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• GLOBAL PERSPECTIVE

The Venture Capital Industry in India^


Numerous academic studies have development financial institutions. With
examined the venture capital industry in significant economic liberalization policies
developed countries such as the United introduced by the central government in
States (for reviews of the academic liter- 1991, more domestic and foreign venture
ature, see Barry 1994; Best and Mitra capital companies began operations. In
1997; Amit, Brander, and Zott 1998). To 1996, the central government introduced
date, however, academic studies bave new and improved guidelines for regulating
largely neglected venture capital indus- India's venture capital industry. Despite
tries in less developed countries. Tbis this progress, growth of the industry has
study seeks tofillthis gap by examining been restricted by several factors, including
the venture capital industry in otie such conservative government policies, limita-
less developed country. tions on the availability of funds, and an
In Itidia, while numerous banks and inadequate equity market infrastructure.
other financial institutions provide con-
ventional finance to business firms, risk Data and Methodology
financing ofthe type and scale practiced This study relies on information gath-
in countries such as the United States is ered from several sources, including pub-
not yet significantly widespread. Given the lications of the Indian Venture Capital
conservative lending practices of the Association (fVCA) for the 1993-96 period;
financial institutions, new entrepreneurs questionnaire responses from senior offi-
fmd it difficult to obtain project financing. cials (such as the managing director,
There is a clear need for venture capital CEO, or senior vice-president) of the sev-
to finance technological investments in enteen organization members of FVCA;
such areas as information technology and and in-depth personal interviews with top
software, electronics and communicatioti, officials of five venture capital companies,
biotechnology, healthcare and medicine, including the president of fVCA.
chemicals, consumer products, and non-
conventional energ)' (Verma 1997).
Categories of Venture
Venture capital activity in India was
formalized in 1988 when the cetitral gov- Capital Companies in
ernment announced guidelines for the India
establishment and functioning of the in- Some major Indian venture capital
dustry. Venture capital companies sprang companies are listed in Table 1.There are
up, several sponsored by government six broad categories of venture capital

'This research was conducted while the aiithur was in India on a faciilt)' research fellowship from the
Shastri Indc>-Canadian Institute. The author held a visiting affiliation at the International Management
Institute in New Delhi. India, at the time.The author wishes to thank Dr. Frederick C. Scherr, then editor
of i\\ejoin-nal ofSmall Business Management,forhis heiphil comments on earlier versions of the man-
uscript.

APRIL 2000 67
companies (VCCs) or venture capital funds •VCFs are prohibited from investing
(VCFs) in India.Tbesc include VCCsA'CFs in equity sbares of financial service
promoted by: (I) national fmancial institu- companies or institutions;
tions; (2) state-level development financial •to promote early stage financing and
institutions; (3) nationalized commercial turnaround financing, at least 80 per-
banks; (4) foreign entities including banks, cent of the VCFs should be invested
financial institutions, and non-resident in utilisted or financially weak com-
investors; (5) domestic private sector com- panies;
patiies; and (6) joint initiatives of domestic •investment by VCFs in individual
private sector companies, ftnancial institu- companies is limited to 40 percent
tions, and foreign entities. of their paid-up capital. (This provi-
In our subsequent analysis, funds repre- sion enables entrepreneurs to retain
sented under categories (1), (2), and (3) are majorit)' ownership and control, pro-
grouped as "government" funds, while those viding tbcm tbe incentive to work
under categories (4), (5), and (6) arc group- towards tbe project's success);
ed as "private." Within the "government" •a VCF is prohibited from raising
groupings, theVCCs/VCFs in category (1) funds from the general public. (This
liavc liistorically received a variety of incen- prohibition is designed to protect
tives and benefits from the Indian govern- tbe investing public from higb risk
ment and require separate examination. investing.) Some exceptions apply to
The private and government VCFs differ wealtby investors who may invest in
regarding the scale of tbeir investments. VCFs tbrough private placements.
Private funds tend to have fewer but larger Under section 10 (23F) of the Indian
investments in later-stage ventures, which Income Tax Act, dividends and long-term
require less motiitoring.(A typical invest- capital gains from equity investments made
ment could be for 100 million Indian by VCFs arc exempt from income tax.
Rupees [Rs.]). In contrast, government
funds invest smaller amounts over a larger
number of start-up and later-stage ventures Features of India's
(a typical investment is between Rs. 20 and Venture Capital
Rs. 30 million). Sometimes investments
requiring large funding are financed by Companies and Venture
govertiment agencies on a syndicated basis. Capital Funds
Lately, government funds are moving In India,VCCs do not raise funds (VCFs
more towards larger investments to gain do this) but instead manage tbem. In
the benefits of reduced monitoring. return for a management fee, VCCs make
and manage VCF investments entrusted to
Regulatory Framework them. Exceptions are two central govern-
ment development financial institutions,
and Tax Environment IDBI and SIDBI (see Table 1), which bave
for Venture Capital their own equity funds ear-marked for
venture capital financing.
Firms in India Two of the 17 members of IVCA are
The Securities and Exchange Board of listed on stock exchanges. Both companies
India (SEBO regulates tbe venture capital chose to be listed to take advantage of the
industry. Its 1996 guidelines include the booming stock markets in tbe early 1990s
following provisions: and to raise ftinds inexpensively. Listing
•all VCF investments must be made is no longer an optit)n, as recent govern-
for a minimum tbree-year lock-in ment guidelines prohibit VCCs from rais-
period; ing public funds.

68 JOURNAL OF SMALL BUSINESS MANAGEMENT


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APRIL 2000 69
Venture capital funds are created 1993. multilateral development agencies
either as trust funds" under the Indian have played a consistently declining role
Tmst Act or as Unit Trust of India a^TI) in these ftinds. For 1995 atid 1996, funds
organizations'.Tlie trust funds are man- obtained via the R&D Cess Act also con-
aged independently by venture capital tributed to theVCFs.2
companies. Venture ftinds created under Panel C reports on the government
UTI are known asVecaus I, II, and ill, and funds managed by the state-level fmancial
are managed by the venture capital arms institutions and the nationalized bank (Can-
of two cetital govertiment development bank, Gujarat, and APIDC; see Tahle 1).
financial institutions. Historically, UTI funds Contributions are predominantly from
have received favorable treatment from multilateral development agencies, while
the Indian government through full tax contributions from Indian financial insti-
exemptions and other statutory benefits. tutions piay a substantial but lesser role.
In addition, the nationalized banks have
Sources of made an important, but declining, share
of contributions to the funds. Corporate
Venture Capitat Funds sector contributions (public and private)
Table 2 presents summarized details of have also played an important role.
contributories to the funds for the 1993-
1996 period. Panel A provides the overall The picture that emerges from Panel D
picture. As can be seen from Panel A, the presenting contributions to the private VCFs
size of the funds has grown considerably is quite interesting. Between 1993 and 1995,
over this period. Until 1995. major con- the major sources of funding were multi-
tributions were from the Indian financial lateral development agencies, governmen-
institutions and multilateral development tal financial institutions, and the corporate
agencies" (primarily, the World Bank and sector (public and private). In 1996, how-
the Asian Development Bank). In 1996. ever, there was a sizeable itiflow of con-
the overall pattern of coniributions appears tributions from foreign institutions and
to have undergone a major change, with other investors. For 1996, the highest con-
sizeable increases in the proportions of tribution proportion is from this group
investments from foreign institutions and of investors (61 percent of the total).
other investors.The proportions of contri-
bution from Indian financial institutions Stages of Investment
and "multilateral development agencies" Venture capital investing is a stage-wise
declined in that year. process.Typical investment stages in India
Panel B provides separate details far the can be labeled as seed, start-up, other early
govertiment funds managed by the central stage, later stage, and turnaround financing.
government's nationwide financial insti- Table 3 presents a summary of the funding
tutions (IDBI, RCTC, SIDBl, and TDICI; for different investment stages during
see Table 1). Contributions are mainly 1993-1996. Panel A shows details for all
from Indian financial institutions. Since funds combined. Details arc provided

'The Unit Trust of India is a large central government investment organization. Its variet>' of
mutual funds and other investment plans are very popular witli India s investing public.
the R&D Cess Act, an R&D levy was imposed by the central government on any pay-
ments made for the purchase of technology fmm abroad.These levies have formed a source
of funds for the VCFs run hy the central government's nationwide financial institutions.

70 JOURNAL OF SMALL BUSINESS MANAGEMENT


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APRIL 2000 71
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APRIL 2000 73
separately for government funds managed the form of redeemable and convertible
by the nationwide financial institutions preferred shares.With regard to common
(Panel B). for government funds managed equity financing, the venture capitalist
by stale-level financial institutions and the participates as a minorit)' co-owner (con-
nationalized bank (P;mel C), and for the tribution not exceeding 40 percent of
private funds (Panel D). the total paid-up capital) with the entre-
The overall picture for all funds shows preneur, who retains effective control of
that the highest proportion of investment the enterprise.
has been at the start-up stage followed by Debt can be either through convertihie
investment at the later stage, reflecting or non-convertible instruments. Typically,
the generally conservative attitudes of non-convertible debt can take one of three
venture capital fund managers in India. forms: (1) conditional loan; (2) conven-
This picture is consistent across years tional loan; or (3) income note loan.The
and different types of funds. However, IVCA (1996) has described the condi-
when we look at seed-stage fmancing, tional loan as a quasi-equity instnmient
differences in investment philosophy that does not carr>' a fixed rate of interest
between the various funds emerge. The or a pre-determined amortization schedule
venture capital funds run by the central but is normally liquidated by payment of
government's financial institutions are a royalty on sales. It is similar to equity in
consistently the highest investors in the sense that returns to the financier are
seed-stage projects. Given the favorable performance-based, and royalty becomes
tax treatment and other incentives that payable only wben the investee unit gen-
these institutions receive from the central erates sales. The rate of royalty, decided
government, they are perhaps better able on a case-specific basis, can range between
to take more risks.The other government- two and 15 percent of sales and is usually
affiliated venture capital funds (those collected from the tliird to fifth year after
managed by state-level financial institu- establishment of the project. By tying
tions and a nationalized bank) have also royalty payments to sales rather than to
made some seed-stage investments, profitability, these instruments can some-
altht)ugh in lesser proportions. Although times work to the disadvantage of entre-
the private funds made some investments preneurs.As a result, their recent use has
at the seed stage in 1993. such investments been relatively limited (Verma 1997),The
are negligible or non-existent in later years. convert tional loan carries a fixed interest
The increased conservatism of these invest- rate or a pre-determined amortization
ments in the later years is due to bad schedule. The income note loan is a
investments made in earlier years, to lack hybrid of a conditional loan and a conven-
of tax and other government incentives, tional loan. It carries a flexible nominal
and to the need to protect the bottom interest, typically at a lowrate.The prin-
line in order to survive. With regard to cipal is repaid over a specified period of
other early stage,""later stage," and "turn- time. In addition, a low rate of royalty on
around" financing, the picture is fairly sales is imposed.
consistent across the different categories
of venture capital funds. Table 4 summarizes the kinds of
investments made by the various financial
institutions over the period of this study.
Instruments and Overall, the predominant mode of funding
Methods of Financing is through equity shares (see Panel A of
Venture capital financing in India is Table 4) mainly because of the tax incen-
typically either through equity or debt. tives for equity investments (the tax
Investment in stock is mostly through exemption on income from dividend
common equity and to some extent in and capital gains). Tliis is followed by

74 JOURNAL OF SMALL BUSINESS MANAGEMENT


investments in convertible debt and non- highest proportion of investments concen-
convertible debt, ill that order During trated in the consumer-related products
the period, the use of preferred shares category. Given India's sizeable consumer
and debentures has been fairly limited. base, investments in the consumer-
This pattern of financing is generally fol- related category' tend to generate bigber
lowed by the sub-categories of funds— and faster returns and tend to be rela-
those managed by national financial tively less risk>\ By investing mostly in
institutions (Panel B), state level financial this sector, private institutions have
institutions (Panel C), and private firms demonstrated tbeir bigber risk aversion.
(ftmel D).The one major difference is that Another noteworthy feature is that
the proportion of debt for funds man- investments in computer technology
aged by national financial institutions is bave been quite high for all categories of
higber than for private funds.The reason funds, with the highest investor group
is that national financial institutions being tbe private funds.
receive across-the-board tax benefits,
whereas private funds get tax exemp-
tions only on equity and equity-related Project Appraisal,
instruments (dividends and capital gains Selection^ and Involvement
are tax exempt). As a result, for private Questionnaire and interview responses
funds, equity sbares were used almost indicated that project proposals usually
exclusively (over 88 percent) as the came to venture capital firms tbrough
instrument of finance between 1993 and referrals by merchant banks and otber
1995. In 1996, as tbe stock markets financial institutions, direct marketing
declined, equity share financing went efforts, and word-of-mouth. Respondents
down dramatically, and convertible indicated tbat, in addition to examining
instruments increased. tbe merits of tbe proposal, they consulted
Comparing Table 4 with Table 2, other sources of information about the
another interesting feature can be seen. investee, including bankers, suppliers,
Relative to the size of the fund, the competitors, and clients, to determine
amount of investment tends to be much tbe entrepreneur's credentials.
larger for government funds than for tbe With regard to the typical acceptance
private funds. Tbis, once again, suggests rates for proposals submitted for appraisal,
that private institutions tend to be much responses varied from between two or
more conservative in their investing tban tliree percent (for central and state govern-
tbe government. ment development financial institutions)
to ten percent (for private fmancial insti-
Investment by Industry tutions). The VCC staff assigned to
Regarding investment by industry, appraise projects generally bave degrees
overall tbe bigbest proportion of invest- in engineering, accounting, marketing,
ments was directed at tbe industrial finance, and management.
liroduct and machinery sector, followed In general, the respondents stated tbat
by consumer-related sectors. For funds their involvement included: (1) management
managed by tbe national financial insti- and technical advice; (2) bolding one or
tutions, tbe bigbest proportion of invest- more nominee directorships on boards
ments are in the industrial product and of investee companies; (3) financial
machinery sector. The picture is very- advice; (d) helping implement account-
similar for venture funds run by the state- ing and management control systems; (5)
level ftnancial institutions and tbe nation- providing marketing support; (6) period-
alized bank. For tbe private funds, the ically monitoring performance by requiring
picture is somewhat different, witb the interim financial and operating reports

APRIL 2000 75
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76 JOURNAL OF SMALL BUSINESS MANAGEMENT


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APRIL 2000 77
and audited annual accounts, and by conservatism, with negligible investments
making periodic site visits. Responses to in seed-stagefinancing,focussinginstead
follow-up questions indicated that over- mostly on safer ventures in, for instance,
all VCC involvement both increased in consumer-related products. Also, in
times of poor performance by investee proportion to tbe amounts of financing
firms and was related to the geographical available, government institutions tend
distance from the investee firm. Close to invest mucb more tban private ones.
proximity reduces transportation costs Financing investments is mostly tbrough
which facilitates greater monitoring. equity or equity-related instruments,
To date, exits bave mainly occurred possibly because of available tax benefits.
through initial public offerings, which were Tbrougb questionnaires and in-deptb
successful during tbe stock market and interviews, venture capital fund man-
economic boom of 1994-95, In addition, agers provided insigbts on the process of
promoter buy-back arrangements and project appraisal and selection, on tbeir
third party buy-outs also bave occurred. involvement with investee firms, and on
Exit bas been one of the problem areas their exit and divestment strategies. The
for India's venture capital firms because study concludes that the growth of the
tbe much-heralded Over the Counter industry bas been restricted by several
Exchange of India bas not taken off. In factors in-cluding conservative govern-
general, capita! markets are depressed. ment policies, limitations on availability
Moreover, government regulations such of funds, and lack of an adequate equity
as a prohibition on companies buying back market infrastructure to facilitate the
tbeir sbares bas added to tbe restrictive exit process.
climate for venture capital firms.

Conclusions
This study has examined India's venture
capita! industry and analyzed its historical References
development process. Venture funds oper- Amit. Raphael,James Brander, and Christoph
ating in India include tbose sponsored by Zott (1998). "Why Do Venture Capital
central and state government development Firms Exist? Theory and Canadian
financial institutions and private entities. Evidence," Journal of Business
Since these organizations are prohibited Venturing 13 (November), 441-466.
from raising finances from the general Barry, Cbristopher B. (1994).'New Direc-
public, contributions are mainly from tions in Researcb on Venture Capital
multilateral development agencies, sucb Finance," Financial Management 23(3),
as the World Bank, Indian financial insti- Autumn, 2-15.
tutions and, for private funds, overseas Best, Andrea, and Devasbis Mitra (1997).
institutional investors, Tbe regulatory Tbe Venture Capital Industry in
and tax environment for these funds is Canada," Journal of Small Business
differentiated—funds sponsored by the Management 35(2),April, 105-110.
central government have historically IVCA (1996)."VentureActivit>'," Tbe Indian
received a variety of special incentives and Venture Capital Association.Bangalocc,
benefits, given their broader objectives India.
of facilitating economic development by (1995). "Venture Activity," The
investing in accordance with government Indian Venture Capital Association.
policies. Overall, investment activity has Bangalore, India.
been conservative, concentrating mosdy (1994). "Venture Activity," The
on start-ups and later stage financing.The Indian Venture Capital Association.
private funds have displayed tbe most Bangalore, India,

78 JOURNAL OF SMALL BUSINESS MANAGEMENT


(1993). "Venture Activity," Tbe Devashis Mitra
Indian Venture Capital Association. Faculty of Administration
Bangalore, India. University of New
Verma, J.C. (1997). Venture Capital Brunswick
Financing in India. New Dellii, India: Fredericton, Canada
Response Books.

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