Technology Start up scenario (India & China) and VC, PE funding (India vs.

China) Written by Amit Goel & Yagna Teja Feb 2012 For enquiries please contact: enquiry@knowledgefaber.com +91-80-41231576

Page 1

Technology startup scenario in India & VC, PE funding (India vs. China) Technology startup scenario in India & China Recently I read an article in the Business Insider by an entrepreneur Bowei Gai which talks about the Chinese startup scenario. He put forward a great deal of information to support his arguments. The informative article induced me to further probe the startup scenario in China & India. A careful examination into the same revealed some interesting findings. Indian startups have come a long way from a handful in 2004 to Bangalore alone having close to 800 startups in 2011. India is also seeing a shift towards product technology startups. According to the industry body Nasscom India currently houses 2,400 product technology companies which earned a combined $2 bn in 2010. Around 1,100 product start-ups were launched in the past five years and overall revenues jumped 22% in the same period. The new generations of Indian technology startups are developing high value technology products. To name a few Zoho offers an alternative to Microsoft Office and Google Docs, Tringme provides a VoIP telephony platform; Fusion Charts provides a platform to build graphics. Over the last three decades the Indian I.T. industry has grown from nothing to an estimated $88 bn in revenue in 2011. Apart from the growth in the services Industry this has also resulted in a strong growth of technology start ups in India mainly over the last decade. This recent success in the area of information technology has shown that there is a tremendous potential for the growth of knowledge based industries. The huge talent pool of software developers and designers in India has played a key role behind this growth. There is also an increase in the number of incubation centers providing a platform for the growth of technology startups in India. US Telecommunications company AT&T is also planning to act as a business incubator for a handful of telecom focused technology startup companies in India. The rate of companies getting funded in incubators has increased with more than 60 incubators at institutes across the country supported by the National Science and Technology Entrepreneurship Development Board (NSTEDB). By next year it is estimated that India will produce around 150 startups aided by a better ecosystem which includes intellectual capital, 300 active VC firms, angels, accelerators and successful companies to partner or hunt down. Intel Capital is set to invest $ 20 mn in six Indian technology startups from the Intel $ 250 mn India Technology fund. The Indian government has also come up with a series of initiatives to encourage entrepreneurs in the early stages like the Department of Scientific and Industrial Research (DSIR)s Micro Technopreneurship Support which provides funds in the range of INR 75,000 INR 4,500,000 to the startups in different phases. Also the second generation entrepreneurs like Narayana Murthy & Azim Premji have started their venture fund to support the new age entrepreneurs. We can finally say that the building blocks for the Indian technology startups have been laid. The reverse brain drain to India has resulted in the transfer of cutting edge technologies and a better understanding of global markets which is helping the entrepreneurs to create products with a good customer value proposition. According to Vivek Wadhwa, Senior Research Associate at Harvard Law School and Executive in Residence at Duke University, these returnees are in the U.S. populations educational top tier, precisely the kind of people who can make the greatest contribution to an economys innovation and growth. Business research and consulting firm Frost & Sullivan said that the world will witness reverse brain drain, wherein the vast vacancies for CXOs in countries like India will be filled not only by returning Indians, but
For enquiries please contact: enquiry@knowledgefaber.com; +91-80-41231576 Page 2

Technology startup scenario in India & VC, PE funding (India vs. China) also by Americans and Europeans seeking better prospects. It also listed the most significant factors drawing both Indian and Chinese entrepreneurs home to be economic opportunities, access to local markets, and family ties. All these developments have made an impact on the technology startup ecosystem in India. The accumulation of linkages between entrepreneurs in India and China and entrepreneurs in the United States offers opportunities for mutually beneficial growth.

This can be understood by the way in which India and China have adapted business models from the U.S. and have been successful. In the online travel space there is an Expedia in the U.S., Ctrip in China and in India we have MakeMyTrip, Cleartrip, Yatra and Travelguru. For job portals, there is Monster.com in the U.S., 51.com in China and Naukri in India. Yahoo has SINA in China and Rediff.com in India. In digital mapping, there is MapQuest in the U.S., AutoNavi in Beijing and MapMyIndia in India. For online payment, there is PayPal in the U.S., 99Bill in China, and PayMate in India. Also players like Kreeda, Nazara and Games2Win have come up in the online gaming sector in India. An important reason for the same is that the investors are readily drawn towards business models that have already been proven elsewhere. Bowen Gai points out in his article that setting up a company in China is an absolute nightmare as Chinas incorporation process is a problem, especially for foreigners or any company that wants to raise US funding. The most popular and recommended procedure is called Variable Interest Entities (VIE), which involves creating a company in the Cayman Islands that controls a subsidiary in Hongkong. This subsidiary controls a foreign subsidiary in China which again controls a local subsidiary in China. Gai remarks this procedure to be inefficient. Other problems include acquiring the absolutely necessary Chinese Internet Content Provider license and setting up Trusts for employees in order to grant employee stock options. He also adds that startups are severely deprived of online developer services such as AWS, Heroku, SendGrid, Twilio, BrainTree, Github and Google Apps. Development is China is difficult as one has to manage their own hardware and write their own email server. He opines that technology startups in China are a few generations behind as it takes time for hot new technology documentations to translate into Chinese. One exception to this is mobile software wherein the development tools are standardized by Apple and Google. Overall the Technology startup scenario in China is not so good with Beijing being the sole exception. VC, PE funding for technology startups in India & China: Over the last decade and half, Venture capital industry has been one of the most admired institutions among industrialists and economic policymakers around the world. It is a fact that venture capital is a critical component for the success of entrepreneurial high-technology startups in India and elsewhere. Silicon Valley presents us with ample examples to understand this trend and its significance. India also witnessed the growth of technology startups with the presence of some technology centric investors like Intel, NEA, IDG, Helion, Canaan, KPCB, and DFJ. After the huge takeaways from the Silicon Valley, most VC and PE firms have now focused on countries like India & China which present a potential market filled with opportunities and diminishing risk. A debate most investors would have is about Which country offers better
For enquiries please contact: enquiry@knowledgefaber.com; +91-80-41231576 Page 3

Technology startup scenario in India & VC, PE funding (India vs. China) investment climate? VC, PE funding is generally done at different stages which are Buyout, Turnaround, PIPE, Expansion and pre IPO. A better picture can be arrived only by understanding the funding in specific stages. Do the Chinese & Indian markets present the VCs & PEs with the same kind of opportunities and challenges? The answer - No, It is entirely different. We need to understand a few facts about the VC, PE outlook towards technology startups in India and China before making any conclusion. In India every technology startup that has just been set up should have a new product or a novel way of solving a problem because of well regulated IPO laws. But this is not the case in China. Bowen Gai in his article mentions that in China there are as many as 30005000 clone companies for a product and strategies in China can be deliberately cruel or violent going to the extent of buying negative reviews about competitors and outright theft of intellectual property. The Organization for Economic Co-Operation and Development (OECD) stated in their report that Intellectual Property Rights protection remains a barrier in China both to indigenous innovation and to the involvement of foreign capital and talent in innovative ventures. It also mentioned that finance and banking laws and regulations remains a barrier in China. VCs operate with a model in which they invest in a few companies and expect at least one investment to generate huge returns. This is because even if some companies fail and at least a few generate huge returns the fund as a whole can be profitable. India has witnessed the growth of novel startups as a result of funding by the VCs. India in the Technology sector over the past six years has seen close to 270 deals worth $ 3.70 bn. Total VC investments in India in 2010 was about $ 557 mn (6.8 percent of total PE deal value) spread across 115 deals. Data from Ministry of Corporate Affairs suggest that entrepreneurial activity in India remains strong with nearly 65,000 new companies being incorporated during the period April to December 2010. This marked an increase of about 41 percent over the number of new companies incorporated during the period April to December 2009. In the month of November alone, more than $ 538.6 mn fund has been raised by startup companies in different verticals with over $ 79.8 million raised by the online vertical alone. China Venture's online database system, CVSource, mentioned that the Chinese VC investment rose slightly compared with the previous year, with 804 disclosed deals involving a total investment amount of $ 5.7 bn. But the lack of intellectual property laws in China makes it very easy for clone companies to exist and for the big companies to imitate any novel idea from a start up and also scale it up. This also means that the big companies need not acquire the start ups in China presenting bleak exit opportunities for the VCs. VC firms typically prefer to invest in companies developing a niche product/service, a driven and focused management team and a business model that looks scalable. Knowledgefaber opines that it makes more sense for VCs to invest in India as VC investments are mostly in early-stage, much smaller and also focused on a particular sector where the probability of generating returns is high. PE funding is entirely different in China and India for the larger and grown up firms. China and India together captured 68 per cent of the total PE investments in Asia, with $ 5.8 bn going into China and $ 3.8 bn into India in 2011. India and China accounted for 54 per cent of the total number of completed PE transactions in the January-June period in 2011 with China accounting for 136 completed transactions and India accounting for 142. The total value of PE investments
For enquiries please contact: enquiry@knowledgefaber.com; +91-80-41231576 Page 4

Technology startup scenario in India & VC, PE funding (India vs. China) in China in 2010 was $ 18.1 bn compared to $ 5.3 bn in India. 490 Chinese firms debuted on global exchanges, and raised $ 106.875 bn in 2010. There were 220 VC/PE-backed IPOs, accounting for 44.8% of all the deals, involving 269 foreign institutional investors. The IT sector has seen 53 IPOs in 2010 with a total financing amount of $ 6696 mn with an average financing amount of $ 126 mn (China). IT & ITES sector in India accounted for 17% by volume and 7% by value of the total PE investment during 2005-2010. PE investments over last 6 years in India is around $ US 50 bn and the total FDI inflow is $ 116 bn. To understand the reason why grown up firms in India aren't getting as much funding as in China, one has to go back and understand that PE firms here have a lot of different ideas to choose from, resources are limited and returns are not assured/proven unlike China. PE firms make large investments, buy mature, public companies. VC model would never work in PE, where the number of investments is smaller and the investment size is much larger and if even one company failed, the fund would fail. So thats why they invest in mature companies where the chance of failing in 3-5 years is almost 0%. In China the competition is so insane that a technology startup has to face and overcome lot of difficult battles to be successful. On the other hand in India though there is always a market for innovative technology solutions, the firms do not face a fraction of the competition that their Chinese counterparts do. The extremely challenging situation in China also means that only the Herculean last till the end, which makes them mature firms. Once a company gains reputation in China, the PE firms are putting money more for the brand than for the actual product since the product can be replicated but the brand value cannot be. The Chinese government encourages PE investments because of the kind of management expertise, contacts, technology, skill sets that are associated with it, and not capital alone. In China businesses are conducted more by relations, trust and networks rather than merit. The first company in an industry to become publicly-traded in China usually has a huge advantage over competitors. A careful analysis of the pattern of funding in India and China reveals the investor notion towards these countries. Indian PE market is largely dominated by the global investors who follow a more cautious approach due the risk associated with a particular technology. Of the total PE investments during 2005-2010 in India and China 9% came in during buyout stage in India compared to 17% in China, 0% came in during the turnaround stage in India compared to 4% in China, 27% came in during the PIPE stage in India compared to 25% in China, 58% came in during the expansion stage in India compared to 25% in China. The ratio of expansion investments to total investment in India stands at 96% compared to 41% in China while 6% came in during the pre IPO stage in India compared to 28% in China. Investors are more cautious in India due to the longer payback periods and the uncertainty associated with it. PE firms are cautious because many start ups do not have a well defined business model during this stage and there have been not many major exits. At the same time valuations for promising startups are high as there are few firms with very good business models and strong management. Funding in India has been more in the growth stages where the investors are assured of returns. Investors are active during early stages mostly in the mature markets where the payback period is shorter. China has received 28% of PE funding in the pre IPO stage compared to 6% in India. India has not yet produced a great technology company going global while China has witnessed Baidu, Tencent, ZTE, HTC and Alibaba proving to the investors the
For enquiries please contact: enquiry@knowledgefaber.com; +91-80-41231576 Page 5

Technology startup scenario in India & VC, PE funding (India vs. China) potential of the Chinese market. In addition there is an another Chinese company Jingdong gearing up to raise as much as $ 4 bn to $ 5 bn from an initial public offering in the first half of 2012. The economic environment in India is also making it harder for PE funds to fulfill their primary competence of building value in the companies they have invested in. And finally, exiting these investments is turning out to be the hardest. With stock markets in a freefall, IPOs, private equity's most preferred exit route in India has slammed shut. On the other hand China presents the PE firms with similar risks compared to India but exponentially high returns. FDI in India during the last two years stands at $ US 46 bn where as China witnessed as record FDI of $ 105.7 bn in 2010 alone. This is indicative of the PE investments in India and China. The domestic, government funding and FDI in China are higher than India which has contributed to the growth of China. In the United States, private equity as a percentage of GDP is 3.4%. In China and India it's 0.3%. In absolute terms China stands at $ 34 bn while in India it is $ 5.5 bn. As a result, there's enormous opportunity in China and India because it's still a very small percentage of the economy. Though India also presents similar potential for the PE industry, the complex regulatory issues, poor infrastructure and multiple firms looking at a single deal has affected the PE funding for the technology start ups. No major exit for the start ups in India is a matter of concern for the investors in India. The biggest barrier for PE firms in India is the lack of regulatory support as the policymakers still do not regard PE and VC as a distinct asset class which can create an environment more conducive to the industrys growth. China on the other hand has produced striking private equity returns in the recent years for the investors. China has been very successful in tapping the domestic market which itself is very huge. The investor outlook towards India is more timid compared to China but still positive. Regulations are a concern in India for the PE firms. Companies that funds invest in is still a concern but diminishing with new regulatory policies directed towards opening up investments. FDI policies and pricing restrictions on entry & exit for FDI is also a challenge for the PE firms in India. Many firms operate out of a global fund, so they look at all geographies with the same intention and a much established market does not subject the PE firms to these issues. Knowledgefaber analysis & the interviews conducted with the VC, PE firms have clearly indicated that India presents a great market for the VC investors while China is a much bigger market for the PE investments. Prospects (India): The overall outlook for the PE industry in India is growing more positive everyday with India having the highest CAGR of PE investments in Asia at 17% during 2005-2010. With a proper funding environment and policy support, there is undoubtedly tremendous potential for PE activity in India in the technology sector. India is a safer bet in the longer term than China owing to a stable government, as weaknesses in China's legal system and political instability remains a concern for the investors. China attracts deals across multiple industries while in India the focus is still biased towards technology and services. India presents the PE investors with a much better environment to invest in technology startups with a mention that only proper policies and support from government and financial institutions will help realize its true potential. Increased funding in the seed stages will ensure that over a period of time India will produce
For enquiries please contact: enquiry@knowledgefaber.com; +91-80-41231576 Page 6

Technology startup scenario in India & VC, PE funding (India vs. China) better and a larger number of technology companies given the gap at this stage. The onus lies on the companies to come out with less risky business models and with products which are commercially viable for the end user. A recent study by IDG Ventures estimates that India will witness $70-75 bn of private equity and VC investment between 2010 and 2015 of which nearly $10 bn of it is expected to come from VC players, largely in the technology space. India still may not have an ecosystem similar to Silicon Valley but the basic building blocks of mentors, incubators and investors getting united to help technology startups succeed have been established. Flipkart, InMobi, Zoho, Mango Technologies, Leadforce1, 160BY2, Vidteq, Edujini labs and SnapDeal are some companies to watch out. Flipkart with the recent round of funding has raised $ 31 mn until now. Snapdeal has raised $ 40 mn in series B funding hardly six months after it had announced a $ 12 mn series A funding in January this year. It would be more interesting to see whether these companies would hit the public market or present a deal and get acquired by bigger firms. A flourishing VC, PE industry in India will fill the gap between the capital requirements of technology and knowledge based startup enterprises and funding available from traditional institutional lenders such as banks. However, from the viewpoint of a traditional banker, they have neither physical assets nor a low-risk business plan. Not surprisingly, companies such as Apple, Exodus, Hotmail and Yahoo, to mention a few of the many successful multinational venture-capital funded companies, initially failed to get capital as startups when they approached traditional lenders. However, they were able to obtain finance from independently managed venture capital funds that focus on equity or equity-linked investments in privately held, high-growth companies. The gap exists because such startups are necessarily based on intangible assets such as human capital and on a technology-enabled mission. Along with this finance the investors bring smart advice, hand-on management support and other skills that help the entrepreneurial vision to be converted to marketable products. India today is at the cusp of becoming an epicentre for global innovation, which is driven by the timely amalgamation of multiple factors viz domestic market, global aspirations of Indian firms and the need for innovation to succeed. While the private sector has always rooted for technology adoption, the government too seems to be making the strategic shift. The Indian Government has earmarked $ 9 bn for investment in IT initiatives over the next five years; 12 percent year on year rise in IT spending allocation to States. Though several countries are seeing a downturn in fund raising for startups due to financial crisis, the scenario in India is very positive. Knowledgefaber analysis suggests that the eCommerce, data analytics, mobile commerce, and cloud computing are the major areas of interest for the investors in India which is also estimated to receive the major funding in India.

For enquiries please contact: enquiry@knowledgefaber.com; +91-80-41231576

Page 7