VENTURE CAPITAL

Ravish Jain, MBA

(A)
 Definition
Venture capital is a type of private equity capital
typically provided to early stage, high-potential, growth
companies in the interest of generating a return through
an eventual realization event such as an IPO or trade
sale of the company. Venture capital investments are
generally made as cash in exchange for shares in the
invested company.

The European Venture Capital Association has

described it as risk finance for entrepreneurial growth
oriented companies, and investment for medium or long-
term to maximize returns. It is a partnership with the
entrepreneur in which the investor can add value to the
company because of his knowledge and experience.

The SEBI has defined Venture Capital Fund in its

Regulation 1996 as ‘a fund established in the form of a
company or trust which raises money through loans,
donations, issue of securities or units as the case may be
 Origins of VC
Before World War II, venture capital investments were
primarily the domain of wealthy individuals and families.
The Vanderbilts, Whitneys, Rockefellers and Warburgs were
notable investors in private companies in the first half of the
century. It was not until after World War II that what is
considered today to be true private equity investments
began to emerge marked by the founding of the first two
venture capital firms in 1946: American Research and
Development Corporation. (ARDC) and J.H. Whitney &

Georges F. Doriot John Hay Whitney

Laurance Rockfellar
 Structure of Venture Capital Firms
Venture capital firms are typically structured as
partnerships, the general partners of which serve as the
managers of the firm and will serve as investment
advisors to the venture capital funds raised. Typical
career backgrounds vary, but broadly speaking venture
capitalists come from either an operational or a finance
background. Venture capitalists with an operational
background tend to be former founders or executives of
companies or will have served as management
consultants. Venture capitalists with finance
backgrounds tend to have investment banking or other
corporate finance experience.
Although the titles are not entirely uniform from firm to
firm, other positions at venture capital firms include:
• Venture partners - Venture partners are expected to
source potential investment opportunities ("bring in
 Structure contd …
• Entrepreneur-in-residence (EIR) - EIRs are experts
in a particular domain and perform due diligence on
potential deals. EIRs are engaged by venture capital
firms temporarily (six to 18 months) and are expected
to develop and pitch startup ideas to their host firm.
• Principal - This is a mid-level investment professional
position, and often considered a "partner-track"
position. Principals are either promoted from a senior
associate position or have commensurate experience
in fields such as investment banking or consulting.

• Associate - This is typically the most junior

apprentice position within a venture capital firm. After
a few successful years, an associate may move up to
the "senior associate" position and potentially
principal and beyond. Associates will often have
 Characteristics of VC
Long Time Horizon – Venture financing is a long term
illiquid investment; it is not repayable on demand. VCFs
may have to wait long period (7-12 years) to make
substantial profits.

Lack of Liquidity – The investments made in the private

company are illiquid until the company goes public or is
sold. That is why investment is done in stages. First few
years, 1-3 years, are of intense investment activity.
Promising companies are included in the portfolio. 1 out of
400th company is successful.

Years 4-6th are growth period in which follow on

investments are made and a few new investments are
added. Partners decided which venture to cut out and
which to continue to support.
 Characteristics of VC
High Risk – Few investments will return many times the
initial investments, other will fail completely. Approximately
40% of all investments are losers. Almost 30% become
living dead. About 20 % return 2 to 5 times the initial
investment. And around 8% return 8-10 times returns. And
only 2% of all the investments ends up generating returns
of 10 times the initial investment.

Equity Participation – The objective is to make capital

gains by selling off the investment once the enterprise
becomes profitable.

Participation in Management – This helps VC to protect

and enhance the investment by actually involving and
supporting the entrepreneur. Apart from finance, a VC
provides his marketing, technology, planning and
 Investment Determinants
A venture capital; fund studies and critically examines the
under mentioned variables to make SWOT analysis of the
ventures before it takes financing decision.
1. Analysis of Management – Mental Attributes
– Behavioral Attributes
2. Analysis of Organization Pattern – Management Team
– Equity Holders
– Trade Union &
Industrial Peace
– Strengths and
Weaknesses
3. Analysis of Production Process
4. Analysis of Marketing and Sales
5. Financial Analysis and Projections
6. Analysis of Reference Information
 A Study on Investment Criteria
Dr A K Mishra of IIM Lucknow, conducted a detailed study
in the year 2001 on the investment evaluation criteria
used by the Indian venture capitalists. Even though the
study was conducted six years back, its findings are still
relevant and confirm the findings of researchers globally.

Mishra found the entrepreneurs' personality (integrity,

attention to detail, long term vision, etc.) to be the most
important criteria for the VC, followed by growth
prospects of the business.

Past research shows that trustworthiness, enthusiasm

and expertise of the entrepreneur are the most
important factors considered by the VCs. It has also been
seen that about 50-60 per cent of the projects which are
seriously considered for financing but are ultimately
 Valuation Methods
Valuation is important to take a decision about the share
in equity capital of the company. The various methods
used are:

CONVENTIONAL VALUATION METHOD

Based on the expected increase in the initial investment

that could be sold out to a third party or through public
offering via exit route.

P/E ratio is calculated on the maturing date, also known

as liquidity date.

The earning level post-tax is multiplied by P/E ratio gives

valuation of the investment at a future date.

Does not take into account the stream of cash flows from
 Valuation Methods
PRESENT VALUE BASED METHOD / FIRST CHICAGO
METHOD

This method takes into account the stream of earnings

(or losses) generated during the entire period of the
investment from the date of the initial investment to
date of maturity at a presumed discounted rate.

Three scenarios are assumed : SUCCESS, SURVIVAL and

FAILURE.

Each scenario is assigned a probability figure which

depends on many things which affect earnings: prices of
raw material; prices of finished good; marketing factors.

The total of these scenarios gives the present value of

the company. Based on such value the venture capitalist
 Valuation Methods
REVENUE MULTIPLIER METHOD

Revenue multiplier is an assumed factor used to

estimate the value of an enterprise. By multiplying the
annual estimated sales by such factor, the valuation
figure is derived. This method is based on sales income
and not on earnings.
The multiplier M is obtained by using the following
equation:

M = (1 + g) n (e) (PE)
1+dn
g – growth rate
N – number of years between initial investment and exit
date
e – expected profit margin (post tax) percentage at the
 Deal Structuring
Its an important step of the overall process. Terms are
negotiated with respect to amount, form and price of the
investment. The agreement also includes the protective
covenants and earn-out arrangements.

Covenants include the venture capitalist’s right to

control the company and to change its management, if
needed, buy-back arrangements, acquisition, making
initial public offering, etc.

Earn-out arrangements specify the entrepreneur’s equity

share and the objectives to be achieved.

The venture companies like deal to be structured in such

a way that their interests are protected. They would like
to earn reasonable return, minimize taxes, have enough
liquidity to operate their business.
 Pricing
Pricing is the most sensitive part of the negotiation
process. Pricing involves valuation of a company before
and after financing based on an analysis of risk and
return.

In seed capital and early stage investment, VC expect a

compounded annual return of 50 percent.

In second stage investment VC may be satisfied with an

annual return of 30-40 percent

In later stage financing they would expect something like

25-30 percent.

The pricing of the deal is done by valuation. Different

valuation methods are used in structuring and pricing
 Venture Financing
There are typically six stages of financing offered in
Venture Capital, that roughly correspond to these stages
of a company's development.
• Seed Money: Low level financing needed to prove a
new idea
• Start-up: Early stage firms that need funding for
expenses associated with marketing and product
development
• First-Round: Early sales and manufacturing funds
• Second-Round: Working capital for early stage
companies that are selling product, but not yet turning
a profit
• Third-Round: Also called Mezzanine financing, this is
expansion money for a newly profitable company
 Venture Financing
The financing pattern of the deal is the most important
•

element.
•

• Equity
•It is the most desirable form of financing, as it does not
put any pressure in the initial teething period. Ideally the
support should be through equity to reflect an approach
of sharing risk and rewards. The normal limit of
assistance by way of equity is to be at a level slightly
lower than of the promoter’s equity.
•

• Conditional Loan
•It is repayable in the from of royalty after the venture is
able to generate sales. No interest is paid on such loans.
In India royalty charges are between 2 to 15 %; actual
rate depends on various factors such as gestation
period, cost flow patterns, risk and other factors of the
 Venture Financing
• Income Note
•

•This method is unique to India. It’s a hybrid security

which combines the feature of both conventional and
conditional loan. The entrepreneur has to pay both
interest and royalty on sales, but at substantially low
rates.
•

• Participating Debenture
•

•Such security carries charges in 3 phases. In the start-up

phase, before the venture attains operations to a
minimum level, no interest is charged, After this, low rate
of interest is charged up to a particular level of
operation. Once the venture is commercial, a high rate of
interest is required to be paid.
• A variation could be in terms of paying a certain share of
 Venture Financing
Quasi Equity
•

•Quasi equity instruments are converted into equity at a

later date. Convertible instruments are normally
converted into equity at the book value or at certain
multiple of EPS, i.e. at a premium to par value at a later
date. The premium automatically rewards the promoter
for their initiative and hard work. Since it is performance
related, it motivates the promoter to work harder so as
to minimize dilution of their control on the company.
The different quasi-equity instruments are as follows:
•

1. Cumulative convertible preference shares.

2. Partially convertible debentures.
3. Fully convertible debentures.
 Project Monitoring
The VC carry out close monitoring through various
•

devices like periodical reports, appointing nominee

directors on the boards of the assisted companies,
carrying out periodical inspections and at times
appointing their own management personnel. Three
styles of monitoring are in use:
•

3. Hands-on style
•

Involves supportive and direct involvement of VC in firm

•

through
representation on matters of technology, marketing and
•

general management. They make active contribution to

strategies and policies of the firm, rather than only
acting as financial watchdogs. In India VC do not involve
themselves on the hands-on basis and do not interfere
 Project Monitoring
• 2. Hands-off style
•

Also know as passive style and involves occasional

•

assessment of the assisted firms management and their

performance with no direct assistance being provided.
•The VC would receive periodic post-investment
information from the entrepreneur. Indian VC generally
follow this practice
•

• 3. Intermediate style
•

•This is intermediate style between hands-off and hands-

on. VCs are entitled to obtain on regular basis
information about the assisted projects. VCs are also
entitled to be consulted on key decisions such as major
capital expenditure, acquisitions and board
 Exit Route
• Initial Public Offer
•The most preferred exit route for a venture capitalist is the
Initial Public Offer.
•

• Trade Sale
•In a trade sale the venture capitalist sells his stake to a
strategic buyer that already owns a business similar or
complementary or plans to enter into the target industry.
This helps the strategic buyer to produce a synergistic
increase in value.
•

• Promoter Buy Back

In this the promoter buy back the venture capitalist stake
•

at a predetermined price.
•

• Acquisition by another company

•
 DEVELOPMENT OF
VENTURE CAPITAL IN
INDIA
• The concept of venture capital was
formally introduced in India in 1987
by IDBI
• The government levied a 5 per cent
cess on all know-how import
payments to create the venture fund
• ICICI started VC activity in the same
year
• Later on ICICI floated a separate VC
 VCFs in India can be
categorized into following five
• Central financial institutions such as
IDBI and SIDBI
• State level financial institutions such as
Punjab Infotech Venture Fund
• Banks such as Canbank Venture Capital
Fund Limited
• Private Sector institutions such as IL&FS
Venture Corporation Limited
• Overseas such as HSBC Private Equity
management Mauritius Limited
 Future Prospects of Venture
Financing
• VC can assist small ancillary units to
upgrade their technologies so that they
could be in line with the developments
taking place in their parent companies.
• VCFs can play a significant role in
developing countries in the service
sector including tourism, publishing,
health care etc.
• They can provide financial assistance to
people coming out of universities,
technical institutes etc thus promoting
 Elements needed for success
of venture capital in any
• Entrepreneurial Tradition
• Unregulated economic environment
• Disinvestments avenues
• Fiscal incentives
• Broad based education
• Venture capital managers
• Promotion efforts
• Institute industry linkage
• R&D activities
 PE Investments by Stage :
2007

• Stage of Company No. of Deals

Amount (US$M)
• Early Stage 24
154
• Growth Stage 25
1082
• Late Stage 67
2162
• PIPE 34
1714
• Buyout 6
440
• Others 6
 PE/VC Investments by
Industry
• IT & ITES 16%
• Manufacturing 07%
• Healthcare & Life Sciences 02%
• Textiles & Garments 03%
• BFSI* 37%
• Hotels & Resorts 02%
• Media & Entertainment 07%
• Engg. & Construction 14%
• Shipping & Logistics 05%
• Energy 02%
• Telecom 01%
• Others 04%
 Top Cities attracting PE
Investments
• City No. of Deals
Value(US$M)
• Mumbai 69
1,780
• Delhi/NCR* 41
395
• Bangalore 40
1,525
• Chennai 22
Venture Intelligence with the guidance of Prof. Amit
Bubna of Indian School of Business, Hyderabad,
studied the economic impact of PE and VCs on the
Indian businesses.

The following are some of the interesting

observations of this study:

The study shows that the VC backed companies

grew faster compared to the non-VC backed peers
and even better than the benchmark indices like the
NSE Nifty. They found that the sales of listed PE-
backed companies grew at 22.9% as compared to
10% for non-PE-backed listed firms.

PE backed firms added more jobs to the economy

and even the wages at listed PE financed firms grew
• An astonishing finding was that almost 96% of the
top executives felt that without the support and
the backing of private equity these companies
would not have existed or would have grown at a
slower rate, while only about 4% felt that they
would have developed the same way even
without PE funding.

• The study also shows that the biggest support of

the PE investors were provided in the area of
strategic direction followed by the financial
advice and then recruitment and the marketing
activities
MAIN PROVISIONS OF VCF
REGULATIONS (1996)
 PROVISIONS Cont.
1) A venture capital fund may be set
up by a company or a trust, after a
certificate of registration is granted
by SEBI on an application made to
it. On receipt of the certificate of
registration, it shall be binding on
the venture capital fund to abide by
the provisions of the SEBI Act, 1992
. The VCF shall not carry on any
other activity than that of VCF>
 PROVISIONS Cont.
2) A VCF may raise money from any
investor, Indian, Non-resident Indian
or foreign, provided the money
accepted from any investor is not
less than Rs 5 lakh. The VCF shall
not issue any document or
advertisement inviting offers from
the public for subscription of its
security or units
 PROVISIONS Cont.
3) A VCF is not permitted to invest in
the equity shares of any company or
institutions providing financial
services.
 PROVISIONS Cont.
4) At least 80% of the funds raised by a
venture capital funds shall be invested
in
b) the equity shares or securities by an
unlisted company. Such investment
may be made through private
placement prior to the listing of such
securities is permitted.
c) the equity shares and securities of a
financially weak company whose
 PROVISIONS Cont.
5) The societies or units issued by a
venture capital fund shall not be
listed on any recognized stock
exchange till the expiry of 4 years
from the date of issuance .
 PROVISIONS Cont.
6) A VCF may receive monies for
investment in the venture capital
fund through private placement of its
securities units.
 PROVISIONS Cont.
7) A Scheme of VCF set up as a trust shall
be wound up
b) when the period of the scheme if any,
is over
c) If the trustee are of the opinion that
the winding up shall be in the interest
of the investors
d) 75 % of the investors in the scheme
pass a resolution for winding up or,
e) If SEBI so directs in the interest of the
 VENTURE CAPITAL
GUIDELINES
1. ESTABLISHMENT
2. MANAGEMENT
3. ASSISTANCE
d) Size
e) Technology
f) Promoters/Entrepreneurs
4. Size
VENTURE CAPITAL GUIDELINES
Cont.
5. Capital Issues:
b) Funds be raised through public issues and/
or private placement to finance VCC/VCFs.
c) Foreign equity up to 25% in multilateral/
international financial organizations,
development finance institutes, reputed
mutual funds etc.
d) NRI investment would be permitted up to
74% on a non repayable bases.
e) Application should be addressed to Ministry
of Finance, Investment Division with a copy
to Chairman, SEBI, foreign NRI participation
VENTURE CAPITAL GUIDELINES
Cont.
6. Debt-equity ratio
7. Underwriting Listing
8. Exit
9. Eligibility for Tax Concession.
 VCF REGULATION AS PER
PROVISION OF INCOME-TAX
1) 80% of money raised under the fund
should be invested in equity shares
of unlisted company, with in a
period of three years.
2) VCFs are required to hold
investment for a minimum period of
3 years.
3) VCFs can not invest more than 20%
of total money raised in a venture.
4) VCFs can not invest in more than
 DISINVESTMENT AND EXIT
ROUTES IN VC BUSINESS
I. Sale of share on stock Exchange
after Listing
II. IPO/Offer for sale
III. Strategic Sales
IV. Buy Back of Equity by Company
V. Promoters Buy Back
ISSUES IN EXERCISING EXIT
OPTION
I. Threshold Limit for Listing
II. Formalities Involved in Sale of
Venture
III. Stock Market Support
IV. Weak Legal Framework
V. Underdeveloped Market for Mergers
and Acquisition
 PRE-REQUISITE FOR THE
EFFICIENT EXIT MECHANISM
I. Efficient Stock Market
II. Mechanism for listing of Equity by
Companies with Low Equity Base
III. Legal Framework
IV. Facilitate Smooth Transfer/Sale of
Ventures
 GUIDELINES FOR FOREIGN
VENTURE CAPITAL
1. Off-shore investors, with the
permission of Foreign Investment
Promotion Board, can invest in approve
venture capital funds or VCCs.
2. Off-shore VCC can contribute 100%
capital as well as set up a domestic
asset management company.
3. Subsequent investment does not
require FIPB’s permission, and will be
subject to the general restriction
applicable to VCCs to invest only in
unlisted companies but not exceeding
 GUIDELINES FOR FOREIGN
VENTURE CAPITAL Cont.
4. Tax exemption similar to the
domestic VCFs/VCCs, are available to
foreign VCCs, subject to the existing
guidelines. If they want to avail tax
exemptions, they are free to invest in
any sector.
5. Offshore investors’ income from
Indian VCFs/VCCs would be subject to
existing rates for foreign investors.
 References
BOOKS
• Chary T Satyanarayana, Venture Capital: Concepts and
Application, Macmillian, 2005
• Pandey I M, Venture Capital: The Indian Experience,
Prentice Hall, 1999
• Pandey I M, Financial Management, 9e, Vikas Publication,
Chapter 23, Pg 455 – 486

PAPERS
Mishra A K, 2004, Indian Venture Capitalists (VCs):
Investment Evaluation Criteria , ICFAI Journal of Applied
Finance, Vol. 10, No. 7, pp. 71-93

WEBSITES
• Website of Indian Venture Capital Association,
www.ivca.org
• http://www.rediff.com/money www.wiekepedia.com