EVALUATION OF BUSINESS STRATEGIES FOR EFFECTIVE BANK BRANCH MANAGEMENT

THESIS Submitted in partial fulfilment of the requirements of BITS C421T/422T Thesis

By NARENDRA KUMAR. D 2000B3A4564

Under the supervision of Prof. Omvir Chaudhry Faculty Member Economics and Finance group

Birla Institute of Technology and Science, Pilani (Rajasthan) May 2005

EVALUATION OF BUSINESS STRATEGIES FOR EFFECTIVE BANK BRANCH MANAGEMENT

THESIS Submitted in partial fulfilment of the requirements of BITS C421T/422T Thesis

By NARENDRA KUMAR. D 2000B3A4564 M.Sc. (Hons.) Economics, B.E. (Hons.) Mechanical Engineering.

Under the supervision of Prof. Omvir Chaudhry Faculty Member Economics and Finance Group

Birla Institute of Technology and Science, Pilani (Rajasthan) May 2005

Acknowledgements

I would like to express my gratitude to Prof. Ravi Prakash, Dean, Research and Consultancy Division, for giving me the opportunity to work on this thesis. I am greatly indebt to Prof. Omvir Chaudhry, for guiding me and for giving constant inputs and spending his valuable time on me in spite of a busy schedule.

I am also grateful to my examiner Prof. Prakash Singh who has constantly supported me in bringing out this thesis. Their suggestions were invaluable and I tried to incorporate them to the best of my ability.

Last but not least I would to thank Library staff, IPC Staff and my friends who constantly helped me with their valuable suggestions.

BIRLA INSTITUTE OF TECHNOLOGY & SCIENCE PILANI 333 031 (RAJASTHAN) INDIA

CERTIFICATE
This is to certify that the Thesis report entitled EVALUATION OF BUSINESS STRATEGIES FOR EFFECTIVE BANK BRANCH MANAGEMENT submitted by NARENDRA KUMAR.D (2000B3A4564) in partial fulfillment of the requirements of BITS C421T/422T Thesis embodies the work done by him. He has duly completed his thesis and has fulfilled all the requirements of the course to my satisfaction.

(Prof. Omvir Chaudhry) Date: 05-05-05 Economics and Finance Group BITS, Pilani

Birla Institute of Technology and Science, Pilani(Rajasthan).

Course Title: Course No.: Duration: Date of Submission: Thesis Title: THESIS
BITS C421T/422T

I SEMESTER, 2004-2005 5th MAY, 2005.

EVALUATION OF BUSINESS STRATEGIES FOR EFFECTIVE BANK BRANCH MANAGEMENT

Name / ID No.: Thesis Guide: Key Words:

NARENDRA KUMAR.D Prof. OMVIR CHAUDHRY

2000B3A4564

Banking, venture capital, Branch banking, challenges in banking

Abstract: This thesis report aims at understanding the Banking Industry

and the working of a Commercial Bank. This report also deals with the services offered by a Commercial bank and about the Venture Capital service in detail. Prior research has shown that Venture Capital (VC) plays an important role for the commercialization of innovation in sectors such as information and communication technologies, and biotech. These sectors account for about two thirds of all VC investments and the report deals with the problems faced by the VC in India and the management of challenges faced by the banks in India. A case study about the importance of branch banking also has been dealt.

Signature of Student Date: 05-05-05

Signature of Project Guide Date: 05-05-05

TABLE OF CONTENTS Topic Abstract pg no ii

acknowledgements ..........................................................................................................i 1. INTRODUCTION ...................................................................................................... 1 2. BANKING STRATEGIES OF TODAY....................................................................... 2 3. MANAGEMENT CHALLENGES IN BANKING........................................................ 4 4. BRANCH BANKING: THE BACKBONE OF BANKING INDUSTRY - A CASE STUDY ......................................................................................................................... 12 5. BUSINESS STRATEGIES UNDER CHANGING ENVIRONMENT........................ 16 5.1 HIKING DEPOSITS..........................................................................................16 5.2 BANKINGS PROBLEMS WITH GROWTH .................................................16 5.3 BANKING INDUSTRY IN A CHANGING SOCIETY...................................17 5.4 BANCASSURANCES ......................................................................................18 6. SERVICES OFFERED BY BANKS......................................................................... 19 6.1 SERVICES BANKS HAVE DEVELOPED MORE RECENTLY ...................20 7. AN INTRODUCTION TO VENTURE CAPITAL..................................................... 23 7.1 VENTURE CAPITALISTS-NEED IN INDIA .................................................27 7.2 ROLE OF VENTURE CAPITALIST INDIAN CONTEXT...........................28 7.3 A SUCCESSFUL VENTURE CAPITALIST-INDIAN CONTEXT ................29 7.4 INDIA STRATEGIC VENTURE CAPITAL IMPORTANCE......................33 7.5 CREATING AN ENVIRONMENT: DEVELOPING VENTURE CAPITAL IN INDIA ......................................................................................................................34 7.6 SUCCESSFUL VENTURE CAPITAL INVESTMENT A BLUEPRINT.....42 7.7 AN UPDATE ON STRUCTURING VENTURE CAPITAL AND OTHER INVESTMENTS IN INDIA ....................................................................................47 7.8 VENTURE CAPITAL: TIME TO REFLECT ..................................................50 8. CONCLUSIONS....................................................................................................... 55 BIBILIOGRAPHY ........................................................................................................ 56

1. INTRODUCTION
Banks are an integrated and essential part of daily life of human being that we cannot even imagine life without banks. This is the kind of service banking industry has been providing to individuals and institutions. Banks are the most important financial institutions in the economy. World wide banks grant more installment loans to consumers than any other financial institution. Banks are among the most important sources of short-term working capital for business and have become increasingly active in the recent years. Today banking industry is in a change. Rather than being something in particular, it is continually becoming something new- offering new services, merging and consolidating into much larger and more complex businesses, adopting new technologies that seem to change faster than most of us can comprehend, and facing a new and changing set of rules as more and more nations cooperate to regulate and supervise the banks that serve their citizens. Banking industry is one of most heavily regulated industries in the world. The purpose of this project is to get an insight into the banking industry and the latest happenings of the industry and know where the industry is heading. The first part of the project deals with the general aspects of the banks, the necessity of effective branch management, the management challenges in banking industry, and the business strategies deployed by banks under changing environment, whereas the later part concentrates on venture capital and its importance in Indian context, the need of Venture capital in India, the necessary condition that are ought to be met by a successful VC and the problems faced by VCs in India.

2. BANKING STRATEGIES OF TODAY

A banking strategy to exploit the potential of Internet is the move towards Account Aggregation- an interactive financial manager. Account aggregation web sites, a technology not heard of before, is becoming the buzzword of the banking industry.

What is account aggregation? The concept necessitates customers to provide their user identifications (Ids) and passwords to an aggregator, which then visits the web sites of their financial institutions and "scrapes" relevant information from the provider's screens. The information is then funneled into a single, easy-to-read page, accessible by customers with one login. From the above it can be seen that such a service benefits customers in obtaining a consolidated snapshot of their financial relations with many providers. As customers have different accounts with multiple financial service providers, such a service offers them comprehensive financial information at one place. It is this convenience that is making customers demand such a service from the banking sector. Bankers may not wholeheartedly endorse account aggregation, but they may need to offer it. Account aggregation holds the potential to create deeper and closer relationships with online customers. Hence, though wary, banks are foraying into the service. New York based Citigroup Inc. was the first bank to do so, on its Myciti.com web site. By providing a complete online picture of the customer's financial status, it helps a financial institution in cross-selling products This service offers a medium to learn about the customer's overall financial position and then use this information to formulate marketing strategies Concerns for banks. Account aggregation is a cause for concern in such issues as privacy, security and disintermediation. As aggregators extract customer relevant information without the bank's knowledge from their sites, banks worry about the security and privacy of customer information. Also the existence of middlemen could hamper customer relations for the bank. In spite of these concerns, banks are willing to offer the services to customers to remain competitive. Another emerging strategy amongst banks today is the move towards Wireless Banking. Venturing into this medium would mean that banks have to redefine their business channels. On the other hand banks cannot ignore this, as they would lose 2

their customers to other banks offering such a service. According to Virginia H.Philipp, a TowerGroup analyst, "Wireless banking is not about making money. It's more an issue of keeping the right customers happy, namely the top 10-20% who contribute to the bulk of bank profits". Customers having an option to choose, among banks, would select the medium that is easy and cheap for them. In terms of infrastructure and support, wireless banking offers one of the cheapest channels for obtaining banking services.

Banks perspective of this new business medium. Banks are keenly looking at developing wireless banking as the demographics of wireless usage is broad, encompassing not only high net worth individuals, but also middle class individuals attracted by the convenience. Adopting such a medium would increase the customer base of the bank. This will have a positive impact on the bank bottom line. Another interesting feature about wireless banking is that it can be adopted by banks of all sizes. The bank has to make use of its already existing infrastructure and technology. It needs to export its banking applications and spread it across additional channels, to increase business volumes. Capital investment for such a medium is minimal. Its affordability prompts banks to consider this strategy. For instance, Bank of Montreal, which is a national bank with six million retail relationships in Canada, has adopted wireless banking. At the same time, even First Tech Credit Union, a bank that has around 80000 customers, and a regional market also adopted wireless banking. As customers are becoming Internet and technology savvy, the wide usage and success of wireless banking will not be mere hype, but a reality.

3. MANAGEMENT CHALLENGES IN BANKING

Recent developments have underscored the urgency to sensitize the banking industry on emerging issues and quickly adapt to the change. There are two ways in which this topic can be interpreted firstly, as challenges faced by bank management and secondly as the management of challenges faced by banks. Both these issues are of concern to us and although there is a common thread between the two topics, the focus of the two would be different. Before the onset of the reform process, Indian banking was operating in a relatively comfortable and protected environment. The reform process has brought the Indian banking system into the era of intense competition even though it paved the way for achieving remarkable improvement in various parameters. Every aspect of functioning of the banking industry, be it profitability, NPA management, customer service, risk management, human resource development, etc. has to undergo the process of transformation to align with the international best practices. Managing the challenges effectively becomes the most urgent task for the banks management.

Profitability An important indicator of the strength of any system is its profitability level. The financial sector reform process brought in its wake measures like tightening of prudential norms, which affected the profitability of banks in the initial years. However, banks had responded well to the reform process. This has been possible due to careful sequencing of introduction of various prudential norms by the Regulator as also proper planning by the banks in adopting these norms. Except for the year ended March 31, 2001, when public sector banks introduced Voluntary Retirement Scheme (VRS), resulting in huge charge to their profit and loss account and affecting their profitability, the operating and net profit of all bank groups for the last three years ended March 31, 2000 to 2002, from the table below, had shown remarkable improvement.

Bank Group Public sector banks Private sector banks Foreign banks Total

Operating profit (Rs crore)* 2000 13,042 (1.46) 2,576 (1.95) 2001 13,801 (1.34) 2,843 (1.74) 2002 21,672 (1.88) 4,628 (1.73)

Net profit (Rs. crore) 2000 5,116 (0.57) 1,160 (0.88) 2001 4,316 (0.42) 1,141 (0.70) 2002 8,301 (0.72) 1,778 (0.66)

2,687 5,739 8,719 967 2,221 3,449 (3.24) (3.05) (3.13) (1.17) (0.93) (1.33) 18,305 22,383 35,019 8,243 7,678 13,528 (1.66) (1.53) (1.94) (0.66) (0.49 (0.75)

Table 3.1 *Figures given in parenthesis are operating profit and net profit as a percentage to total assets As compared to March 2000, the operating and net profit of banks had almost doubled by March, 2002. However, we agree that there are still some factors/constraints, which affect profitability levels in banks. One of them is NPAs, particularly in the public sector banks and old private sector banks. Other factors are the large number of unremunerative branches, low staff productivity and archaic methods of operations. With increasing competition, margins will come under further pressure and therefore banks have to build long-term strategies for increasing their profitability levels by: rationalization of branch network rationalization of manpower deployment use of latest technology in banking for further reduction in cost of operations and well concerted efforts to minimize the NPAs to the lowest possible level

NPA Management The issue of NPA management continues to be the biggest challenge before the banking sector. One of the major constraints of the competitive efficiency of banks is the tendency to accumulate poor quality of assets. Nothing is more true indicator of the quality of assets than the incidence and quantum of NPAs in relation to the total portfolio. The level of gross NPAs of all groups of banks for the last three years from the table below, is on the rise, though the rate of growth has decelerated.

Table 3.2 *Figures given in parenthesis are gross NPAs as percentage of gross advances While the steps taken by the banks in reducing the level of NPAs are noteworthy, it still continues to be high by international standards. RBI / Government of India have taken several steps to arrest the NPA levels. The steps taken have been preventive, remedial and legal in nature. For instance, the Corporate Debt Restructuring (CDR) mechanism has been introduced which is aimed at restructuring the debt of viable corporate entities outside the purview of BIFR, DRT, etc. Further, efforts are being made to make CDR mechanism more efficient. However, some banks have not joined the CDR mechanism and those who have joined have not referred many cases to CDR Cell. Another major step in this direction has been the introduction of One Time Settlement Schemes (OTS). The success of the OTS has been modest. Under both the OTS schemes, i.e. upto Rs.5 crore and upto Rs.25, 000 banks could recover only around Rs.3000 crore. Let us hope banks would make effective use of the forthcoming OTS guidelines for NPAs upto Rs. 10 crore. The Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Ordinance, 2002 has been another major initiative from the legal side. This legislation would provide a comfort level to banks in tackling the problem of NPAs. While the steps taken by RBI / Government of India will go a long way in reducing the level of NPAs, banks' Boards, on their part should also formulate clear cut guidelines for monitoring NPA level, refine their own appraisal systems and strengthen the loan review mechanism to prevent incidence of fresh NPAs.

Capital Adequacy Ability of a bank to absorb unexpected shocks and losses is solely dependant upon its capital base. Basle Capital Accord of 1988 played a positive role in strengthening the soundness and stability of banks and enhanced the competitive equality among international banks. While on the one hand ongoing refinement in the capital adequacy norms had increased the capital requirements of our banks, there was increased pressure on the bottom lines of banks in view of the demand for setting aside profits for meeting the increased provisioning requirements. However, as indicated in the table below, the system as a whole has managed to maintain capital adequacy ratio of more than 11% over the last few years. However, there are still a few banks in the system, which operate with a capital adequacy below the stipulated level. Year Nationalised Banks SBI Group Public Sector Banks Old Private Sector Banks New Private Sector Banks Foreign Banks All Banks 98-99 10.63 12.34 11.25 12.07 11.76 10.78 11.27 99-00 10.11 11.57 10.66 12.35 13.44 11.93 11.1 Table 3.3 The introduction of 90 days delinquency norm for recognition of loan impairment effective from March 31, 2004, reduction in the transition period for migration of a sub-standard asset into doubtful category from 18 months at present to 12 months effective from March 31, 2005, making adequate provision to cover country risk, etc. would put increased pressure on the capital adequacy and bottom lines of banks. Indian banking industry is playing a significant role in the financial intermediation process and as the pace of economic development is accelerated, the ratio of the bank credit to GDP is likely to be doubled from the existing ratio of about 25% to 50% 2000-01 10.2 12.7 11.15 11.93 11.51 12.57 11.39 2001-02 10.91 13.26 11.76 12.52 11.69 12.97 11.92

within next 5 years which implies that the bank credit would increase two fold. Added to this, the big thrust being accorded to infrastructure sector requires substantial support from the banking system in the form of long-term loans. Hence, banks would be required to increasingly explore avenues to raise capital from the market. Banks have, in recent years, placed greater reliance on subordinated debt to meet the increased capital requirements. However, scope for raising capital through subordinated debt is also limited in view of the prudential limit that subordinated debt cannot exceed 50% of Tier I capital. Added to this, there is a constraint for public sector banks to raise capital from the market. A Quantitative Impact Study (QIS) has been conducted by the Reserve Bank of India in seven banks and the impact assessment is being evaluated. In the meanwhile, the banks have to refine their existing systems with a view to ensuring smooth transition to the New Accord.

Management Recent developments in the country have brought to the fore the need for banks management to exercise proper vigilance and supervision over the functioning of their respective banks. Corporate governance, which represents the value framework, the ethical framework and the moral framework under which business decisions are taken, calls for transparency in decision-making and accountability to stakeholders. In the context of the Indian banking system, though much greater autonomy and powers have been entrusted to the Boards of banks and financial institutions to lay down effective internal guidelines and procedures for transparency, disclosure, risk management, etc. Boards of some banks have not lived up to the expectation. Reserve Bank of India had set-up a Consultative Group under the Chairmanship of Dr. A.S. Ganguly to review the supervisory role of Boards of banks and financial institutions and obtain feed back on the functioning of the Boards vis--vis compliance, transparency, disclosures, audit committees etc. and give recommendations for making the role of Board of Directors more effective with a view to minimising risks and over exposure. The recommendations of the Group have been benchmarked with international best practices as enunciated by the Basel Committee on Banking Supervision, as well as of other committees and advisory bodies, to the extent applicable to the Indian environment.

Corporate Governance not only calls for greater responsibility of the Board. In fact, the role of the CEO also becomes equally crucial in sensitising not only the Board but the institution as a whole to appreciate the importance of corporate governance and supplement it. CEOs should therefore pay importance to building a team of performers and motivate the organisation as a whole. Fraud The reason to stress upon bank frauds is that banks in recent times have not adhered to the laid down systems and procedures thus giving rise to incidence of fraud. Practices in some banks like release of funds by lower level functionaries on oral instructions of the top management with no record maintained on such instructions, had contributed to the perpetration of frauds. In many cases the Board of Directors had in a routine manner ratified, post facto, the credit decisions of CMDs or other functionaries taken in excess of their delegated authorities. In many such cases, the loans had turned into NPAs later on. In as many as 23 cases of large value frauds for Rs.10 crore and above, cases filed for more than 5 years ago are yet to reach their logical end. This is the reason for urging the banks, particularly CEOs to ensure that laid down systems and procedures are followed and there should be quick disposal of cases relating to large value frauds of say Rs. 1 crore and above within the time limit of 4 months as prescribed by CVC. There is justification in the demand being made by banks that appropriate legislative amendment to Public Servants Act should be brought out to provide for dismissal of a public servant, through a focused enquiry lasting not more than a week in case of large frauds. This would, besides serving as a deterrent, would also ensure that fraudulent officials are not allowed to stay around to commit further mischief and tamper records.

Customer service The reform process has resulted in shift from highly regulated banking to deregulation and liberalization of the banking sector. The objective was to evolve a level of banking services which is efficient, effective and customer-oriented and which should seek to emulate the best practices in the industry the world over. Indian banking,

realizing the challenges thrown by global competition is undergoing significant developments and improvements in the field of customer service. This has by and large been possible due to increased use of technology in banking resulting in branch computerization, growth of retail banking and automation of banking processes. Extension of reach of customer service and rationalization of costs of operations were the by-products of this process. For instance, ATM has emerged as an alternative banking channel which facilitates low-cost transactions vis-a vis traditional branch banking. The increased use of modern technology by foreign banks and new private sector banks has helped them to increase their market share vis-a-vis public sector banks. Modern clearing operations, electronic funds transfer system and centralized funds management systems are some projects receiving priority of RBI to enhance customer service in the banking sector. Banks should not be satisfied only with introducing latest technology towards providing better customer service. The level of service still needs improvement. Complaints about delay in crediting proceeds of outstation instruments by banks and fraudulent encashment of instruments by unscrupulous persons after opening deposit accounts in the name/s similar to already established concern/s resulting in erroneous and unauthorised debit of drawers' accounts continue to be received. In such cases, there have been instances where banks have also not restored funds promptly to customers even in bona-fide cases but deferred action till completion of either departmental action or police interrogation. There is a lot more to be done to enhance customer service in banks. Best way to come up to the customers' expectations would be to obtain regular feedback from them especially from rural and non-metro branches, and filling the gaps wherever exist. Banks' Boards should, in particular, review the policies regarding customer service at periodical intervals to fine tune them in line with customer needs. Complaints redressal mechanism should be quick, responsive and prompt.

Future road map For a diverse and vast banking system like the one in India, it is important to build a future road map for the banking system. The future of Indian banking system needs a long term strategy which would broadly cover areas like structural aspects, business 10

strategies, prudential standards, control systems, integration of markets, technology issues, credit delivery mechanism, information sharing, etc. With increasing competition and globalisation the need for specialised one window service concept will grow. Banks would, therefore be required to draw business strategies keeping in view their risk bearing capacity and need for additional capital. Banks would also have to explore new markets and strive to achieve consolidation of their operations taking into account the client profile, business opportunities, etc. In recent times, RBI has taken a number of initiatives keeping in mind the future road map of the banking system. Introduction of Prompt Corrective Action framework is one among them. Under the PCA framework, RBI can initiate certain structured actions in respect of banks which have hit the trigger points in terms of CRAR, net NPA and ROA. RBI, at its discretion, will resort to additional actions (discretionary actions) as indicated under each of the trigger points. It would be better for banks to avoid coming under PCA framework. The CEO and the banks Board have to work together to ensure that banks business is not conducted in such a way that trigger points under PCA framework are attracted by it. As the saying goes, prevention is better than cure. RBI is in the process of evolving fair practices code on lenders liability. The same has been put on the RBI website for comments from the public. Under the proposed guidelines, banks would be required to follow proper procedures with respect to loan application, such as acknowledging receipt of all loan applications, conveying reasons for rejection of loans, timely disbursement of loans etc. Banks would be given the freedom to draft fair practices code. However, it should be ensured that RBI guidelines are not diluted. For this, Board of banks should lay down clear policy on all loan sanction and loan disbursement matters.

11

4. BRANCH BANKING: THE BACKBONE OF BANKING INDUSTRY A CASE STUDY

Is branch-banking back in business? Has the banking industry realised the limitations of using non-branch channels and banking on technology? A case study by an international consultant Booze Allen Hamilton on international banking, has thrown some interesting findings on these issues. Though the basic survey has been conducted in an international setting, it has some universal findings, which will of interest to the domestic banking industry, which is undergoing a paradigm shift with technology networking and reaching out to mass retail customers. To a basic question, whether state-run banks with a large branch network or private sector banks with sleek technology will call the shots in terms of customer loyalty and profitability, some pointers have been offered in this study. Booz Allen Hamiltons research shows that after withering for 20 years, branch banking is making a comeback. And there is a good reason for this revival: branches are significant growth engines, helping acquire up to 90 per cent of new customers. Call-centers and the Web are fine for routine transactions, but the branch needs to be the centerpiece of the customers interaction with the bank because it is the best place to get personalised information and attention, and to conduct complex banking activities. It is also the best channel to encourage customers to entrust more of their assets to the bank as their needs change with time. But the moot question is that can large retail banks revive the branch system without letting it become a costly drag on their profits? Absolutely, but only if they reinvent the management model so it can profitably deliver what consumers expect: choice, convenience, and customization, feels the study. Booz Allen Hamiltons research shows that up to 90 per cent of customer relationships are won or lost in branches. For todays consumer banks, reinventing local branches as a hub to attract and retain customers is essential to profit and growth. It is not enough for retail banks simply to open up more branches that run like existing ones or to redesign them to resemble hip retail stores. The successful branch bank of the future must be a financial-services resource center. Financial advisors could conduct seminars after hours on topics as

12

managing debt, savings strategy, or how to transition from paycheck-to-paycheck banking to accumulating wealth. For the mass affluent customer - the person who is already saving and investing the branch can offer light relationship management. For example, a bank specialist who sold one financial product to a customer could periodically review that customers needs and recommend other appropriate products. Booz Allen Hamiltons research in 2003 shows that there is a good reason for the revival of branch systems: they are significant growth engines for retail banks. Moreover, the study found a high correlation between branch visits and sales. Banks are reinventing the management model in a bid to profitably deliver what demanding consumers expect: choice, convenience, and customization. In the customer-centric, federation business model, the study proposes that the branch is the hub of an integrated multi-channel banking framework designed to maximize local responsiveness. In 2003, the consultant collected data and conducted on-site observations of branch operations that show the enormous value of the branch. For example, evidence that customers favor branches over other channels for purchasing financial-services products was overwhelming. The survey showed 12 per cent of customers, who were seeking a home loan obtained information over the Internet, but 49 per cent closed the sale in a branch. In one recent client study, Booz Allen Hamilton found that 90 per cent of a superregional banks new customers were acquired in a branch. Equally important, almost all accounts were closed at a branch, suggesting that branches can be a first line of defence in retaining customers. Customers often provide predictable clues before they close their accounts. Banks spend heavily on customer relationship management (CRM) systems to predict customer defections, but a vigilant branch staffer can just as effectively use the personal touch to solve a problem and keep a customer from leaving. The branch customer service representatives handle simple product sales and know when to refer customers to a branch-based specialist. Customers perceive the value of consulting a banker, and the bank gets more involved with customers. When they are planning and optimizing their choices, not just when theyre shopping for products.

13

To deliver consultation services economically, branches must offer a set of standardised products targeted for different life stages or for immediate needs. Banks can package existing products and information in a new way in order to focus on the 80 per cent of the customers, who need advice when planning for college tuitions, maximising retirement savings, and so on. Focussing on local demographics, a customer-focused branch economically also requires tailoring branch services to local market needs. This micromarket alignment is typically driven by age and income, and incorporates factors as area population concentration, branch proximity to business centers, and customers ethnicity. Achieving this alignment drives decisions regarding branch staffing, skills, product configurations, and customer sales/retention targets. Proposing a federation model, Booze Allen Hamilton says that many large banks pursuit of scale has come at a huge loss of control over local capabilities and costs. These banks have achieved neither the cost savings of monoline banks nor the deeper wallet penetration and service quality of small local banks. Booz Allen Hamiltons federation model addresses these issues by striving for efficient centralised management and greater responsiveness to micromarkets. It calls for central controls at corporate headquarters that exploit product, infrastructure, and administrative scale, but the center delegates decision making to the branch manager, who knows the local market and is empowered to make resource, incentive, and pricing decisions locally. The branch is accountable for its own P&L. If branch managers are offered the right inducements for instance, compensation and perks based on performance the international consultant believes that they will work smarter to customise their operations to be more competitive. Applying the federation model is not merely a matter of making organisational adjustments. Nor is it the same as franchising. By giving each branch responsibility for managing its own P&L and retaining some centralized management, banks allow branch managers to run their own businesses and to leverage the brand and infrastructural power of the institution. The federation model can increase revenue between 35 per cent and 65 percent per branch. This improvement stems mostly from increased product cross-selling due to the availability of financial service product packages and greater customer retention as 14

customer satisfaction rises. There are higher costs for staff training, performance incentives, and technology investments, but much of these cost increases can be recovered through lower staff changeover and reduced layers of management. To implement the federation business model, action is required in four areas. People: Hiring, training, and certification of front-line employees; significantly improving branch management; making major modifications to incentives. Internal Benchmarking: understanding branch performance; aligning to micromarkets; increasing readiness for change. Geographic specialization: determining local resource needs and establishing sales focus based on demographic, purchasing behavior, and the local growth trajectory. Structure: establishing mechanisms to coordinate local versus central decision rights; refining roles and responsibilities within the branch network. The days of the branch bank as weve known are over. But something better is emerging. In creating a multiproduct, multichannel federation, retail banks have an opportunity to provide greater value to their customers and to make branch banking a profitable, winning strategy, concludes Booz Allen Hamilton.

15

5. BUSINESS STRATEGIES UNDER CHANGING ENVIRONMENT

Deposits strategies for hiking deposits. 6 steps that will guide banks on how to introduce cross selling of

Banc Assurances

insurance products through their branches. 5.1 HIKING DEPOSITS A host of commercial banks are now raising their short term deposit rates to woo customers. Banks have been forced to hike short term rates since the growth in deposit rates has not kept pace with credit growth. Different banks have adopted different strategies to woo back depositorssweeteners like free credit cards, accident insurance and so on are being offered. Attracting fresh deposits is a challenge. While banks offer shorter maturity deposits, the administered interest rates are coming as a big challenge to these banks.

5.2 BANKINGS PROBLEMS WITH GROWTH Investors seek higher interest rates while they are depositing their money and they crave for lesser interest rates while they take loans. Present scenario banks have started begging for deposits and not loans any more. The reason being the industrys credit port folio is growing at a scorching pace far ahead of its deposit growth. In the first nine months of the fiscal year 2004-05 non food credit of all scheduled commercial banks grew by Rs1,92,548 crore. On a year basis (that is between Dec-2003 and Dec 2004) the non food credit growth was even higher Rs2,58,274 crore. Against this, the deposit growth is Rs 1,61,1041 crore and Rs 2,43,561 crore, respectively. These statistics reveal that the Indian banking systems incremental credit deposit (CD) ratio for the past one year has been over 100%. In percentage terms, the aggregate deposit growth in the first nine month of the year has been 10.7% against 23.9% credit growth. Nonetheless, it is a significant trend. The banks have finally come back to their bread and butter business of giving loans. With the first sign of

16

rising interest rates, Indian banks have shifted focus from investment in government securities to loans. On an outstanding basis, the credit deposit ratio is 62.54. In other words, for every Rs100 worth of deposit in the system, Rs 62.54 is being disbursed as credit, which didnt happen at least in the past one decade. Companies and high net worth individuals have started bargaining for a few paise more on their deposits and banks are obliging them without making a fuss. Banks are also offloading their excess statutory liquidity ratio (SLR) holdings to generate liquidity to support new loan asset creation. Despite a small rise in lending rates, corporations are lapping up bank funds but savers are going to greener pastures like post office run small savings schemes that offer better returns. The next battle on the Indian banking turf will be fought for deposits. The present trend of the corporate players is such that they have started auctioning deposits to the highest interest payers. Companies and high net worth individuals also look for safety, because only up to Rs 1 lakh of deposit gets insurance cover and any money over this can vanish into the blue if a financial intermediary crumbles. The above cited reason may become a reason to relatively weaker banks to raise deposits even if they offer competitive rates. It is these players that will feel the heat if they are on a massive asset building mission.

5.3 BANKING INDUSTRY IN A CHANGING SOCIETY Till social control on banks in1968 and the subsequent nationalization of the 14 major Indian banks took place in 1969, the scheduled banks were directing their advances to the large and medium scale industries and big business houses. Since then there has been a stupendous expansion in the banking industry. With the rapid expansion in the banking network there has been a steady deterioration in bank service and efficiency. Worse it also opened up opportunities for corrupt officials of the banks and for other unscrupulous individuals, jointly or otherwise to commit fraud on the banks. The bank unions have made it very difficult for bank managements to discipline their employees. In fact the face of the onslaught of the unions and the corruption within their own ranks, bank managements have buckled in very badly.

17

It was reported that the profitability of the Indian banks is low and is getting progressively eroded. In contrast 16 foreign banks made an after tax profit in the same year out of their aggregate earnings. The reasons are explicit: Lack of cost consciousness in nationalized banks Inefficiency Frauds, and Poor yields on advances

The Reserve Bank of India has taken a number of adhoc measures to improve the profitability of the banks by increasing the rates of interest payable to them on their cash balances and food advances but to no avail. Despite its statutory powers of control and regulation it is neither able to resist political pressures nor keep a close watch on banking operations. The spread of social banking has brought about the politicization of banking industry in several unfortunate ways. Apart from the loss of profit, it has encouraged frauds and corrupt practices. The rate at which deposits and advances is growing means that, the risk of fraud is also increasing.

5.4 BANCASSURANCES 6 Steps to implement insurance selling in banks are as follows: 1. To project the fee income potential through insurance products over 5 years for the entire bank. 2. Create internal awareness in all layers of the hierarchy about this new initiative and its relevance. 3. Banks should make internal changes in the parameters for evaluating performance of branches to include fee based income through cross selling. (New age bank customers look for convenience and informed advice from the branch manager and they prefer banks that display this attitude at the front desk.) 4. Banks should enter into a distribution alliance with an insurance company after evaluating its product profile, after sale service standards, overall commitment to training and other relevant factors. 5. Bank should create the best sales team at the front desk level and equip them with skills to undertake cross selling. This is the most complex part and banks abroad often undertake this talk with the help of professional agencies.

18

6. Lastly banks should acknowledge efforts made by staff in cross selling and consider rewarding the best performers. The best form of motivation is to openly acclaim the good work done, and give wide publicity through internal forums.

6. SERVICES OFFERED BY BANKS

Carrying out currency exchanges: Banks trade one form of currency, such as dollars, for another form such as francs or pesos or rupees. This is very important to travelers and people involved in exports and imports. In todays financial marketplace, trading in foreign currency is usually carried out primarily by the largest banks due to the risk involved and the expertise required to carry out such transactions. Discounting commercial notes and making Business loans: Early in their history, bankers began discounting commercial notes- in effect; making loans to local merchants who sold the debts (accounts receivable) they held against their customers to a bank in order to raise cash quickly. Offering Savings Deposits: Making loans proved so profitable that banks began searching for ways to raise additional loanable funds. One of the earliest sources of funds consisted of offering savings deposits interest bearing funds left with banks for a period of weeks, months or years. Safekeeping of Valuables: Banks began practice of holding gold, securities and other valuables owned by their customers in secure vaults. Today the safekeeping of customer valuables is usually handled by a banks safety deposit department. Supporting Government activities with credit: Banks are required to purchase government bonds with a portion of any deposits they received. So this helps the government raise money for developmental activities. The government can control the ratio of deposits (held by banks) so that the banks can come to rescue of the government when there is a crisis.

19

Offering Checking Accounts (Demand Deposits): Demand Deposit is a checking account that permitted the depositor to write drafts in payment for goods and services that the bank had to honor immediately. Offering demand deposits improved the efficiency of the payments process, making business transactions easier, faster, and safer. Offering Trust Services: For many years banks have managed the financial affairs and property of individuals and business firms in return for a fee that is often based on the value of properties or the amount to funds under management. This property management function is known as Trust services. Most banks offer both personal trust services to individuals and families and commercial trust services to corporations and other business.

6.1 SERVICES BANKS HAVE DEVELOPED MORE RECENTLY Granting consumer loans: Early in this century, however bankers began to rely more heavily on consumers for deposits to help fund their large corporate loans. Then, too heavily competition for business deposits and loans caused bankers increasingly to turn to the consumer as a potentially more loyal customer. So now banks grant a variety of consumer loans including housing loans, vehicle loans etc Financial Advising: Bankers have long been asked for financial advice by their customers, particularly when it comes to the use of credit and the saving or investing of funds. Many banks today offer a wide range of financial advisory services, from helping to prepare tax returns and financial plans for individuals to consulting about marketing opportunities at home and abroad for their business customers. Cash management: Cash management services are services in which banks agree to handle cash collections and disbursements for a business firm and to invest any temporary cash collections and disbursements for a business firm and to invest any temporary cash surpluses in short-term interest bearing securities and loans until the cash is needed to pay the bills.

20

Offering Equipment Leasing: Many banks have moved aggressively to offer their business customers the option to purchase needed equipment through a lease arrangement in which the bank buys the equipment and rents it to the customer. Making Venture Capital Loans: Increasingly, banks have become active in financing the start-up costs of new companies, particularly in high-tech industries. Because of the added risk involved in such loans, this is generally done through a venture capital firm that is a subsidiary of a bank holding company and other investors are often brought in to share the risk. Selling Insurance Services: For many years, banks have sold credit life insurance to customers receiving loans, thus guaranteeing repayment of the loan if the customer dies or becomes disabled. Banks now make insurance policies available to their customers usually through joint ventures or franchise agreements. Selling Retirement Plans: Bank trust departments are active in managing the retirement plans that most businesses make available to their employees, investing incoming funds and dispensing payments to qualified receipts who have reached retirement or become disabled. Offering Security Brokerage Investment Services: In todays financial market place many banks are striving to become true financial department stores offering a sufficiently wide array of financial services to permit customers to meet all of their financial needs at one location. This is one of the main reasons banks have begun to market security brokerage services, offering their customers the opportunity to buy individual stocks, bonds, and other securities without having to go to a security dealer. Offering Investment Banking and Merchant Banking Services: Banks today are following in the footsteps of leading financial institutions all over the globe in offering investment banking and merchant banking services to larger corporations. These services include possible merger targets, financing acquisitions of other companies, dealing in a customers securities (i.e. new security underwriting), providing strategic marketing advice, and offering hedging services to protect their

21

customers against risk from fluctuating world currency prices and changing interest rates. The list clearly shows that banks are offering a wide range of services to the customers. Still the bankers service menu is growing rapidly with new product innovation. New types of loans and deposits are being developed, new service delivery methods like the Internet and smart cards with digital cash are expanding, and whole new service lines are being launched every year. Customers can satisfy virtually all their financial service needs at one financial institution in one location. Truly, banks are the financial department stores of the modern era which unify banking, fiduciary, insurance, and security brokerage services under one roof a trend often referred to as Universal banking.

22

7. AN INTRODUCTION TO VENTURE CAPITAL

The origin of venture capital: In the 1920's & 30's, the wealthy families of and individuals investors provided the start up money for companies that would later become famous. Eastern Airlines and Xerox are the more famous ventures they financed. Among the early VC funds set up was the one by the Rockfeller Family which started a special fund called VENROCK in 1950, to finance new technology companies. General Doriot, a professor at Harvard Business School, in 1946 set up the American Research and Development Corporation (ARD), the first firm, as opposed to a private individual, at MIT to finance the commercial promotion of advanced technology developed in the US Universities. ARD's approach was a classic VC in the sense that it used only equity, invested for long term, and was prepared to live with losers. ARD's investment in Digital Equipment Corporation (DEC) in 1957 was a watershed in the history of VC financing. While in its early years VC may have been associated with high technology, over the years the concept has undergone a change and as it stands today it implies pooled investment in unlisted companies. VC in India: This activity in the past was possibly done by the developmental financial institutions like IDBI, ICICI and State Financial Corporations. These institutions promoted entities in the private sector with debt as an instrument of funding. For a long time funds raised from public were used as a source of VC. This source however depended a lot on the market vagaries. And with the minimum paid up capital requirements being raised for listing at the stock exchanges, it became difficult for smaller firms with viable projects to raise funds from public. In India, the need for VC was recognized in the 7th five year plan and long term fiscal policy of GOI. In 1973 a committee on Development of small and medium enterprises highlighted the need to faster VC as a source of funding new entrepreneurs and technology. VC financing really started in India in 1988 with the formation of Technology Development and Information Company of India Ltd. (TDICI) promoted by ICICI and UTI. The first private VC fund was sponsored by Credit Capital Finance Corporation (CFC) and promoted by Bank of India, Asian Development Bank and the

23

Commonwealth Development Corporation viz. Credit Capital Venture Fund. At the same time Gujarat Venture Finance Ltd. and APIDC Venture Capital Ltd. were started by state level financial institutions. Sources of these funds were the financial institutions, foreign institutional investors or pension funds and high net-worth individuals. Though an attempt was also made to raise funds from the public and fund new ventures, the venture capitalists had hardly any impact on the economic scenario for the next eight years. How VCs differ from banks: Conventional financing generally extends loans to companies, while VC financing invests in equity of the company. Conventional financing looks to current income i.e. dividend and interest, while in VC financing returns are by way of capital appreciation. Assessment in conventional financing is conservative i.e. lower the risk, higher the chances of getting loan. On the other hand VC financing is a risk taking finance where potential returns outweigh risk factors. Venture Capitalists also lend management support and provide entrepreneurs with many other facilities. They even participate in the management process. VCs generally invests in unlisted companies and make profit only after the company obtains listing. VCs extend need based support in a number of stages of investments unlike single round financing by conventional financiers. VCs are in for long run and rarely exit before 3 years. To sustain such commitment VC and private equity groups seek extremely high returns. A return of 30% in dollar terms. A bank or an FI will fund a project as long as it is sure that enough cash flow will be generated to repay the loans. VC is not a lender but an equity partner. Venture capitalists take higher risks by investing in an early-stage company with little or no history, and they expect a higher return for their high-risk equity investment. Internationally, VCs look at an internal rate of return (IRR) north of 40% plus. In India, the ideal benchmark is in the region of an IRR of 25% for general funds and more than 30% for IT-specific funds. With respect to investing in a business, institutional venture capitalists look for average returns of at least 40 per cent to 50 per cent for start-up funding. Second and later stage funding usually requires at least a 20 per cent to 40 per cent return compounded per annum. Most firms require large portions of equity in exchange for start-up financing.

24

Tax benefits : In terms of section 10(23 F) of IT Act income by exemptions way of dividend and long term capital gains received by approved VC Companies/Funds from investment made by way of equity shares in a VC undertaking are exempt from tax. IT rules amended on 18th July 1995 introduced a rule 2(D) which allowed tax exemption under the aforementioned section provided, among others, (1) An application is made to Director of IT (Exemptions) by the VCC or VCF (2) VCF/VCC is registered with SEBI. (3) Not less than 80% of the fund corpus/paid up capital is invested by year 3. (4) The VCC/VCF does not invest more than 5% of paid up capital/fund corpus in one VC undertaking. (5) VCC/VCF does not invest more than 40% in equity capital of one VC undertaking. Types of VCs: Generally there are three types of organized or institutional venture capital funds: venture capital funds set up by angel investors, that is, high net worth individual investors; venture capital subsidiaries of corporations and private venture capital firms/ funds. Venture capital subsidiaries are established by major corporations, commercial bank holding companies and other financial institutions. Venture funds in India can be classified on the basis of the type of promoters Financial institutions led by ICICI ventures, RCTC, ILFS, etc. Private venture funds like Indus, etc. Regional funds: Warburg Pincus, JF Electra (mostly operating out of Hong Kong). Regional funds dedicated to India: Draper, Walden, etc. Offshore funds: Barings, TCW, HSBC, etc. Corporate ventures: venture capital subsidiaries of corporations Angels: high net worth individual investors Merchant bankers and NBFCs who specialize in "bought out" deals also fund companies.

25

Making a VC invest in your venture: In the USA, only one or two business plans in 100 results in successful financing. And of every 10 investments made, only one or two are successful. But this is enough to recover investments made by the venture capital (VC) in all 10 start-ups in addition to an average 40-50% return. Securing an investment from an institutional venture capital fund is extremely difficult. It is estimated that in the US only five business plans in 100 are viable investment opportunities and only three in 100 result in successful financing. In fact, the odds could be as low as one in 100. More than half of the proposals to venture capitalists are usually rejected after a 20-30 minute scanning, and 25 per cent are discarded after a lengthier review. The remaining 15 per cent are looked at in more detail, but at least 10 per cent of these are dismissed due to irreconcilable flaws in the management team or the business plan. A Venture Capitalist looks at various aspects before investing in any venture. A strong management team - each member of the team must have adequate level of skills, commitment and motivation that creates a balance between members in areas such as marketing, finance, and operations, research & development, general management, personnel management, and legal and tax issues. A viable idea establish the market for the product or service, why customers will purchase the product, who the ultimate users are, who the competition is, and the projected growth of the industry. Business plan: the plan should concisely describe the nature of the business, the qualifications of the members of the management team, how well the business has performed, and business projections and forecasts. So while approaching a venture fund one needs to be fully prepared and keep the above requirements in mind while submitting the business plan. The VC Philosophy As against Bought out deals (BODs) , VCs carry out very detailed due diligence and make 2-7 year investments. The VCs also hand-hold and nurture the companies they invest in besides helping them reach IPO stage when valuations are favourable. VCFs help entrepreneurs at four stages: idea generation, start-up, ramp-up and finally in the exit, which is done through M&As. According to Indian Venture Capital Association, almost 41% (Rs 5146.40 m) of the total venture capital investment is in start-up projects followed by Rs 4478.60 m in 26

later stage projects and only Rs 82.95 in turnaround projects. Majority have invested in only three stages of investment, indicating that most VCs in India have not started developing niches for investing with regard to the stages of projects. The main difficulty in early stage funding are related to lack of exit opportunities as probability of an IPO or buy out by of VC stake is less due to lack of understanding for evaluation of the knowledge based companies compared to the companies in the traditional sectors. Some such VCs are: ICICI ventures, Draper, SIDBI and Angels. Funding growth or mezzanine funding till pre IPO: The size of investment is generally less than US$1mn, US$1-5mn, US$5-10mn, and greater than US$10mn. As most funds are of a private equity kind, size of investments has been increasing. IT companies generally require funds of about Rs30-40mn in an early stage which fall outside funding limits of most funds and that is why the government is promoting schemes to fund start ups in general, and in IT in particular. Management of investee firms: The venture funds add value to the company by active involvement in running of enterprises in which they invest. This is called "hands on" or "pro-active" approach. Draper falls in this category. Incubator funds like e-ventures also have a similar approach towards their investment. However there can be "hands off" approach like that of Chase. ICICI Ventures falls in the limited exposure category. In general, venture funds who fund seed or start ups have a closer interaction with the companies and advice on strategy, etc while the private equity funds treat their exposure like any other listed investment. This is partially justified, as they tend to invest in more mature stories. 7.1 VENTURE CAPITALISTS-NEED IN INDIA India needs venture capital where capital meets great ideas in an informed manner. This activity in the past was possibly done by the developmental financial institutions like IDBI, ICICI and State Financial Corporations. These institutions promoted entities in the private sector with debt as an instrument of funding under the erroneous belief that debts are obligations to be repaid and hence safest have not been so and the

27

result is non-performing assets to the tune of Rs840bn. Further stray venture capital activities were for ventures not of the risk taking kind but more based on some entities in that industry performing well, defeating the very role of a venture capitalist. Venture Capitalists or for that matter Developmental Institutions have not given management inputs and not ensured highly competent personnel working in providing Corporate governance in the organizations. This has resulted in lack of transparency in operations, weak monitoring and extra legal transactions becoming role models for survival and success stories. The foreign institutions instead of setting standards have followed the regressive practices set by the Indian counterparts resulting in opportunistic deals and no sustainable role models save a few exceptions. 7.2 ROLE OF VENTURE CAPITALIST INDIAN CONTEXT Venture capital is essentially one where capital meets great ideas and facilitates improved corporate governance, finance and marketing. Venture capital has to be in the form of informed equity capital provided directly to new and growing venture where management follows capital as a matter of principle. It is indeed an imperative to note what is needed is a strong management culture to convert ideation to strategies and action instead of having covenants of loans. Possibly what is needed to be appreciated is the role play of the Venture Capitalist and in this regard the definition as given by the British Venture Capital Association is appropriate for the Indian context namely: "Equity capital provided directly to new and growing unquoted businesses by wealthy individuals usually acting as individuals or part of an informal syndicate. These investors provide a wealth of experience and ideas to a new and growing business and should look at them as partners in your business rather than just investors." Essentially what is being conveyed is that there is a need to have venture capitalists that are in an engaging mode instead of an exchange mode - a mindset change which needs to set in. The concept of innovation and newness itself needs to be redefined in the context of emerging markets. There is a need of a private version of Venture capital and not the conversion of Developmental Financial institutions into Universal banks also involved in venture capital, as has been the recent trend in the country. Also the Indian Venture Capitalist needs to look at small funding and providing management inputs in strategy and implementation. This is a distinguishing factor as

28

International Venture capitalists have high funds requirement based on cost of management a requirement not observed in the Indian markets. 7.3 A SUCCESSFUL VENTURE CAPITALIST-INDIAN CONTEXT All activities need contextual relevance. Venture capital financing is no exception to this rule. There is a necessity to look at small amounts of funding, as ideation needs to mature over a period of time. There is a great need for proper articulation and it is in achieving this objective there is a need to invest in the right people first and business plans later. The person behind the venture is a key input for the success of the project itself. The entity being funded either needs to have a management team or strengthened in terms of fulfilling the requirements of leadership skills, vision, integrity and transparency in operations. In conclusion it can be stated that India has opportunities to be availed off for venture capitalists to act as angel investors for first round of funding. Venture capitalists can also perform white knight activities in the form of turnaround funds. It is essential to look at quantum returns over a three to five year time frame instead of looking at quick safe returns. Location of the Headquarters of the Members of Indian Venture Capital Association 19931998 and 2000

Table 7.3.1 Source: Indian Venture Capital Association Various Years; Nasscom 2000.

29

Recent Government Efforts to Encourage Venture Investing In the late 1990s, the Indian government became aware of the potential benefits of a healthy venture capital sector. Thus in 1999 a number of new regulations were promulgated. Some of the most significant of these related to liberalizing the regulations regarding the ability of various financial institutions to invest in venture capital. Perhaps the most important of these went into effect in April 1999 and allowed banks to invest up to 5 percent of their new funds annually in venture capital. However, as of 2001 they have not made any venture capital investments. This is not surprising since bank managers are rewarded for risk-averse behavior. Lending to a risky, fast-growing firm could be unwise because the loan principal is at risk while the reward is only interest. In such an environment, even if bankers were good at evaluating fledgling firms, itself a dubious proposition, extending loans would be unwise. This meant that since banks control the bulk of discretionary financial savings in the country, there is little internally generated capital available for venture investing. The bureaucratic obstacles to the free operation of venture capital remained significant. There continued to be a confusing array of newly created statutes. The main statutes governing venture capital in India included the SEBIs 1996 Venture Capital Regulations, the 1995 Guidelines for Overseas Venture Capital Investments issued by the Department of Economic Affairs in the Ministry of Finance, and the Central Board of Direct Taxes (CBDT) 1995 Guidelines for Venture Capital Companies (later modified in 1999). In early 2000, domestic venture capitalists were regulated by three government bodies: the Securities and Exchange Board of India (SEBI), the Ministry of Finance, and the CBDT. For foreign venture capital firms there was even greater regulation in the form of the Foreign Investment Promotion Board (FIPB), which approves every investment, and the Reserve Bank of India (RBI), which approves every disinvestment. The stated aim of the Indian regulatory regime is to be neutral with regard to the risk profile of investment recipients, but concerns about misuse have not allowed for complete neutrality. Only six industries have been approved for investment: software, information technology, pharmaceuticals, biotechnology, agriculture, and industries allied to the first five.

30

Statutory guidelines also limited investments in individual firms based on the firms and the funds capital. These regulations regarding venture capital were cumbersome and sometimes contradictory. Income tax rules provided that venture capital funds may invest only up to 40 percent of the paid-up capital of a recipient firm, and also not beyond 25 percent of their own funds. The Government of India guidelines also prescribed similar restrictions. Finally, the SEBI regulations did not have any sectoral investment restrictions except to prohibit investment in financial services firms. The result of these various restrictions was a micromanagement of investment, complicating the activities of the venture capital firms without either increasing effectiveness or reducing risk to any appreciable extent. Impediments to the development of venture capital also can be traced to Indias corporate, tax, and currency laws. Indias corporate law did not provide for limited partnerships, limited liability partnerships, or limited liability corporations (LP, LLP, and LLC, respectively). Moreover, corporate law allowed equity investors to receive payment only in the form of dividends (i.e., no in-kind or capital distributions are allowed). Disclosure requirements were, however, consistent with best international practice. However, in the absence of seasoned institutional investors, advancedcountry standards of investor protection that would normally be imposed by such investors have not developed. These regulations did not create an inviting environment for investors. For example, all investors in the venture capital fund had limited liability, and there was no flexibility in risk sharing arrangements. There were no standard control arrangements, so they had to be determined by negotiation between management and investors in the fund. Also, Indian regulations did not recognize limited life funds, so in India it was relatively easy to terminate a trust, but this meant that the entire firm was closed rather than a specific fund within the firm. Therefore, each fund had to be created as a separate trust or company. This process is administratively and legally timeconsuming. Terminating a fund is even more cumbersome, as it requires court approval on a case-by-case basis. 31

Indias regulatory framework earlier inhibited practices used in the United States to reward employees of startup firms. From 1998, however, founders and employees can participate in employee stock option programs. Indias corporate laws allow for flexible risk sharing, control and exit arrangements between financiers and firm management, provided the firms in which they invest are private. These are defined as firms having less than 50 outside shareholders (who are not employees). However, for firms with more than 50 non-employee shareholders, Indias corporate law does not provide flexibility in using equity to reward employees. While this may be satisfactory for early-stage venture capital investors, it could discourage later-stage investors who invest as parts of a consortium. The restrictions on venture capital extend beyond the framework of corporate law. For instance, tax restrictions on corp rations require that corporations paying dividends must pay a 10 percent dividenddistribution tax on the aggregate dividend.13 On the other hand trusts granting dividends are exempt from dividend tax. An optimal environment for venture capital requires a tax regime that is fiscally neutral from the viewpoint of tax revenue. The environment should also be tax-competitive with other domestic uses of institutional and private equity finance, particularly the domestic mutual funds sector. However, the tax code in 2001 was disadvantageous from the viewpoint of the international venture capital investor. Earnings from an international venture capital investor are taxed even if it is a tax exempt institution in its country of origin. Another significant impediment to developing a vibrant venture capital industry was Indias foreign currency regulations. Even in 2001, the Indian rupee was nonconvertible. The lack of convertibility hampered venture capital inflows from offshore because specific, time-consuming governmental approvals from multiple agencies were required for each investment and disinvestment. Just as the currency regime inhibited international venture capital firms from investing in India, domestic venture capital firms were not allowed to invest offshore. Synergistic investments in overseas firms that collaborate with domestic firms were next to impossible. The currency regime also frustrated exit strategies. For example, in early 1999, Armedia, an Indian manufacturer of high-technology telecommunications equipment, was in 32

discussion with Broadcom, a U.S. firm, about being acquired, and it also was seeking an investment from an Indian venture capitalist. However, since Indian venture capital firms cannot own offshore shares, the deal with Broadcom would have had to be changed from a pooling of interests transaction to a cash acquisition. Broadcom, therefore, offered a significantly smaller sum to Armedia, because of the Indian venture capital firms involvement. Fortunately for Armedia, it was able to obtain bridge funding offshore and did not have to use an Indian venture capital firm (Dave 1999). The Indian legal and regulatory environment continued to inhibit venture capital investors from maximizing their returns.

7.4 INDIA STRATEGIC VENTURE CAPITAL IMPORTANCE During the last three months, India played hosts to two separate groups of General Partners from leading global venture firms. Participants included General Partners from among others New Enterprise Associates, Mayfield, Sequoia, Bessemer, US Venture Partners, Bay Partners, Battery Ventures, and JP Morgan Partners who collectively manage in excess of $20 billion. These trips underscored the growing importance of India in the global venture capital landscape. The first trip was organized and sponsored by Silicon Valley Bank, while TiE took the lead in organizing the second trip. The US-India Venture Capital Association (USIVCA) played an important role in helping organize both events. The US-IVCA was established in 2002 with a mission to promote and strengthen US-India cross-border investing by providing an organized forum for venture capitalists, entrepreneurs and other key players to network and collaborate. US-IVCA today has 21 members including leading firms such as NEA, Sequoia, Battery Ventures and Warburg Pincus. While recent success stories emerging from India have been from the Business Processing Outsourcing services space, most delegates felt that India is well poised to play an important role in product success stories of future as well. Key reasons for India becoming critical for product companies include:

Leveraging Indian development skills can reduce the capital intensity of startups India is also fast emerging as an important technical talent base with Indian

with cost reductions ranging from 40-60% compared to Silicon Valley.

centers of several product companies becoming their worldwide centers of excellence.

33

India is increasingly being able to attract mid and senior level managers to come

back and work in India increasing the attractiveness of India as a design and development centre. 7.5 CREATING AN ENVIRONMENT: DEVELOPING VENTURE CAPITAL IN INDIA In the last decade, one of the most admired institutions among industrialists and economic policymakers around the world has been the U.S. venture capital industry. A recent OECD (2000) report identified venture capital as a critical component for the success of entrepreneurial high-technology firms and recommended that all nations consider strategies for encouraging the availability of venture capital. With such admiration and encouragement from prestigious international organizations has come various attempts to create an indigenous venture capital industry. This article examines the efforts to create a venture capital industry in India. The possibility and ease of cross-national transference of institutions has been a subject of debate among scholars, policymakers, and industrialists during the entire twentieth century, if not earlier. National economies have particular path dependent trajectories, as do their national systems of innovation (NIS). The forces arrayed against transfer are numerous and include cultural factors, legal systems, entrenched institutions, and even lack of adequately trained personnel. Failure to transfer is probably the most frequent outcome, as institutional inertia is usually the default option. In the transfer process, there is a matrix of possible interactions between the transferred institution and the environment. There are four possible outcomes: A) The institution can be successfully transferred with no significant changes to either the institution or the environment. B) The institutional transfer can fail. C) The institution can be modified or hybridized so that it is able to integrate into the new environment. D) The institution can modify the new environment. Though A and B are exclusionary, it is possible for transfer to yield a combination of C and D. The establishment of any institution in another environment can be a difficult trial and error learning process. Even in the United States, state and local government policies to encourage venture capital formation have been largely unsuccessful, i.e., outcome

34

B (Florida and Smith 1993). Similarly, efforts in the 1980s by a number of European governments to create national venture capital industries also failed. Probably the only other nation to develop a fully Silicon Valley-style venture capital industry is Israel. Taiwan, perhaps, is the only other country that appears to have developed a venture capital industry, though there has been little research on the dynamics of this process in Taiwan. Given the general difficulties in more wealthy and developed nations, it would seem that India would have poor prospects for developing a viable venture capital community. India is a significant case study for a number of reasons. First, in contrast to the United States, India had a history of state-directed institutional development that is similar, in certain ways, to such development in Japan and Korea, with the exception that ideologically the Indian government was avowedly hostile to capitalism. Furthermore, the governments powerful bureaucracy tightly controlled the economy, and the bureaucracy had a reputation for corruption. Such an environment would be considered hostile to the development of an institution dependent upon a stable, transparent institutional environment. India did have a number of strengths. It had an enormous number of small businesses and a public equity market. Wages were low, not only for physical labor, but also for trained engineers and scientists, of which there was a surfeit. India also boasted a homegrown software industry that began in the 1980s, and became visible upon the world scene in the mid-1990s. Experiencing rapid growth, some Indian software firms became significant successes and were able to list on the U.S. NASDAQ. Finally, beginning in the 1980s, but especially in the 1990s, a number of Indian engineers who had immigrated to the United States became entrepreneurs and began their own high-technology firms. They were extremely successful, making them multimillionaires or even billionaires, and some of them then became venture capitalists or angel investors. So there was a group of potential transfer agents. For any transfer process, there has to be some match between the environment and the institution. Also, there must be agents who will mobilize resources to facilitate the process, though these agents can be in the public or private sector. Prior to 1985, the development of venture capital in India was very unlikely. However, the environment 35

began to change after 1985, and continues to change. Even in the United States, venture capital is only a small component of the much larger national system of innovation (NIS), and as such is dependent on many other institutions. In the United States and in India the development of venture capital has been a co-evolutionary process. This is particularly true in India, where it remains a small industry precariously dependent upon other institutions, particularly the government, and external actors such as international lending agencies, overseas investors, and successful Indian entrepreneurs in Silicon Valley. The growth of Indian venture capital must be examined within the context of the larger political and economic system in India. As was true in other countries, the Indian venture capital industry is the result of an iterative learning process, and it is still in its infancy. If it is to be successful it will be necessary not only for it to grow, but also for its institutional context to evolve.

General Indian Economic and Financial Environment From its inception, the Indian venture capital industry has been affected by international and domestic developments; its current situation is the result of the evolution of what initially appeared to be unrelated historical trajectories. To create a venture capital industry in India through transplantation required the existence of a minimal set of supportive conditions. They need not necessarily be optimal, because, if the industry survived, it would likely set in motion a positive feedback process that would foster the emergence of successful new firms, encourage investment of more venture capital, and support the growth of other types of expertise associated with the venture capital industry; in other words, if the venture capital industry experienced any success it could entrain a process of shaping its environment. Small and mediumsized enterprises have a long history and great importance to India. The leaders of the Independence movement were supporters of small businesses as an alternative to exploitation by multinational firms. And yet, despite the emphasis upon and celebration of small enterprises, the Indian economy was dualistic. It was dominated by a few massive private-sector conglomerates, such as the Tata and Birla groups, and various nationalized firms, even though there was an enormous mass of small shopkeepers and local industrial firms. As anywhere else, these small firms were in traditional industries and were not relevant for the emergence of venture 36

capital, but they do indicate a culture of private enterprise. This entrepreneurial propensity also has been demonstrated by the willingness of Indians in other countries to establish industries, shops, restaurants, and hotels. Already, right up to British rule, Indians valued education very highly. After Independence, the Indian government invested heavily in education, and Indian universities attracted excellent students. In the 1960s, the Ford Foundation worked with the Indian government to establish the Indian Institutes of Technology (IIT), which adopted MITs undergraduate curriculum. These institutions very quickly became the elite Indian engineering schools with extremely competitive entrance examinations and to which only the most intelligent students could gain entry. The excellent Indian students were very desired by overseas university graduate programs generally, and in engineering particularly. After graduating from overseas programs many of these Indian students did not return to India. However, many other Indian graduates remained in India working in the large family conglomerates, the many Indian universities, and various top-level research institutes such as those for space research (Baskaran 2000). This meant that there was a significant pool of excellent engineers and scientists who were underpaid (by global standards), and potentially mobile. Despite these strengths, India had many cultural rigidities and barriers to entrepreneurship and change, beginning with an extremely intrusive bureaucracy and extensive regulations. Until recently the labor market was quite rigid. For well-educated Indians the ideal career path was to enter the government bureaucracy, a lifetime position; enter the family business, which was then a lifetime position; or join one of the large conglomerates such as Tata and Birla, which also effectively guaranteed lifetime employment. The final career path was to emigrate; not surprisingly, among the immigrants were many seeking better opportunities and release from the rigidities at home. In summation, the institutional context discouraged investment and entrepreneurship. The next sections examine the features of the Indian economy that would evolve to make the creation of the Indian venture capital industry possible.

The Indian Financial System India has a large, sophisticated financial system including private and public, formal and informal factors. In addition to formal financial institutions, informal institutions such as family and moneylenders are important sources of capital. India has 37

substantial capital resources, but as the table below, on the disposition of Indian capital resources, indicates, the bulk of this capital resides in the banking system. In the formal financial system, lending is dominated by retail banks rather than the wholesale banks or the capital markets for debt. The primary method for firms to raise capital is through the equity markets, rather than private financial intermediaries.

The Banking System Prior to independence from Britain, the banking system was entirely private and largely family-operated. In the pre-war period, the family-run banks often invested in new ventures. After Independence, the Reserve Bank of India (RBI) and the State Bank of India were nationalized, with the State Bank of India continuing to play the role of banker to government agencies and companies. Then, in 1969, the next fourteen largest banks were nationalized. Together with the State Bank of India, the state then controlled 90 percent of all bank assets. The nationalized banking system became an instrument of social policy. Between 1969 and 1991, the financial position of the banks progressively weakened, due to loss making branch expansions, everstrengthening unions, overstaffing, and politicized loans. Until 1991, depositors were reluctant to use banks because, although their savings were safe, the government set deposit interest rates below the rate of inflation. By 1991, the entire bank system was unprofitable and close to collapse.

38

The Disposition of Indian Capital Resources and Their Availability for Venture Investing in 199697

Table 7.5.1 Source: Statistical Outline of India, 1998-99, pub. By Tata Services Ltd.

Table 7.5.2 Top VC investments in the July-September 2004 Quarter

The socialized banking system had other perverse effects. For example, although the bank managers were civil servants and very risk-averse, they could offer belowmarket interest rates. This created excessive demand for funds, but, quite naturally, bankers extended the loans to their safest customers. These were primarily the large firms owned by the government, which operated the largest steel, coal, electrical, and other manufacturing industries. The other large bank borrowers were the giant family

39

conglomerates such as the Tata and Birla group. This increased the groups economic power, but did not lead to economically efficient decisions about how to deploy capital.6 Small firms were starved for capital. Thus the Indian banks provided no resources for entrepreneurial firms.

Equity The first Indian stock markets were established during the British Raj in the nineteenth century. During the early part of the twentieth century, Indian equity markets actively financed not only banking, but also the cotton and jute trades (Schrader 1997). In 1989 there were fourteen stock markets in India, though Bombay was by far the largest (World Bank 1989). The socialization of the economy, and particularly banking, after independence reinforced the strength of the stock markets as a source of capital, and by the 1960s, India had one of the most sophisticated stock markets in any developing country. There were several reasons for the growth of the Indian stock market. Motivated by its egalitarian principles, the government supported the stock markets as an instrument for reducing the concentration of ownership in the hands of a few industrialists (an outcome of the government policy of providing below-market interest loans). Second, the government industrial licensing policy instituted in 1961 meant that businesses had to apply for government permission to establish new ventures. Permissions were given only in the context of the Soviet-style national plans for each sector. There was a strong element of favoritism in who received permission. Most important, due to government central planning controls, shortages were endemic. A permission to produce was a guarantee of profits. The distortion these policies created by encouraging concentration were meant to be offset by RBI stipulation that privatesector borrowers could not own more than 40 percent of the firms equity if they wished to receive bank finance. So, to raise money the private sector became reliant on stock markets. Investors, large and small, readily financed ventures since the shortages induced by the planning system guaranteed a ready market for anything produced. Curiously, the retention of 40 percent of the equity by the core investors meant that in reality they controlled the firm.

40

The stock market also benefited when in 1973 the government required all foreign firms to decrease ownership in their Indian subsidiaries to 40 percent. Faced with a choice between selling stakes privately and listing on the stock exchanges, most firms chose the latter and issued new stock, which led to a large increase in public ownership of such companies. The 40-percent regulation did not liberalize firms as much as one might expect. Because loans were also necessary for firms and this required collateral in fixed assets, new entrepreneurs were restricted to sectors with asset-heavy projects. This disadvantaged the service sector, resulting in even greater concentration, and the equity markets focused on financing low-risk projects. Finally, the publics enthusiasm for firms operating within a licensed industry meant that it was difficult for other new firms to secure capital through listing on the stock exchanges. In 1991, as part of a large number of financial reforms, the Securities and Exchange Board of India (SEBI) was created to regulate the stock market. At the time, there were 6,229 companies listed on all the stock exchanges in India (RBI 1999). The reforms and loosening of regulations resulted in an increase in the number of listed companies to 9,877 by March 1999, and daily turnover on the stock exchanges rose to 107.5 billion rupees (US $2.46 billion) by December 1999. One reform was the removal of a profitability criterion as a requirement of listing. To replace the profitability requirement, it was stipulated that a firm would be de-listed if it did not earn profits within three years of listing. This reform meant unprofitable firms could be listed, providing an exit mechanism for investors. Not surprisingly, there was a dramatic increase in the listings of high-technology firms. In terms of experience, India contrasted favorably with most developing countries, which had small, inefficient stock markets listing only established firms. Even in Europe, until the creation of new stock markets in the mid-1990s, it was extremely difficult to list small high-technology firms (Posner 2000). However, although these stock markets provided an exit opportunity, they did not provide the capital for firm establishment. Put differently, accessible stock markets did not create venture capital for startups; they merely provided an opportunity for raising follow-on capital or an exit opportunity.

41

7.6 SUCCESSFUL VENTURE CAPITAL INVESTMENT A BLUEPRINT The purpose of this chapter is to develop a generic blueprint for a successful venture capital investment process. There are three basic domains where the venture capitalist should emphasize. These three domains are: I) INVESTMENT CRITERIA II) MANAGING THE INVESTMENT III) EXIT MANAGEMENT The venture capital investment process is described in the figure illustrated below and the elements of enterprising capital are also illustrated. Figure 7.6.1 describes the overall flow of venture capital funds and how these funds are recycled via means of exit. Figure 7.6.2 outlines the basic elements of enterprising capital that an entrepreneur need on the road to a successful business. The development of these elements within the business can possibly be aided with the presence of a venture capitalist.

The Venture Capital Investment Process (Figure 7.6.1)

42

Elements of Enterprising Capital (Figure 7.6.2)

I) INVESTMENT CRITERIA All negotiations start from the main issue of rewards the venture capitalist can expect to get out of the investment. The word venture literally means a risky undertaking, which makes venture capitalists risk-takers. However, like all other types of investors, venture capitalists will only invest if perceived returns are greater than perceived risk. The saying, greater the risk, greater the return holds for venture capital financing provided it is not a speculative deal. Therefore, it is necessary to identify and quantify the probability of risk. For example, one common method of quantifying risk is by the means of assigning probability to categories of investment opportunities (e.g. success, failure) to form a probability distribution. However quantitative these methods may be, the qualitative elements of venture capital financing play a very important role in the decision-making process (since it is the opinions of managers that assign the risk probabilities).

1) Industry Criteria The myth is that venture capitalists invest in good ideas and management. The reality is that they tend invest in good industries instead that is, industries that are more

43

competitively forgiving than the market as a whole. Nevertheless, good ideas and management are essential ingredients to a successful venture capital investment. Moreover, the definition of a good industry can be quite subjective. It can also be dependent on the venture capitalists industry preference, which is correlated to the venture capitalists expertise, knowledge and capabilities in specific industries.

2) Business Criteria Sales potential is probably the most important of the business criteria. High technology businesses will require safeguards against competition by other businesses copying their ideas. A list of the various business criteria is as follows: Clear and achievable sales potential and revenue stream Overall viability of business The need for the product/service Ability to change the bases of competition Investment forecast calculations (e.g. IRR, Cash flow forecast etc.) of prospective investee business. The lack of reliability of forecasts meant that they are more indicative than predictive in nature. Forecasts can possibly yield the businesss potential profitability, cash needs, viability of strategies and the identification potential problem areas.

3) Management Criteria The prospective business must possess indicative capabilities of a successful entrepreneur and business. The enterprise success, inevitably, requires a potentially successful entrepreneur to drive the project. Thus the crucial challenge for the venture capitalist is to identify competent management that can execute.

a) Personal Traits Drive and energy Single minded determination Imagination and dreams and aspirations Ability to listen - to identify and take good advice Recognition of own business strengths and weaknesses Recognition of others strengths and weaknesses 44

 Resourcing to overcome own weaknesses b) Management Skills Rigorous planning Strict financial control Market analysis skills Technical skills c) Business Skills Ability to spot marketing opportunities and approaches Deep knowledge of business area Ability to spot new opportunities and how they may be exploited Appreciation of target markets or customers need

4) Risk reduction Structuring of deals can reduce risk substantially by splitting equity investment into non-equity instruments. Managers should explore this risk reducing process since debt is less risky than equity. Coupled with convertible options, debt instruments can possibly enhance the rate of return of such investments, if used prudently. Another effective way to reduce risk is to multi-stage the investment process with each stage marked with a realistic milestone.

5) Other Factors Availability of exit options and ease of exit. For example, the existence of buoyant Second-Tier markets. Political stability Currency and financial stability Governmental incentives (e.g. lowering of capital tax rates)

II) MANAGING THE INVESTMENT The key to successful management of a VC investment lies in the monitoring process. Given that venture capital financing is not mere finance but rather a more hands-on approach, the venture capitalist, therefore, must provide the relevant assistance at the appropriate juncture of the business. Obviously, the requirements of the business differ from stage-to-stage of its business life-cycle; the purpose of the following is 45

to provide a short list of aspects to the venture capitalist managing a portfolio business. Strategy - Ensure investee firm has a business strategy. - Try to achieve a consistent growth record - Ensure the creation of new opportunities as old ones are realized. This is to ensure that growth continues - Existence of an exit plan PR/Marketing - Publicize all achievements in trade and financial press - Announcement of financial results and new orders - Advertising and marketing do not sell the product; it may help sell the business Financial reporting - Ensure accounts look professional and well presented from the very beginning. - It should be informative, reflect the strategy of business. - Ensure statements are consistent year to year Legal - Simple legal matters simple. However, ensure that contracts do not have legal exposure due to managerial inexperience. Management - Ensure the team is balanced, experienced and of high calibre - Plan for succession - Do not allow gaps to develop

III) EXIT MANAGEMENT Many VCs are opposed to managing a business solely with a view to maximizing the chances of and proceeds from exit; many prefer business decisions to be made in the long-term interests of the business itself. Although it is acknowledged that, at the margin, they might not make a large capital investment if they were about to sell their stake. Despite these concerns, there are many aspects of strategy and day to day management where the thought of exit may lead to decisions that are in the interests of the business. Decision-making may for example be quicker and more focused if management is working towards a set timescale. Aspects of the Exit Process Planning exit from Day 1 Selection of alternative exit routes (IPO, Trade sale etc.) Reflect timing of exit

46

 Getting support of management Management of the buy-back option Effective marketing of investments Planning and preparation of trade and financial sale There are two aspects of venture capital investment that needs mathematical formulation. The two aspects and methods used respectively are: 1. Valuation of Equity Investments Methods Cost Method Equity Method Market-based Valuation Method 2. Pricing the Deal Methods Simple Method Conventional Venture Capitalist Valuation Method First Chicago Method Revenue Multiplier Method

7.7 AN UPDATE ON STRUCTURING VENTURE CAPITAL AND OTHER INVESTMENTS IN INDIA Many U.S. and other foreign investors are evaluating alternatives for investments into software development, business process outsourcing (BPO), drug discovery and other service companies in India. Despite news stories about U.S. venture capitalists traveling to India to look for investments in Indian companies, both U.S. and India venture capitalists tend to make investments into a U.S. company which has a subsidiary in India for fulfillment. An investable Indian business is likely to be restructured in this manner.

47

The primary structures for investing in India are: Investment in a U.S. company with a services fulfillment subsidiary in India; Direct investment in an India company from outside India (usually through a Mauritius subsidiary for tax reasons); Investment in a U.S. company that invests in a Mauritius subsidiary that in turn invests in a service fulfillment subsidiary in India; and Direct investment in an India company through a venture capital fund registered with the Securities and Exchange Board of India. The primary business considerations in determining how to structure such an investment are: Relative valuations in the U.S. and India capital markets for the type of investment; Ease of IPO exit including any currency exchange restrictions; Ease of acquisition by the likely set of acquirers as an exit strategy; Investor comfort with the securities of an Indian company; Likelihood of an acquisition of the Indian subsidiary rather than acquisition at the U.S. parent level; Location of market pull for the investee company; and Customer and employee preferences in dealing with a U.S. holding corporation as compared to an Indian company with a U.S. subsidiary. Valuation and ease of exit for investors are the most important considerations. Many India-related investments by U.S. investors in the high tech related services spaces have been structured as an investment in a U.S. corporation, the front end, which then establishes and capitalizes a subsidiary in India, which is the back end for fulfillment or the operations of the U.S. company. The U.S. front end is the marketing and sales engine. This approach has been used because of the valuations on and ease of using Nasdaq, the ease of being acquired in the U.S. and because the companys primary market is the U.S. Other reasons include concern over the India currency exchange controls for repatriation of investor proceeds; sales employees in the U.S. are more comfortable being granted options under a U.S. stock option plan conventional liquidity and customers may prefer to contract with a U.S. company with meaningful assets on the balance sheet. To hedge on the exit location strategy, a structure can be used in which a Mauritius holding company holds all the shares of both the U.S. and India entities. This structure provides flexibility in the exit strategy 48

and takes advantage of the fact that Mauritius does not tax capital gains. This structure may be impractical in most cases from a business operating standpoint and is not often used.

Investment through a Venture Capital Fund A venture capital fund, which registers in accordance with SEBI guidelines and complies with specified investment restrictions will receive pass through tax benefits (no capital gains or withholding tax on dividends). The permitted activities of a fund, however, are limited. No services such as incubation services may be provided. A separate entity would be needed in order to provide such services. There may also be restrictions on where the fund can raise money. At this time, the best business course of action is likely to not register in India as a venture capital fund unless having a fund in India is necessary for relationship or political reasons. This will reduce regulatory requirements and maintain investment flexibility.

GOI and Other Investment Approvals The most complex set of approvals needed for investment in India is registration as a foreign venture capital fund in India with the Security and Exchange Board of India (SEBI). Government of India (GOI) approval for direct investments from Mauritius or elsewhere is required in the following situations: When the investment is by way of purchase of outstanding shares of an Indian company from shareholders as opposed to purchasing newly issued shares of the issuer (such purchase of shares that meet pricing and other guidelines specified by GOI would not need prior approval if the investment is otherwise freely permitted); When the investing company has a joint venture in India in the same line of business; when the investment falls within a list of industries (such as real estate, banking, insurance, telecom) in which overseas investments are subject to some restrictions. Software, integrated circuit design, bioscience (other than the manufacture of certain types of drugs) and BPO services are not on the restricted list. GOI approvals for investment proposals for the first two categories above can take up to six weeks. No time estimates are possible for proposed investments in the third category. The primary considerations in selecting an investment structure for India are 49

valuation and ease of exit for investors. Both U.S. and India venture capitalists tend to structure India related investments by investing into a U.S. company which has a subsidiary in India for services fulfillment. 7.8 VENTURE CAPITAL: TIME TO REFLECT Venture capital has been a remarkable catalyst of entrepreneurial activity in many developed countries. But the VC industry in India appears to be going through difficult times, its main problems being the poor quality of corporate governance and the inadequate legal grievance redress system. It is time the industry evolved a strategy to re-invent itself. The Indian venture capital (VC) industry has witnessed considerable turmoil in the last two years. At least seven VC funds (VCFs) shut shop. Many others simply ran out of funds. A few set up high-cost Indian operations, with no funds raised or allocated for investment. The rest of the industry appears to be busy, restructuring their investment focus, making very few new investments. After a period of hectic investing, from 1998 to 2000, the Indian VC industry appears to be going through difficult times. This is a time for the industry to engage in some serious reflection. Managers in the industry may possibly disagree with this fact, but they might argue that the developments in the Indian industry are a mere reflection of a larger global phenomenon. After all, the American and European VC industries have not slowed down. That comparison though, is inappropriate. The slow down and the poor performance of many funds in the Western world are part of a cyclical phenomenon. The Indian industry, on the contrary, faces issues of a fundamental nature. Four issues of concern have been brought into light. First, there is a serious mismatch between the kind of venture capital available in India and what the market demands. Almost all VCFs in India have been targeting their capital at companies in the information technology, pharmaceuticals and some services industries, looking for expansion financing of Rs 15 crore or more. Now, this is a limited market segment. Most of the industries mentioned above are relatively young. There are very few firms in these sectors, seeking large amounts of capital for expansion financing. At the same time, a large number of aspiring entrepreneurs,

50

start-ups, early- stage companies and Old Economy firms, which are fundamentally sound businesses, are unable to attract the VC financing that they badly need in order to grow. Apart from the relatively smaller amounts of funding that they seek, on average start-ups require considerable post-funding support from the investor to grow their businesses. That is painstaking work, for which Indian VCF managers have demonstrated neither experience nor training nor temperament. Old Economy firms do not provide the quick or glamorous exits that VCFs often desire. Second, most VCFs in India are an extended arm or a division of global investment institutions. International funds represent more than 95 per cent of the VC invested in India. Two consequences follow from this near-total dependence on foreign capital. One, the investment mandates of these VCFs are often driven by the parent institutions' global world view, which often ignores local market needs. The homogenous investment preferences of VCFs outlined earlier follow from the parent institutions' global investment strategies. Two, at a portfolio level, every international VC investor in India has been a victim of the depreciation of the rupee against the dollar. The returns produced by Indian VCFs, measured in US dollars or other Western currencies, turn out to be considerably less attractive than that measured in Indian currency. Many nations such as the Netherlands, Portugal, Finland, Norway and Israel recognized the limitations of depending on foreign funds at the time of evolving a policy for developing a local VC industry. Their first step was to kickstart VCFs in the private sector with funds from domestic institutions. Over a decade, or even less, they succeeded in creating a local VC industry that depended less and less on government support and international investors. The third issue is the poor quality of corporate governance and lack of sensitivity among entrepreneurs and investors, to each other's legitimate business aspirations. This is a universal problem and not unique to India. What is however unique to India is the hopeless system of legal redress of grievances when partners renege on contractual obligations. Often, aggrieved parties in India agree to settlements that are unfair to them, apprehending that litigation in Indian courts could be dysfunctional. This situation may not change in the foreseeable future. The alternative to litigation and unfair bad investments would be to invest more effort in better identification and selection of investments and supervision of the portfolio. Indian VCF managers need 51

to ask themselves if they are prepared to put in that extra effort to minimize prospects for litigation in the first place. Last, but not the least, the industry lacks a broad-based and effective trade association. The Indian Venture Capital Association (IVCA) does not represent a large proportion of the VCFs who are active in India. For some years initially, the IVCA used to produce a delightfully uninformative annual report, many months after the end of the year. For the past four years even those reports do not appear to have been published! Venture capital has been a remarkable catalyst of entrepreneurial activity, after the Second World War, in many developed countries. It has led to significant growth in industry and innovation. The prospects for the Indian VC industry are no less humongous. It is up to the industry to reflect on its current predicament and evolve a strategy to seize the opportunity.

Problems with VCs in the Indian Context One can ask why venture funding is so successful in USA and faced a number of problems in India. The biggest problem was a mindset change from "collateral funding" to high risk high return funding. Most of the pioneers in the industry were people with credit background and exposure to manufacturing industries. Exposure to fast growing intellectual property business and services sector was almost zero. All these combined to a slow start to the industry. The other issues that led to such a situation include:

License Raj and the IPO Boom Till early 90s, under the license raj regime, only commodity centric businesses thrived in a deficit situation. To fund a cement plant, venture capital is not needed. What was needed was ability to get a license and then get the project funded by the banks and DFIs. In most cases, the promoters were well-established industrial houses, with no apparent need for funds. Most of these entities were capable of raising funds from conventional sources, including term loans from institutions and equity markets.

Scalability The Indian software segment has recorded an impressive growth over the last few years and earns large revenues from its export earnings, yet our share in the global 52

market is less than 1 per cent. Within the software industry, the value chain ranges from body shopping at the bottom to strategic consulting at the top. Higher value addition and profitability as well as significant market presence take place at the higher end of the value chain. If the industry has to grow further and survive the flux it would only be through innovation. For any venture idea to succeed there should be a product that has a growing market with a scalable business model. The IT industry (which is most suited for venture funding because of its "ideas" nature) in India till recently had a service centric business model. Products developed for Indian markets lack scale.

Mindsets Venture capital as an activity was virtually non-existent in India. Most venture capital companies want to provide capital on a secured debt basis, to established businesses with profitable operating histories. Most of the venture capital units were offshoots of financial institutions and banks and the lending mindset continued. True venture capital is capital that is used to help launch products and ideas of tomorrow. Abroad, this problem is solved by the presence of `angel investors. They are typically wealthy individuals who not only provide venture finance but also help entrepreneurs to shape their business and make their venture successful.

Returns, Taxes and Regulations There is a multiplicity of regulators like SEBI and RBI. Domestic venture funds are set up under the Indian Trusts Act of 1882 as per SEBI guidelines, while offshore funds routed through Mauritius follow RBI guidelines. Abroad, such funds are made under the Limited Partnership Act, which brings advantages in terms of taxation. The government must allow pension funds and insurance companies to invest in venture capitals as in USA where corporate contributions to venture funds are large.

Exit The exit routes available to the venture capitalists were restricted to the IPO route. Before deregulation, pricing was dependent on the erstwhile CCI regulations. In general, all issues were under priced. Even now SEBI guidelines make it difficult for pricing issues for an easy exit. Given the failure of the OTCEI and the revised

53

guidelines, small companies could not hope for a BSE/ NSE listing. Given the dull market for mergers and acquisitions, strategic sale was also not available.

Valuation The recent phenomenon is valuation mismatches. Thanks to the software boom, most promoters have sky high valuation expectations. Given this, it is difficult for deals to reach financial closure as promoters do not agree to a valuation. This coupled with the fancy for software stocks in the bourses means that most companies are preponing their IPOs. Consequently, the number and quality of deals available to the venture funds gets reduced.

54

8. CONCLUSIONS
The discussion has given an insight into the working of the banking industry. An Indian venture capital industry is emerging, but it may not thrive in the current investment environment. As we have seen, many of the preconditions do exist, but the obstacles are many. Some of these can be addressed directly without affecting other aspects of the Indian political economy. Others are more deeply rooted in the economy and will be much more difficult to overcome without having a significant impact on other parts of the economy. Earlier patterns of growth or failure in venture capital industries in other countries and regions indicate that the evolution of venture capital seems to be either entry into a self reinforcing spiral, such as occurred in Silicon Valley and Israel, or growth and stagnation, as occurred in Minnesota in the 1980s (Kenney and von Burg, 2000) or the United Kingdom until recently. Given Indias wish to develop a high-technology industry funded by venture capital, it is necessary to keep improving the environment by simplifying the policy and regulatory structure (including eliminating regulations that do not perform necessary functions such as consumer protection). Today, a venture capital industry is emerging in India as a result of internal and external factors. India still remains a difficult environment for venture capital. Even in 2005 the Indian government remains bureaucratic and highly regulated. To encourage the growth of venture capital will require further action, and it is likely that the government will continue and even accelerate its efforts to encourage venture capital investing.

55

BIBILIOGRAPHY
1. Zider, B., 1998. How venture capital works. Harvard Business Review. 2. Venture Capital; The Indian experience. I M Pandey, Prentice Hall of India, New Delhi, 1996. 3. William D Bygrave and Jeffry A Timmons, Venture capital at the crossroads, HBS Pr, 1992. 4. Ruhnka, J.C., Young, J.E., 1991. Some Hypotheses about Risk in Venture Capital Investing. Journal of Business Venturing. 5. Dossani, R. 1999. Accessing Venture Capital in India. Working Paper, Asia/Pacific Research Center, Stanford University (October). 6. Wright, M., Robbie, K., 1998. Venture Capital and Private Equity: A Review and Synthesis. 7. Satish Taneja, Venture Capital in India, Tata Mc Graw Hill, New Delhi, 2002. 8. http://www.economictimes.com 9. http://www.rbi.org.in 10. Baye, Jansen: Money, Banking and Financial Markets, A.I.T.B.S. Publishers & Distributors, India, 1996.

56