• GLOBAL PERSPECTIVE

The Venture Capital Industry in India^

Numerous academic studies have
examined the venture capital industry in
developed countries such as the United
States (for reviews of the academic liter-
ature, see Barry 1994; Best and Mitra
1997; Amit, Brander, and Zott 1998). To
date, however, academic studies bave
largely neglected venture capital indus-
tries in less developed countries. Tbis
study seeks tofillthis gap by examining
the venture capital industry in otie such
less developed country.
In Itidia, while numerous banks and
other financial institutions provide con-
ventional finance to business firms, risk
financing ofthe type and scale practiced
in countries such as the United States is
not yet significantly widespread. Given the
conservative lending practices of the
financial institutions, new entrepreneurs
fmd it difficult to obtain project financing.
There is a clear need for venture capital
to finance technological investments in
such areas as information technology and
software, electronics and communicatioti,
biotechnology, healthcare and medicine,
chemicals, consumer products, and non-
conventional energ)' (Verma 1997).
Venture capital activity in India was
formalized in 1988 when the cetitral gov-
ernment announced guidelines for the
establishment and functioning of the in-
dustry. Venture capital companies sprang
up, several sponsored by government
development financial institutions. With
significant economic liberalization policies
introduced by the central government in
1991, more domestic and foreign venture
capital companies began operations. In
1996, the central government introduced
new and improved guidelines for regulating
India's venture capital industry. Despite
this progress, growth of the industry has
been restricted by several factors, including
conservative government policies, limita-
tions on the availability of funds, and an
inadequate equity market infrastructure.
Data and Methodology
This study relies on information gath-
ered from several sources, including pub-
lications of the Indian Venture Capital
Association (fVCA) for the 1993-96 period;
questionnaire responses from senior offi-
cials (such as the managing director,
CEO, or senior vice-president) of the sev-
enteen organization members of FVCA;
and in-depth personal interviews with top
officials of five venture capital companies,
including the president of fVCA.
Categories of Venture
Capital Companies in
India
Some major Indian venture capital
companies are listed in Table 1.There are
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
either as trust funds" under the Indian
Tmst Act or as Unit Trust of India a^TI)
organizations'.Tlie trust funds are man-
aged independently by venture capital
companies. Venture ftinds created under
UTI are known asVecaus I, II, and ill, and
are managed by the venture capital arms
of two cetital govertiment development
financial institutions. Historically, UTI funds
have received favorable treatment from
the Indian government through full tax
exemptions and other statutory benefits.
Sources of
Venture Capitat Funds
Table 2 presents summarized details of
contributories to the funds for the 1993-
1996 period. Panel A provides the overall
picture. As can be seen from Panel A, the
size of the funds has grown considerably
over this period. Until 1995. major con-
tributions were from the Indian financial
institutions and multilateral development
agencies" (primarily, the World Bank and
the Asian Development Bank). In 1996.
the overall pattern of coniributions appears
to have undergone a major change, with
sizeable increases in the proportions of
investments from foreign institutions and
other investors.The proportions of contri-
bution from Indian financial institutions
and "multilateral development agencies"
declined in that year.
Panel B provides separate details far the
govertiment funds managed by the central
government's nationwide financial insti-
tutions (IDBI, RCTC, SIDBl, and TDICI;
see Table 1). Contributions are mainly
from Indian financial institutions. Since
1993. multilateral development agencies
have played a consistently declining role
in these ftinds. For 1995 atid 1996, funds
obtained via the R&D Cess Act also con-
tributed to theVCFs.2
Panel C reports on the government
funds managed by the state-level fmancial
institutions and the nationalized bank (Can-
bank, Gujarat, and APIDC; see Tahle 1).
Contributions are predominantly from
multilateral development agencies, while
contributions from Indian financial insti-
tutions piay a substantial but lesser role.
In addition, the nationalized banks have
made an important, but declining, share
of contributions to the funds. Corporate
sector contributions (public and private)
have also played an important role.
The picture that emerges from Panel D
presenting contributions to the private VCFs
is quite interesting. Between 1993 and 1995,
the major sources of funding were multi-
lateral development agencies, governmen-
tal financial institutions, and the corporate
sector (public and private). In 1996, how-
ever, there was a sizeable itiflow of con-
tributions from foreign institutions and
other investors. For 1996, the highest con-
tribution proportion is from this group
of investors (61 percent of the total).
Stages of Investment
Venture capital investing is a stage-wise
process.Typical investment stages in India
can be labeled as seed, start-up, other early
stage, later stage, and turnaround financing.
Table 3 presents a summary of the funding
for different investment stages during
1993-1996. Panel A shows details for all
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 73
separately for government funds managed
by the nationwide financial institutions
(Panel B). for government funds managed
by stale-level financial institutions and the
nationalized bank (P;mel C), and for the
private funds (Panel D).
The overall picture for all funds shows
that the highest proportion of investment
has been at the start-up stage followed by
investment at the later stage, reflecting
the generally conservative attitudes of
venture capital fund managers in India.
This picture is consistent across years
and different types of funds. However,
when we look at seed-stage fmancing,
differences in investment philosophy
between the various funds emerge. The
venture capital funds run by the central
government's financial institutions are
consistently the highest investors in
seed-stage projects. Given the favorable
tax treatment and other incentives that
these institutions receive from the central
government, they are perhaps better able
to take more risks.The other government-
affiliated venture capital funds (those
managed by state-level financial institu-
tions and a nationalized bank) have also
made some seed-stage investments,
altht)ugh in lesser proportions. Although
the private funds made some investments
at the seed stage in 1993. such investments
are negligible or non-existent in later years.
The increased conservatism of these invest-
ments in the later years is due to bad
investments made in earlier years, to lack
of tax and other government incentives,
and to the need to protect the bottom
line in order to survive. With regard to
other early stage,""later stage," and "turn-
around" financing, the picture is fairly
consistent across the different categories
of venture capital funds.
Instruments and
Methods of Financing
Venture capital financing in India is
typically either through equity or debt.
Investment in stock is mostly through
common equity and to some extent in
74 JOURNAL OF SMALL BUSINESS MANAGEMENT
the form of redeemable and convertible
preferred shares.With regard to common
equity financing, the venture capitalist
participates as a minorit)' co-owner (con-
tribution not exceeding 40 percent of
the total paid-up capital) with the entre-
preneur, who retains effective control of
the enterprise.
Debt can be either through convertihie
or non-convertible instruments. Typically,
non-convertible debt can take one of three
forms: (1) conditional loan; (2) conven-
tional loan; or (3) income note loan.The
IVCA (1996) has described the condi-
tional loan as a quasi-equity instnmient
that does not carr>' a fixed rate of interest
or a pre-determined amortization schedule
but is normally liquidated by payment of
a royalty on sales. It is similar to equity in
the sense that returns to the financier are
performance-based, and royalty becomes
payable only wben the investee unit gen-
erates sales. The rate of royalty, decided
on a case-specific basis, can range between
two and 15 percent of sales and is usually
collected from the tliird to fifth year after
establishment of the project. By tying
royalty payments to sales rather than to
profitability, these instruments can some-
times work to the disadvantage of entre-
preneurs.As a result, their recent use has
been relatively limited (Verma 1997),The
convert tional loan carries a fixed interest
rate or a pre-determined amortization
schedule. The income note loan is a
hybrid of a conditional loan and a conven-
tional loan. It carries a flexible nominal
interest, typically at a lowrate.The prin-
cipal is repaid over a specified period of
time. In addition, a low rate of royalty on
sales is imposed.
Table 4 summarizes the kinds of
investments made by the various financial
institutions over the period of this study.
Overall, the predominant mode of funding
is through equity shares (see Panel A of
Table 4) mainly because of the tax incen-
tives for equity investments (the tax
exemption on income from dividend
and capital gains). Tliis is followed by
 investments in convertible debt and non-
convertible debt, ill that order During
the period, the use of preferred shares
and debentures has been fairly limited.
This pattern of financing is generally fol-
lowed by the sub-categories of funds—
those managed by national financial
institutions (Panel B), state level financial
institutions (Panel C), and private firms
(ftmel D).The one major difference is that
the proportion of debt for funds man-
aged by national financial institutions is
higber than for private funds.The reason
is that national financial institutions
receive across-the-board tax benefits,
whereas private funds get tax exemp-
tions only on equity and equity-related
instruments (dividends and capital gains
are tax exempt). As a result, for private
funds, equity sbares were used almost
exclusively (over 88 percent) as the
instrument of finance between 1993 and
1995. In 1996, as tbe stock markets
declined, equity share financing went
down dramatically, and convertible
instruments increased.
Comparing Table 4 with Table 2,
another interesting feature can be seen.
Relative to the size of the fund, the
amount of investment tends to be much
larger for government funds than for tbe
private funds. Tbis, once again, suggests
that private institutions tend to be much
more conservative in their investing tban
tbe government.
Investment by Industry
Regarding investment by industry,
overall tbe bigbest proportion of invest-
ments was directed at tbe industrial
liroduct and machinery sector, followed
by consumer-related sectors. For funds
managed by tbe national financial insti-
tutions, tbe bigbest proportion of invest-
ments are in the industrial product and
machinery sector. The picture is very-
similar for venture funds run by the state-
level ftnancial institutions and tbe nation-
alized bank. For tbe private funds, the
picture is somewhat different, witb the
APRIL 2000
highest proportion of investments concen-
trated in the consumer-related products
category. Given India's sizeable consumer
base, investments in the consumer-
related category' tend to generate bigber
and faster returns and tend to be rela-
tively less risk>\ By investing mostly in
this sector, private institutions have
demonstrated tbeir bigber risk aversion.
Another noteworthy feature is that
investments in computer technology
bave been quite high for all categories of
funds, with the highest investor group
being tbe private funds.
Project Appraisal,
Selection^ and Involvement
Questionnaire and interview responses
indicated that project proposals usually
came to venture capital firms tbrough
referrals by merchant banks and otber
financial institutions, direct marketing
efforts, and word-of-mouth. Respondents
indicated tbat, in addition to examining
tbe merits of tbe proposal, they consulted
other sources of information about the
investee, including bankers, suppliers,
competitors, and clients, to determine
tbe entrepreneur's credentials.
With regard to the typical acceptance
rates for proposals submitted for appraisal,
responses varied from between two or
tliree percent (for central and state govern-
ment development financial institutions)
to ten percent (for private fmancial insti-
tutions). The VCC staff assigned to
appraise projects generally bave degrees
in engineering, accounting, marketing,
finance, and management.
In general, the respondents stated tbat
their involvement included: (1) management
and technical advice; (2) bolding one or
more nominee directorships on boards
of investee companies; (3) financial
advice; (d) helping implement account-
ing and management control systems; (5)
providing marketing support; (6) period-
ically monitoring performance by requiring
interim financial and operating reports
75
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76 JOURNAL OF SMALL BUSINESS MANAGEMENT

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APRIL 2000 77
and audited annual accounts, and by
making periodic site visits. Responses to
follow-up questions indicated that over-
all VCC involvement both increased in
times of poor performance by investee
firms and was related to the geographical
distance from the investee firm. Close
proximity reduces transportation costs
which facilitates greater monitoring.
To date, exits bave mainly occurred
through initial public offerings, which were
successful during tbe stock market and
economic boom of 1994-95, In addition,
promoter buy-back arrangements and
third party buy-outs also bave occurred.
Exit bas been one of the problem areas
for India's venture capital firms because
tbe much-heralded Over the Counter
Exchange of India bas not taken off. In
general, capita! markets are depressed.
Moreover, government regulations such
as a prohibition on companies buying back
tbeir sbares bas added to tbe restrictive
climate for venture capital firms.
Conclusions
This study has examined India's venture
capita! industry and analyzed its historical
development process. Venture funds oper-
ating in India include tbose sponsored by
central and state government development
financial institutions and private entities.
Since these organizations are prohibited
from raising finances from the general
public, contributions are mainly from
multilateral development agencies, sucb
as the World Bank, Indian financial insti-
tutions and, for private funds, overseas
institutional investors, Tbe regulatory
and tax environment for these funds is
differentiated—funds sponsored by the
central government have historically
received a variety of special incentives and
benefits, given their broader objectives
of facilitating economic development by
investing in accordance with government
policies. Overall, investment activity has
been conservative, concentrating mosdy
on start-ups and later stage financing.The
private funds have displayed tbe most
78 JOURNAL OF SMALL BUSINESS MANAGEMENT
conservatism, with negligible investments
in seed-stagefinancing,focussinginstead
mostly on safer ventures in, for instance,
consumer-related products. Also, in
proportion to tbe amounts of financing
available, government institutions tend
to invest mucb more tban private ones.
Financing investments is mostly tbrough
equity or equity-related instruments,
possibly because of available tax benefits.
Tbrougb questionnaires and in-deptb
interviews, venture capital fund man-
agers provided insigbts on the process of
project appraisal and selection, on tbeir
involvement with investee firms, and on
their exit and divestment strategies. The
study concludes that the growth of the
industry bas been restricted by several
factors in-cluding conservative govern-
ment policies, limitations on availability
of funds, and lack of an adequate equity
market infrastructure to facilitate the
exit process.
References
Amit. Raphael,James Brander, and Christoph
Zott (1998). "Why Do Venture Capital
Firms Exist? Theory and Canadian
Evidence," Journal of Business
Venturing 13 (November), 441-466.
Barry, Cbristopher B. (1994).'New Direc-
tions in Researcb on Venture Capital
Finance," Financial Management 23(3),
Autumn, 2-15.
Best, Andrea, and Devasbis Mitra (1997).
Tbe Venture Capital Industry in
Canada," Journal of Small Business
Management 35(2),April, 105-110.
IVCA (1996)."VentureActivit>'," Tbe Indian
Venture Capital Association.Bangalocc,
India.
(1995). "Venture Activity," The
Indian Venture Capital Association.
Bangalore, India.
(1994). "Venture Activity," The
Indian Venture Capital Association.
Bangalore, India,
 (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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