a great opportunity for venture capital firms.

70
 Venture Capitalists: Scenario 2010
But the value proposition of the VC industry toward its two clients—investors and
entrepreneurs—have since weakened. For one thing, VC has never recovered from the
commercialization of the internet, which brought a staggering 250% increase in deals
between 1997 and 2000 and a quintupling of investment dollars. IRR rose spectacularly, but
perversely this attracted too much capital too quickly from too many investors, which in turn
funded too many inexperienced VC partnerships competing for portfolio companies.
Meanwhile, deal activity has dried up. The total number and value of investments in 2009
reached their lowest points since 1997 (see the exhibit “Few Deals”). This has dramatically
thrown out of whack investment multiples and returns industry-wide.

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

owing in part to the credit crunch and stricter post-boom revenue requirements for start-ups
(see the exhibit “Long Waits”). To be an attractive investment category, venture capital needs
to off er competitive returns to alternatives on a risk adjusted basis. Part of that risk
adjustment should include a premium for non liquidity. If IPOs are harder to create and take
longer to achieve, then VCs will need to pay the premium and IRR, ceteris paribus, will fall.
That means VCs are now in the unenviable position of offering investors higher-risk, lower-
yield investment opportunities.
What’s more, VCs are losing their ability to attract the entrepreneurs that will generate better
returns. They’ve fallen short in marketing their relevance to entrepreneurs who don’t need
capital as much as they need guidance. Instead of marketing their operational expertise, their
well-developed networks of experts, and the personalized attention they can offer, many VC
firms have resorted to peddling wildly attractive financing options. “The perception is that
top fi rms have too much money to waste time on small investments,” says the CEO of the
VC-backed Silicon Valley firm. “Combine that with the fact that many internet services
companies have low capital needs. Why go to big firm when a business angel can cover
financing and give more personalized attention?”
What’s happening to the industry is, as one VC insider puts it, “a train wreck in slow
motion.” And whether the train can get back on the track is, frankly, an open question, thanks
to what Fred Wilson, a VC industry expert, calls the VC math problem.He calculates how
much cash VCs need to generate from liquidity exit events to recoup even a minimum return
for investors. Wilson believes that VC funds need to generate gross investment multiples of 3

71
(or 2.5 after accounting for management expenses). He estimates that the industry is returning
a multiple of only 1.6 on investors’ capital, which translates to about a 10% annual IRR.
Essentially, Wilson argues that the venture capital asset class does not scale, and thus the
industry must “downsize to get returns back on track.”

Is Downsizing the Answer?

Whether these changes are structural or cyclical is a matter of ongoing vigorous debate. But
to make the math work in the current climate, the VC industry must, above all, get smaller.
“[The attrition has] already started,” says a VC partner in San Francisco with more than $840
million in active investments, and “it will be significant both in number of firms and number
of investment professionals per firm. I think a 50% decrease in industry size is a fair
estimate.”
The only truly safe firms are the small number of top-tier firms in the VC industry. They will
continue to set the terms for investment, generally meaning 2.5% in management fees and
30% in carried interest.
The next tier will have to negotiate harder for their terms and will have to accept lower
management fees and stakes. The rest will have an even tougher time raising new funds
unless they are able to establish uniquely specialized strategies. Many will likely perish.
“This is the story,” said the CEO of a VC backed firm, who asked to remain anonymous to
protect his funding. “Every VC I know thinks there are too many VCs, too much dumb
money, too many people bidding up valuations and reducing returns for the top guys. Too
many—except, of course, themselves!”
But it’s not just size that counts. What industry veteran Gailen Krug calls the “spray and
pray” approach—investing in dozens of firms in hopes of a few hits—is on the wane. “We
see the thoughtful, quality VCs moving to a more focused approach of investing larger
amounts of capital into fewer, more fundamentally sound companies with a higher potential
for success,” says Krug. “This shift in strategy dictates that the marketing and fund-raising
process must change.”
In a sense, the road ahead for VCs appears to be retro. Venture capitalists must return to their
roots of being patient, handson consultancies that nurture their start-ups until they are
sustainable, while returning healthy dividends to deep-pocketed, risk-taking investors.
“When we enter an investment, we don’t think about how to sell it,” says Bernard Liautaud, a
partner at Balderton Capital, a leading European VC firm, and cofounder of Business

72
Objects, one of the most successful VC-backed firms of this decade.“We think about how to
help the entrepreneur build a great company.”
How a VC firm accomplishes that goes well beyond handing over a pile of cash. “Forward-
thinking VC funds do not stay still; they evolve,” Liautaud says. “I believe in a Darwinian
VC ecosystem where the ones who adapt will succeed.”

73
74
 Case Study

Picking Winners or Building Them?

Selection Criteria in New Venture Financing and Performance

In the entrepreneurial setting, financial intermediaries such as venture capital firms (VCs) are
perhaps the dominant source of selection shaping the environment within which new ventures
evolve. VCs affect selection both by acting as a scout able to identify future potential and as a
coach that can help realize it. It is generally taken-for-granted that VCs are expert scouts and
coaches, and so the ways in which VCs actually enhance start-ups performance are not well
understood (Shepherd and Zacharakis 2001). But only a fraction of the firms VCs fund
succeed, most achieving an average rate of return on invested capital (Gifford 1997).
Moreover, while research shows VC-backed start-ups outperform comparable non-VC-
backed start-ups (Megginson and Weiss 1991), research has rarely sought to identify whether
these results are attributable to inherent differences between VC-backed and non-VC-backed
start-ups or to post-investment benefits that accrue to VC-backed firms. Existing research
thus offers little insight into how VCs create value.
If VCs pick winners, start-ups characteristics that attract VC investment should also enhance
their future performance. If VCs build winners, start-ups characteristics that attract VC
investment need not be associated with future start-ups performance, and may even impede it.
The question to be asked is are VCs are good scouts adept at identifying exceptionally
promising start-ups ventures or that they are good coaches skilled at injecting expertise and
sound business judgment into start-ups ventures.
Prior research implicates three broad types of signals that may affect VCs’ assessments of
start-ups:
 Alliance Capital. A start-up’s alliances provide signals both of access to valuable
resources and knowledge critical to early performance, as well as serving as external
endorsements, suggesting that the start-up has earned positive evaluations from other
knowledgeable actors. Alliance advantages are particularly strong when timely access
to knowledge or resources is essential or when ambiguous technologies force reliance
on indirect indicators to assess firm performance.
 Intellectual Capital. The ability to stake technological claims is a critically important
early signal of a start-up’s future potential. By signalling innovative capabilities,

75
 patents and patents pending help start-ups possessing them to acquire additional
resources, increasing the likelihood that they will obtain VC financing. The
appropriability regime surrounding biotechnology patents is particularly strong because
patented compounds are difficult to circumvent (Lerner 1995).
 Human Capital. The identity and background of top management are widely regarded
as important signals of a start-up’s future potential, increasing its chances of obtaining
VC financing. VCs report that “nothing is more important than people…” and, in
particular, that they look “for people who have high levels of energy, are willing to
work around the clock, and are still hungry for success” (Byrne 2000: 96). Top
management team experience and skills are the most frequent selection criteria self-
reported by VCs.
A research done on the above by analyzing VC financing and performance of Canadian
biotechnology start-ups, 1991 to 2000 gave the following results:

 All three ‘capitals’ are implicated in VC financing decisions. Notably, the largest
magnitude effects are associated with human capital. One standard deviation increases in
the size of a start-up’s top management team and its president’s number of other
presidencies increased the estimated value of VC financing by C$800K-900K annually. A
start up whose president currently acted as president for one other biotechnology startup
is estimated to raise nearly $4M more in VC financing per year. While smaller, the effects
of alliance and intellectual capital are also large relative to the mean value of annual VC
financing ($879K, S.D. = $6.3M). Nevertheless, in the empirical setting, human capital
effects appear to predominate in VC financing decisions.
 The alliance variables generally have significant effects on performance, although the
effects for upstream alliances are generally weaker, and in some cases the alliance effects
are detrimental to performance. In contrast, the human capital variables have limited
impact on start up performance, and the few significant effects are split equally between
enhancing and impeding performance. Given the large impact of human capital on VC
financing decisions, the weak link between human capital and start up performance is
surprising.

The Conclusions were as follows:

76
Taken together, the convergent influence of alliance, intellectual and human capital on VCs’
financing decisions and start-ups’ technological performance, and divergent influence of
these factors on start-ups’ revenue growth and survival point to a combined logic of scouting
out start-ups with the right technological and relational ‘stuff’ and coaching troubled startups
to which, given their technological potential, VCs offer the greatest potential value post-
investment. Start-ups may thus need to increase their short-term risk of failure in order to
attract VCs capable of enhancing their long-run prospects. Our findings may also reflect
VCs’ emphasis on picking portfolios of start-ups in which to invest, rather than considering
investments independently. This account is also consistent with classic notions of risk and
return – since VCs traditionally seek extremely high returns, they are naturally attracted to
more risky start-up, and consequently a start up that is at low risk of failure may also offer a
return too low to interest a VC.

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