CHAPTER 1 INTRODUCTION TO VENTURE CAPITAL

I L'tiiiire ( apiial Manaf^emeni Indian Experience CHAPTER 1 INTRODUCTION TO VENTURE CAPITAL S.No. 1.1 1.2 1.3 1.4 1.5 1.6 1.7 1.8 1.9 TITLE INTRODUCTION DEFINITION VENTURE CAPITAL COMPANY NATURE & SCOPE FEATURES OF VENTURE CAPITAL VENTURE CAPITAL-THE HISTORY BEGNININGOF MODERN VENTURE CAPITAL NEED AND RELEVANCE OF VENTURE CAPITAL IN INDIA STAGES OF VENTURE CAPITAL INVESTMENT Page No. 24 25 27 28 29 31 31 33 33 23

I 'ftiiure ( apiial Management Indian Experience Chapter I INTRODUCTION TO VENTURE CAPITAL 1.1 INTRODUCTION Venture capital is a growing business of recent origin in the area of industrial financing in India. The various financial institutions set-up in India to promote industries have done commendable work. However, these institutions do not come up to the benefit of risky ventures when new or relatively unknown entrepreneurs undertake them. They contend to give debt finance, mostly in the form of term loan to the promoters and their functioning has been more akin to that of commercial banks. The financial institutions have devised schemes such as seed capital scheme. Risk capital Fund etc.. to help new entrepreneurs. However, to evaluate the projects and extend financial assistance they follow the criteria such as safety, security, liquidity and profitability and not the potential to grow. The capital market with its conventional financial instruments/ schemes does not come much to the benefit or risky venture. New institutions such as mutual funds, leasing and hire purchase Company's have been established as another source of finance to industries. These institutions also do not mitigate the problems of new entrepreneurs who undertake risky and innovative ventures. The term Venture Capital comprises of two words that is "Venture" and "Capital".(Subbulakshmi. 2004: 44-46). Venture is defined as a course of processing, the outcome of which is uncertain but to which is attended the risk or danger of LOSS. Capital means resources to start an enterprise. To connote the risk and adventure of such a fund, the generic name Venture Capital was coined. Venture capital is long-term risk capital to finance high technology projects, which involve risk, but at the same time has strong potential for growth. Venture capitalists pool their resources including managerial abilities to assist new entrepreneur in the early years of the project. Once the project reaches the stage of profitability, they sell their equity holdings at high premium. 24

( cfinire ( apuutmanugcitwiu Indian l.xpentfiht' Venture capital refers to organize private or institutional financing that can provide substantial amounts of capital mostly through equity purchases and occasionally through debts offerings to help growth oriented firms to develop and succeed. The term venture capital denotes institutional investors that provide equity financing to young businesses and play an active role advising their managements. Broadly the Venture Capital finance includes a variety of investment vehicles. A much wider range of activities than purely start up situations are undertaken by Venture capital. 1.2 DEFINITION : Venture capital is a type of private equity capital typically provided by professional, outside investors to new, growth businesses. Generally made as cash in exchange for shares in the investee company, venture capital investments are usually high risk, but offer the potential for above-average returns. The term 'Venture Capital" is understood in many ways. In a narrow sense, it refers to, investment in new and tried enterprises that are lacking a stable record of growth. In a broader sense, venture capital refers to the commitment of capital as shareholding, for the formulation and setting up of small firms specializing in new ideas or new technologies. It is not merely an injection of funds into a new firm, it is a simultaneous input of skill needed to set up the firm, design its marketing strategy and organize and manage it. It is an association with successive stages of firm's development with distinctive types of financing appropriate to each stage of development. It means an investment in those business ventures where uncertainties are yet to be reduced to the risk that is subject to rational criteria of security analysis. 25

Venture ('apttal Management Indian Experience Venture capital can also include managerial and technical expertise. Most venture capital comes from a group of wealthy investors, investment banks and other financial institutions that pool such investments or partnerships. This form of raising capital is popular among new companies, or ventures, with limited operating history, which cannot raise funds through a debt issue. The downside for entrepreneurs is that venture capitalists usually get a say in company decisions, in addition to a portion of the equity. Contrary to popular perception, venture capital plays only a minor role in funding basic Innovation. Where venture money plays an important role is the next stage of innovation life cycle-the period in a company's life when it begins to commercialize its innovation. It is estimated that more than 80% of the money invested by Venture Capitalist goes into building the infrastructure required to grow the business in expense investments (manufacturing, sales, and manufacturing) and the balance sheet (providing fixed asset and working capital). Venture money is not long term money. The idea is to invest in a company's balance sheet and infrastructure until it reaches a sufficient size and credibility so that it can be sold to a corporation or so that an institutional public equity markets can step in and provide liquidity. In essence Venture Capital buys a stake in an entrepreneur's idea, nurtures it for a short period of time, and then exits with a help of Investment Banker. Venture capitals niche exists because of the structure and rule of capital markets. Someone with a new idea or technology often has no other institution to turn to. Usually law, limits the interest banks can charge on loans-and the risk inherent in start ups justify the higher rates so charged by the banks. This limits a bank to invest in those projects that secure the debt with hard assets. And in today's information based economy, many start ups have few hard assets. Public Equity and Investment Bank are both constrained by regulations and operating practices to protect the public investor. Venture Capital fills the gap between innovation and traditional lower cost sources of capital available for ongoing concerns. Filling that void successfully requires the venture capital industry to provide a sufficient return on capital to attract private equity funds, attractive returns for its

Venture ('apiial Managemcnl Indian lixpertence own participants, and sufficient upside potential entrepreneurs to attract high quality ideas that will generate high returns. The new economy is driven by technological development and the basis of technological development is new technologies which come from invention. However having invention by itself is not enough; there also needs to be successful commercialisation of invention.(hisrich & peters,1998 :55-60) It is here the role of successful entrepreneurs come into force because this person is the one who develop projects, take risk and work to succeed in commercialisation of new products, servicesand process. 1.3 VENTURE CAPITAL COMPANY A venture capital company is defined as a financing institution which joins an entrepreneur as a co-promoter in a project and shares the risks and rewards of the enterprise.{subbarao,2002:2-3) Venture capital general partners (also known in this case as "venture capitalists" or "Venture Capitalists") are the executives in the firm, in other words the investment professionals. Typical career backgrounds vary, but many are former chief executives at firms similar to those which the partnership finances and other senior executives in technology companies. Investors in venture capital funds are known as limited partners. This constituency comprises both high net worth individuals and institutions with large amounts of available capital, such as state and private pension funds, university financial endowments, foundations, insurance companies, and pooled investment vehicles, called fund of funds. 27

Venture ('apital Management Indian Experience 1.4 NATURE AND SCOPE Venture capital refers to organize private or institutional financing that can provide substantial amounts of capital mostly through equity purchases and occasionally through debts offerings to help growth oriented firms to develop and succeed. The term venture capital denotes institutional investors that provide equity financing to young businesses and play an active role advising their managements. It is also important to understand the financial problems or barriers that prevents entrepreneurs and inventors from innovating and commercialissing their inventions.(carlsson,2002:25-26) Venture capital thrives best where it is not restrictively defined. Both in the U.S.A., the cradle of modern venture capital industry and U.K. where it is relatively advance venture capital as an activity has not been defined. Laying down parameters relating to size of investment, nature of technology and promoter's background do not really help in promoting venture proposals. Venture capital enables entrepreneurs to actualize scientific ideals and enables inventions. It can contribute as well as benefit from securities market development. Venture capital is a potential source for augmenting the supply of good securities with track record of performance to the stock market that faces shortage of good securities to absorb the savings of the investors. Venture capital in turn benefits from the rise in market valuation that results from an active secondary market.a study by NVCA revealed that company originally backed by Venture Capitalist generated US$ 736 billion in revenue in the year 2000.According to the study Venture Capitalist backed companies represent 3.3% of US total Jobs.(NVCA 2002) 28

Viniure Capital Management - Indian Experience 1.5 FEATURES OF VENTURE CAPITAL The key terms found in most definition of Venture capital are: high technology and high risk, equity investment and capital gains, value addition through participation in management. High Risk By definition the Venture capital financing is highly risky and chances of failure are high as it provides long term start up capital to high risk-high reward ventures. Venture capital assumes four types of risks: ^ Management Risk-inability of the management teams to work together. => Market Risk- product may fail in the market. => Product Risk- product may not be conimercially viable => Operation Risk- operations may not be cost effective resulting in increased cost and decreased gross margins. High Technology As opportunities in the low technology area tend to be few and of lower order, and hi-tech projects generally offer higher returns than projects in more traditional areas, Venture capital investments are made in high technology areas using new technology. Not just high technology, any high-risk ventures where the entrepreneur has conviction but little capital gets venture finance. Venture capital is available for expansion of existing business or diversification to a high-risk area. Thus technology financing had never been primary objective but incidental to Venture capital. Equity Participation and Capital Gains Investments are generally in equity and quasi equity participation through direct purchase of shares, options, convertible debentures where the debt holder has the option to convert the loan instruments into stock of the borrower or a debt with warrants to equity investment. The funds in the form of equity help to raise term loans that are cheaper source of funds. In the early stages of business, because _

Venture ('opital Management Intlian Kxpenence dividends can be delayed. Equity investment implies that investors bear tiie risic of venture and would earn a return commensurate with the success in the form of capital gains. Participation in Management Venture capital provides value addition by managerial support, monitoring and follow up assistance. It monitors physical and financial progress as well as market development initiative. It helps by identifying key resource persons. They want to be on the company's board of directors and involvement, for better or worse, in the major decisions affecting the direction of the company. This is a unique philosophy of "hands on management" where Venture capitalist acts as complementary to the entrepreneurs. Based upon the experience with other companies, a venture capitalist advises the promoters on project planning, monitoring, financial management, including working capital and public issue. Venture capital investor cannot interfere in day today management of the enterprise but keeps close contact with the promoters or entrepreneurs to protect his investment. Length of Investment Venture capitalists help companies grow, but they eventually seek to exit the investment in three to seven years. An early stage investment may take seven to ten years to mature, while most of the later stage investments take only a few years. (Subba Rao,2002:6-7) The process of having significant returns takes several years and calls on the capacity and talent of venture capitalist and entrepreneurs to reach fruition. Illiquid Investment Venture capital investments are illiquid that is, not subject to repayment on demand or following a repayment schedule. Investors seek return ultimately by means of capital gains when the investment is sold at market place. The investment is realized only on enlistment of security or it is lost if enterprise is liquidated for unsuccessful working. It may take several years before the first investment starts to return proceeds. In some cases the investment may be locked

Venture Capital Maiiagemeni Indian Experience for seven to ten years. Venture Capitalist understands this illiquidity and factors in his investment decisions. 1.6 VC - THE HISTORY 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 famous ventures they financed. Among the early Venture Capital Funds set up was the one by Rockefeller Family that started a special called VENROCK in 1950, to finance new technology companies.(satyanarayan Chary,2005:2-10) USA is the birthplace of Venture Capital Industry, as we know it today. During most its historical evolution, the market for arranging such financing was fairly informal, relying primarily on the resource of wealthy families.(dilek,2008:8-10) After the Second World War in 1946 the American Research and Development was formed as first venture organization that financed over 900 companies. Venture capital had been a major contributor in development of the advanced countries like UK, Japan and several European countries. 1.7 BEGINNING OF MODERN VENTURE CAPITAL Although many other similar investment mechanisms have existed in the past, General Georges Doriot is considered to be the father of the modern venture capital industry. In 1946, Doriot founded American Research and Development Corporation (AR&DC), whose biggest success was Digital Equipment Corporation. When Digital Equipment went public in 1968 it provided AR&D with 101% annualized Return on Investment (ROI). ARD's $70,000 USD investment in Digital Corporation in 1957 grew in value to $355 million.(subba Rao,2002:5-10) It is commonly accepted that the first venture-backed startup is Fairchild Semiconductor, funded in 1959 by Venrock Associates. Venture capital investments, before World War II, were primarily the sphere of influence of wealthy individuals and families. One of the first steps toward a professionally

I 'enlurc C 'apital Managemeni - huitan Experience managed venture capital industry was the passage of the Small Business Investment Act of 1958. The 1958 Act officially allowed the U.S. Small Business Administration (SBA) to license private "Small Business Investment Companies" (SBICs) to help the financing and management of the small entrepreneurial businesses in the United States. Passage of the Act addressed concerns raised in a Federal Reserve Board report to Congress that concluded that a major gap existed in the capital markets for long-term funding for growth-oriented small businesses. Facilitating the flow of capital through the economy up to the pioneering small concerns in order to stimulate the U.S. economy was and still is the main goal of the SBIC program today. Generally, venture capital is closely associated with technologically innovative ventures and mostly in the United States. Due to structural restrictions imposed on American banks in the 1930s there was no private merchant banking industry in the United States, a situation that was quite unique in developed nations. As late as the 1980s Lester Thurow, a noted economist, decried the inability of the USA's financial regulation framework to support any merchant bank other than one that is run by the United States Congress in the form of federally funded projects. US investment banks were confined to handling large M&A transactions, the issue of equity and debt securities, and, often, the breakup of industrial concerns to access their pension fund surplus or sell off infrastructural capital for big gains. Not only was the lax regulation of this situation very heavily criticized at the time, this industrial policy differed from that of other industrialized rivals notably Germany and Japan which at that time were gaining ground in automotive and consumer electronics markets globally. However, those nations were also becoming somewhat more dependent on central bank and elite academic judgment, rather than the more diffuse way that priorities were set by government and private investors in the United States. Actually venture capitalist developers venture situations in which to invest. For his trouble, venture capitalist receive 20 to 25 percent of the ultimate profits of the partnership know as carried interest. He also collects an annual fee of 2 percent 32"

I'eniure Capilal Management Indian Experience (of capital lent or invested in equity) to cover costs. Apart from individuals, investors include institutions such as pension funds, life insurance companies and even universities. The institutional investors invest about 10 percent of their portfolio in the venture proposals. Specialist venture capital funds in USA have about $30 billions on an annual basis to seek-out promising start-ups and take in them. In Japan there are about 55 active venture firms with funds amounting to $ 7 billions (1993). Venture capital funds are also extant in U.K., France and Korea. 1.8 NEED AND RELEVANCE OF VENTURE CAPITAL IN INDIA In USA given its highly progressive industrial environment and entrepreneurial culture, it is normal for an entrepreneur or inventor of anew product /process to set up company to produce and market the product by obtaining finance through the sale of company shares to Venture Capital Fundss which are readily willing to share the risk in return for future gains.in India risk financing of this type has yet to pick up in any significant way. There are large number of financial institutions which provide conventional finance to business firms.this sort of traditional financing primarily caters to projects based on proven established processes and technology with minimum investment risk.it is security oriented and asset based. It involves fixed and uniform payment of interest and principal and it follows fixed form of financing e.g. debt equity ratio, promoters contribution security margin etc. The existing financial institutions are conservative in their approach A number of people in India feel that financial institutions are not only conservative but they also have bias for foreign technology and they do not trust the abilities of entrepreneurs.(satyanarayan Chary,2005:31-35) 1.9 STAGES OF VC INVESTMENT There are 5 Investments stages widely used by the industry to invest. These stages are defined as under

cntun: ( apnul Mana^emenl Indian i-^xpent'nce Seed Stage Financing provided to new companies for use in product development and initial marketing constitutes Seed Stage. Eligible companies may be in the process of being setup or may have been in business for a short time or may not have sold their product commercially. This is the fmancing provided to companies when the Initial Concept of the business is being formed Startup Financing provided to new companies, for manufacturing and commercializing the developed products, represent Startup. The companies may be in their initial stages of development and finance may be extended for creation of new infrastructure and meeting the Working Capital Margin Other Early Stage Financing provided to companies that have completed the commercial scale implementation and may require further funds to meet initial cash and further working capital is treated as Other Early Stage. The companies may have expended their capital and would require additional funds and may not yet be generating profit Later Stage Financing Capital provided for the growth and expansion of established companies. Funds may be used to finance increase in production capacity, market or product development and/ or provide additional working capital. This would include product diversification, forward/backward integration, besides creation of additional capacity. Capital could be provided for companies that are breaking even or profitable or in turnaround situations Turnaround Financing Capital provided for companies that are in operational or financial difficulties where the additional funds would help in Turnaround Situations.(Subbulakshmi,2004:38-40) 34

I ciiltiiv ( apuui Muiia^nimciu Indian I'^.xpt'rwnLV Earlier VC funds use to invest in Seed and Startup stages and very rarely in Turnaround Stages, but off late the trend is changing and Venture Capitalist funds are a part of every stage and are also actively participating in Turnaround Stages through buyouts and takeovers 35