Venture Capital in It

VENTURE CAPITAL IN THE INFORMATION TECHNOLOGY SECTOR OF INDIA
BY: ZARNA MESWANI ROLL NO: 104 MFM III B NMIMS GUIDE: MS VRINDA KAMAT
Venture Capital In India

TABLE OF CONTENTS TABLE OF CONTENTS................................................................................................................2 TABLE OF CONTENTS................................................................................................................2 INTRODUCTION..........................................................................................................................4 INTRODUCTION..........................................................................................................................4 WHAT IS VENTURE CAPITAL?.................................................................................................7 WHAT IS VENTURE CAPITAL?.................................................................................................7 BRIEF HISTORY...........................................................................................................................9 BRIEF HISTORY...........................................................................................................................9 CLASSIFICATION OF VENTURE CAPITAL..........................................................................11 CLASSIFICATION OF VENTURE CAPITAL..........................................................................11 1. Genesis.......................................................................................................................................11 Financial Institutions Led By ICICI Ventures, RCTC, ILFS, etc.................................................11 ANGELS ......................................................................................................................................13 ANGELS ......................................................................................................................................13 INCUBATORS.............................................................................................................................13 INCUBATORS.............................................................................................................................13 WHAT RISKS DOES THE VENTURE CAPITALIST LOOK AT? .........................................14 WHAT RISKS DOES THE VENTURE CAPITALIST LOOK AT? .........................................14 CORPORATE VENTURING......................................................................................................16 CORPORATE VENTURING......................................................................................................16 THE VENTURE CAPITAL PROCESS.......................................................................................17 THE VENTURE CAPITAL PROCESS.......................................................................................17 ACCESSING VENTURE CAPITAL...........................................................................................27 ACCESSING VENTURE CAPITAL...........................................................................................27 VENTURE CAPITAL IN INDIA................................................................................................28 VENTURE CAPITAL IN INDIA................................................................................................28 GENERAL INDIAN ECONOMIC AND FINANCIAL ENVIRONMENT................................32 GENERAL INDIAN ECONOMIC AND FINANCIAL ENVIRONMENT................................32 The Banking System....................................................................................................................32 Equity............................................................................................................................................33 Other Institutional Sources of Funds............................................................................................34 THE INDIAN INFORMATION TECHNOLOGY INDUSTRY.................................................35 THE INDIAN INFORMATION TECHNOLOGY INDUSTRY.................................................35 OBJECTIVE AND VISION FOR VENTURE CAPITAL IN INDIA.........................................38 OBJECTIVE AND VISION FOR VENTURE CAPITAL IN INDIA.........................................38 CRITICAL FACTORS FOR SUCCESS OF VENTURE CAPITAL INDUSTRY IN INDIA. . .39 CRITICAL FACTORS FOR SUCCESS OF VENTURE CAPITAL INDUSTRY IN INDIA. . .39 Venture Capital / Angel Investments for the IT Sector................................................................41 VENTURE CAPITAL ENVIRONMENT IN INDIA..................................................................43 VENTURE CAPITAL ENVIRONMENT IN INDIA..................................................................43 PROBLEMS WITH VCS IN THE INDIAN CONTEXT...........................................................48 PROBLEMS WITH VCS IN THE INDIAN CONTEXT...........................................................48 SURVEY.......................................................................................................................................51 SURVEY.......................................................................................................................................51 DOTCOMS...................................................................................................................................54
Zarna Meswani MFM, NMIMS

DOTCOMS...................................................................................................................................54 Definition......................................................................................................................................54 CLASSIFICATION OF DOTCOMS ..........................................................................................55 CLASSIFICATION OF DOTCOMS ..........................................................................................55 VALUING DOT.COMS...............................................................................................................59 VALUING DOT.COMS...............................................................................................................59 Start From The Future...................................................................................................................61 Weighing For Probability.............................................................................................................62 Customer Value Analysis.............................................................................................................63 Uncertainty Is Here To Stay.........................................................................................................64 HAS THE BUBBLE BURST?.....................................................................................................66 HAS THE BUBBLE BURST?.....................................................................................................66 MALEGAM COMMITTEE PANEL REPORT ..........................................................................70 MALEGAM COMMITTEE PANEL REPORT ..........................................................................70 DOTCOM CULTURE IS DYING AS NEW REPORT REVEALS NEW FOCUS AMONG EUROPEAN DOTCOM CEOs.....................................................................................................77 DOTCOM CULTURE IS DYING AS NEW REPORT REVEALS NEW FOCUS AMONG EUROPEAN DOTCOM CEOs.....................................................................................................77 IF THE DOTCOM BUBBLE HAS BURST AND IT HAS FAILED THEN WHAT NEXT FOR VCs?.............................................................................................................................................79 IF THE DOTCOM BUBBLE HAS BURST AND IT HAS FAILED THEN WHAT NEXT FOR VCs?.............................................................................................................................................79 CONCLUSION.............................................................................................................................81 CONCLUSION.............................................................................................................................81 REFERENCES.............................................................................................................................81 REFERENCES.............................................................................................................................81
INTRODUCTION
Technology is reshaping this economy and transforming businesses and consumers. This is about more than e- commerce, or e-mail or e-trades, or e-files. It is about the e in the economic opportunity. William Daley, U. S Commerce Secretary. Venture Capitalists are the people who are the early investors in this opportunity. They source new ventures and invest in them. Venture capital means risk capital. It refers to capital investment, both equity and debt, which carry substantial risk and uncertainties. The risk envisaged may be very high may be so high as to result in total loss or very less so as to result in high gains. The investment in equities is expected to grow up as capital gains that can be converted into cash when required. Venture capital is thus an initiative to provide vital equity support to new industries where the risk element is high and entrepreneurs are qualified but lack necessary resources to proceed on their own. A venture capitalist entertains keen interest and active participation in the working of the business. Subject to the understanding with the investee, the investor takes part in the management, production, marketing, accounting, training activities etc. The venture capitalist therefore becomes a partner in the business and shares success or failure proportionate to the equity investment. The venture investment is long term and is not repayable on demand. The venture capitalist ahs to wait between 5 and 10 years for any significant return on his investment. The venture capitalist does not participate in the day-to-day working but protects and enhances his investment through an active supporting role. Venture capital commonly describes not only provision of start-up finance but also for development for later stages of the business. After an evolutionary learning process, the ideal-typical institutional form for venture capital became the venture capital firm operating a series of funds raised from wealthy individuals, pension funds, foundations, endowments and various other institutional sources. The venture capitalists were professionals, often with industry experience, and the investors were silent limited partners. At present a fund generally operates for a set number of years (usually between seven and ten) and then is terminated. Normally, each firm manages more than one partnership simultaneously. Even though the venture capital firm is the quintessential organizational format, there are other vehicles, the most persistent of which have been venture capital subsidiaries of major corporations, financial and non-financial. The venture capitalist invests in a recently established firm believed to have the potential to provide a return of ten times or more in less than five years. This is highly risky, and many of the investments fail entirely; however, the large winners are expected to more than compensate for the failures. In return for investing, the venture capitalists not only receive a major equity stake in the firm, but they also Zarna Meswani MFM, NMIMS

demand seats on the board of directors. By active intervention and assistance, venture capitalists act to increase the chances of survival and rate of growth of the new firm. Their involvement extends to several functions, such as helping to recruit key personnel and providing strategic advice and introductions to potential customers, strategic partners, later-stage financiers, investment bankers and various other contacts. The venture capitalist therefore provides more than just money, and this is a crucial difference between venture capital and other types of funding. The venture capital industry has, more recently, specialized even by stages of growth: there are early or seed funds, mature-stage funds, and bridge funds. The venture capital process is complete when the company is sold through either a listing on the stock market or the acquisition of the firm by another firm, or when the company fails. For this reason, the venture capitalist is a temporary investor and usually a member of the firm's board of directors only until their investment is liquidated. The firm is a product to be sold, not retained. The venture capital process requires that investments be liquidated, so there must be the possibility of exiting the firm. Nations that erect impediments to any of the exit paths (including bankruptcy) are choosing to handicap the development of the institution of venture capital. This is not to say that such nations will be unable to foster entrepreneurship, only that it is unlikely that venture capital as an institution will thrive. There have been many debates about the preconditions for venture capital. One obvious conclusion is that entrepreneurship is the precondition for venture capital, not vice versa; however, this is a misleading statement in a number of dimensions. At some level, entrepreneurship occurs in nearly every society, but venture capital can only exist when there is a constant flow of opportunities that have enormous upside potential. Information technology has been the only business field that has offered such a long history of opportunities. So entrepreneurship is a precondition, but not any type of entrepreneurship will do. Moreover, venture investing can encourage and increase the "proper" type of entrepreneurship, i.e.; successful venture capitalists can positively affect their environment. A number of technocrats are seeking to set up shop on their own and capitalize on opportunities. In the highly dynamic economic climate that surrounds us today, few traditional business models may survive. Countries across the globe are realizing that it is not the conglomerates and the gigantic corporations that fuel economic growth any more. The essence of any economy today is the small and medium enterprises. For example, in the US, 50% of the exports are created by companies with less than 20 employees and only 7% are created by companies with 500 or more employees. This growing trend can be attributed to rapid advances in technology in the last decade. Knowledge driven industries like infotech, health-care, entertainment and services have become the cynosure of bourses worldwide. In these sectors, it is innovation and technical capability that are big business-drivers. This is a paradigm shift from the earlier physical production and economies of scale model.

However, starting an enterprise is never easy. There are a number of parameters that contribute to its success or downfall. Experience, integrity, prudence and a clear understanding of the market are among the sought after qualities of a promoter. However, there are other factors, which lie beyond the control of the entrepreneur. Prominent among these is the timely infusion of funds. This is where the venture capitalist comes in, with money, business sense and a lot more.

WHAT IS VENTURE CAPITAL?
Venture capital is money provided by professionals who invest alongside management in young, rapidly growing companies that have the potential to develop into significant economic contributors. Venture capital is an important source of equity for start-up companies. Professionally managed venture capital firms generally are private partnerships or closely held corporations funded by private and public pension funds, endowment funds, foundations, corporations, wealthy individuals, foreign investors, and the venture capitalists themselves. Venture capitalists generally:

Finance new and rapidly growing companies Purchase equity securities Assist in the development of new products or services Add value to the company through active participation Take higher risks with the expectation of higher rewards Have a long-term orientation
When considering an investment, venture capitalists carefully screen the technical and business merits of the proposed company. Venture capitalists only invest in a small percentage of the businesses they review and have a long-term perspective. They also actively work with the company's management, especially with contacts and strategy formulation. Venture capitalists mitigate the risk of investing by developing a portfolio of young companies in a single venture fund. Many times they co-invest with other professional venture capital firms. In addition, many venture partnerships manage multiple funds simultaneously. For decades, venture capitalists have nurtured the growth of America's high technology and entrepreneurial communities resulting in significant job creation, economic growth and international competitiveness. Companies such as Digital Equipment Corporation, Apple, Federal Express, Compaq, Sun Microsystems, Intel, Microsoft and Genentech are famous examples of companies that received venture capital early in their development. In India, these funds are governed by the Securities and Exchange Board of India (SEBI) guidelines. According to this, venture capital fund means a fund established in the form of a company or trust, which raises monies through loans, donations, and issue of securities or units as the case may be, and makes or proposes to make investments in accordance with these regulations.

INVESTMENT PHILOSOPHY The basic principal underlying a venture capital invest in high-risk projects with the anticipation of high returns. These funds are then invested in several fledging enterprises, which require funding, but are unable to access it through the conventional sources such as banks and financial institutions. Typically first generation entrepreneurs start such enterprises. Such enterprises generally do not have any major collateral to offer as security, hence banks and financial institutions are averse to funding them. Venture capital funding may be by way of investment in the equity of the new enterprise or a combination of debt and equity, though equity is the most preferred route. Since most of the ventures financed through this route are in new areas (worldwide venture capital follows "hot industries" like infotech, electronics and biotechnology), the probability of success is very low. All projects financed do not give a high return. Some projects fail and some give moderate returns. The investment, however, is a long-term risk capital as such projects normally take 3 to 7 years to generate substantial returns. Venture capitalists offer "more than money" to the venture and seek to add value to the investee unit by active participation in its management. They monitor and evaluate the project on a continuous basis. The venture capitalist is however not worried about failure of an investee company, because the deal that succeeds, nets a very high return on his investments high enough to make up for the losses sustained in unsuccessful projects. The returns generally come in the form of selling the stocks when they get listed on the stock exchange or by a timely sale of his stake in the company to a strategic buyer. The idea is to cash in on an increased appreciation of the share value of the company at the time of disinvestment in the investee company. If the venture fails (more often than not), the entire amount gets written off. Probably, that is one reason why venture capitalists assess several projects and invest only in a handful after careful scrutiny of the management and marketability of the project. To conclude, a venture financier is one who funds a start up company, in most cases promoted by a first generation technocrat promoter with equity. A venture capitalist is not a lender, but an equity partner. He cannot survive on minimalism. He is driven by maximization: wealth maximization. Venture capitalists are sources of expertise for the companies they finance. Exit is preferably through listing on stock exchanges. This method has been extremely successful in USA, and venture funds have been credited with the success of technology companies in Silicon Valley. The entire technology industry thrives on it.

BRIEF HISTORY
The concept of venture capital is not new. Venture capitalists often relate the story of Christopher Columbus. In the fifteenth century, he sought to travel westwards instead of eastwards from Europe and so planned to reach India. His far-fetched idea did not find favor with the King of Portugal, who refused to finance him. Finally, Queen Isabella of Spain decided to fund him and the voyages of Christopher Columbus are now empanelled in history. The modern venture capital industry began taking shape in the post World War II years. It is often said that people decide to become entrepreneurs because they see role models in other people who have become successful entrepreneurs. Much the same thing can be said about venture capitalists. The earliest members of the organized venture capital industry had several role models, including these three: American Research and Development Corporation formed in 1946, whose biggest success was Digital Equipment. The founder of ARD was General Georges Doroit, a French-born military man who is considered "the father of venture capital." In the 1950s, he taught at the Harvard Business School. His lectures on the importance of risk capital were considered quirky by the rest of the faculty, who concentrated on conventional corporate management. J.H. Whitney & Co, also formed in 1946, one of whose early hits was Minute Maid juice. Jock Whitney is considered one of the industrys founders. The Rockefeller Family, and in particular, L S Rockefeller, one of whose earliest investments was in Eastern Airlines, which is now defunct but was one of the earliest commercial airlines. In the mid-1950s, the U.S. federal government wanted to speed the development of advanced technologies. In 1957, the Federal Reserve System conducted a study that concluded that a shortage of entrepreneurial financing was a chief obstacle to the development of what it called "entrepreneurial businesses." As a response this a number of Small Business Investment Companies (SBIC) were established to "leverage" their private capital by borrowing from the federal government at belowmarket interest rates. Soon commercial banks were allowed to form SBICs and within four years, nearly 600 SBICs were in operation. At the same time a number of venture capital firms were forming private partnerships outside the SBIC format. These partnerships added to the venture capitalists toolkit, by offering a degree of flexibility that SBICs lack. Within a decade, private venture capital partnerships passed SBICs in total capital under management. The 1960s saw a tremendous bull IPO market that allowed venture capital firms to demonstrate their ability to create companies and produce huge investment returns. For example, when Digital Equipment went public in 1968 it provided ARD with 101% annualized Return on Investment (ROI). The US$70,000 Digital invested to start the company in 1959 had a market value of US$37mn. As a result, venture

capital became a hot market, particularly for wealthy individuals and families. However, it was still considered too risky for institutional investors. In the 1970s, though, venture capital suffered a double-whammy. First, a red-hot IPO market brought over 1,000 venture-backed companies to market in 1968, the public markets went into a seven-year slump. There were a lot of disappointed stock market investors and a lot of disappointed venture capital investors too. The late 1980s marked the transition of the primary source of venture capital funds from wealthy individuals and families to endowment, pension and other institutional funds. The surge in capital in the 1980s had predictable results. Returns on venture capital investments plunged. Many investors went into the funds anticipating returns of 30% or higher. That was probably an unrealistic expectation to begin with. The consensus today is that private equity investments generally should give the investor an internal rate of return something to the order of 15% to 25%, depending upon the degree of risk the firm is taking. However, by 1990, the average long-term return on venture capital funds fell below 8%, leading to yet another downturn in venture funding. Disappointed families and institutions withdrew from venture investing in droves in the 1989-91 period. The economic recovery and the IPO boom of 1991-94 have gone a long way towards reversing the trend in both private equity investment performance and partnership commitments. In 1998, the venture capital industry in the United States continued its seventh straight year of growth. It raised US$25bn in committed capital for investments by venture firms, who invested over US$16bn into domestic growth companies in all sectors, but primarily focused on information technology.
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CLASSIFICATION OF VENTURE CAPITAL
Venture funds in India can be classified on the basis of
1. Genesis
Financial Institutions Led By ICICI Ventures, RCTC, ILFS, etc.
Private venture funds like Indus, etc.
Regional funds like Warburg Pincus, JF Electra (mostly operating out of Hong Kong).
Regional funds dedicated to India like Draper, Walden, etc. Offshore funds like Barings, TCW, HSBC, etc. Corporate ventures like Intel.
To this list we can add Angels like Sivan Securities, Atul Choksey (ex Asian Paints) and others. Merchant bankers and NBFCs who specialized in "bought out" deals also fund companies. Most merchant bankers led by Enam Securities now invest in IT companies. 1. Investment Philosophy Early stage funding is avoided by most funds apart from ICICI ventures, Draper, SIDBI and Angels. Funding growth or mezzanine funding till pre IPO is the segment where most players operate. In this context, most funds in India are private equity investors. 2. Size Of Investment The size of investment is generally less than US$1mn, US$1-5mn, US$510mn, 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. 3. Value Addition The venture funds can have a totally "hands on" approach towards their investment like Draper or "hands off" like 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.
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However, in addition to the organized sector, there are a number of players operating in India whose activity is not monitored by the association. Add together the infusion of funds by overseas funds, private individuals, angel investors and a host of financial intermediaries and the total pool of Indian Venture Capital today, stands at Rs50bn, according to industry estimates! The primary markets in the country have remained depressed for quite some time now. In the last two years, there have been just 74 initial public offerings (IPOs) at the stock exchanges, leading to an investment of just Rs14.24bn. Thats less than 12% of the money raised in the previous two years. That makes the conservative estimate of Rs36bn invested in companies through the Venture Capital/Private Equity route all the more significant. Some of the companies that have received funding through this route include:
Mastek, one of the oldest software houses in India Geometric Software, a producer of software solutions for the CAD/CAM market

Microland, networking hardware and services company based in Bangalore
Satyam Infoway, the first private ISP in India Rediff on the Net, Indian website featuring electronic shopping, news, chat, etc
Planetasia.com, Microlands subsidiary, one of Indias leading portals
Though the infotech companies are among the most favored by venture capitalists, companies from other sectors also feature equally in their portfolios. The healthcare sector with pharmaceutical, medical appliances and biotechnology industries also get much attention in India. With the deregulation of the telecom sector, telecommunications industries like Zip Telecom and media companies like UTV and Television Eighteen have joined the list of favorites. So far, these trends have been in keeping with the global course.
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ANGELS
Angels are important links in the entire process of venture capital funding. This is because they support a fledging enterprise at a very early stage sometime even before commercialization of the product or service offering. Typically, an angel is an experienced industry-bred individual with high net worth. Angels provide funding by "first round" financing for risky investments risky because they are a young /start-up company or because their financial track record is unstable. This venture capital financing is typically used to prepare the company for "second round" financing in the form of an initial public offering (IPO). Example A company may need "first round" financing to develop a new product line, (viz. a new drug which would require significant research & development funding) or make a strategic acquisition to achieve certain levels of growth & stability. It is important to choose the right Angel because they will sit on the Board of Directors, often for the duration of their investment and will assist in getting "second round" financing. When choosing an 'Angel', it is imperative to consider their experience in a relevant industry, reputation, qualifications and track record. Angels are people with less money orientation, but who play an active role in making an early-stage company work. They are people with enough hands-on experience and are experts in their fields. They understand the field from an operational perspective. An entrepreneur needs this kind of expertise. He also needs money to make things happen. Angels bring both to the table of an entrepreneur. There are a number of professionally qualified people, especially from IITs who had migrated to USA. Some of them have made their millions riding the IT boom in Silicon Valley. Having witnessed the maturity of the Silicon Valley into the global tech hotspot and thrived in the environment there, these individuals are rich in terms of financial resources and experience. They are the latest angels in the Indian industry. The IndUS Entrepreneurs (TiE), a networking society that brings together highly influential Indians across the US was set up in 1992. The aim of the organization is to get the community together and to foster entrepreneurs and wealth creation.
INCUBATORS
Incubators are mostly non-profit entities that provide value added advisory, informational and certain support infrastructure, which includes productive office environment, finance and complementary resources. Government or professional organizations seeking to develop small enterprises in a particular area mostly promote incubators. Some times venture capital funds also have their own incubators and companies also set up in-house incubators. Incubators support the entrepreneur in the pre-venture capital stage, that is, when he wants to develop the idea to a viable commercial proposition that could be financed and supported by a venture capitalist.
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WHAT RISKS DOES THE VENTURE CAPITALIST LOOK AT?
The focus of venture capital is a commercial one. They should not be confused with those who have a mission to provide basic research. Consequently, venture capitalists want to know, whether an innovation or invention fits in the marketplace or an innovation offers sustained advantage or whether it will be enough to warrant building a business based on an invention/innovation. These judgements are made on the basis of the risk profile of the project. Usually, venture capitalists use the four risk-related criteria namely market risk, financial risk, technology risk and management risk to evaluate both the strengths of an innovation and the ability of the entrepreneur to commercialize that. Although inventors sometimes overlook these risks, they should all be addressed before a venture capitalist is approached. If these risks are well understood by entrepreneurs, financial backing will be much easier to obtain. The Market Risk This criterion helps venture capitalists determine whether the technology or product addresses a significant "want" in the marketplace, what the competition is, whether the market is large enough to yield high returns on the investment. When a venture capitalist first looks at a project, the initial question is what is the problem solved by this technology or product? Technology-driven business development, in which technology is in search of an application, presents difficult problems. Introducing new technology and simultaneously creating a new market is near impossible. The high failure rate of projects is well known to venture capitalists although there are exceptional successes and these exceptions provide exceptional returns on investment. An entrepreneur with a technology that clearly lacks a demonstrated market is in a difficult position for obtaining financing. In the absence of a demonstrable market, all entrepreneurs are strongly advised to thoroughly demonstrate a problem that the technology can address. Venture capitalists are aware that the entrepreneur's analysis and identification of the market is generally inadequate. Entrepreneurs are not marketing executives; nevertheless they must understand the market potential of, and the competitive threats to the successful commercialization of their inventions. Market segmentation, competitive analysis, and market sizing are important pieces of analysis that must accompany every entrepreneurs overture to an investor. Without these analyses, no framework exists within which to determine the value of an invention. The Financial Risk
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This criterion helps the venture capitalists to determine the amount of capital needed to achieve a sustainable market position and the potential sources of capital required by the project in addition to initial venture capital investments. Most venture capitalists not only want to know what market share can be potentially attained by the product, but what cash flow can be expected and when. The timing and method of returning invested capital called, as exit (e.g., through an initial public offering or acquisition) is important consideration for the venture capitalist. Hence, the entrepreneur should thoroughly research the market, the likely costs to enter the market, and the alternative scenario for providing investors with returns on their investments. The Technology Risk This criterion enables investors to evaluate the proprietary aspects of technology, including patent position and ownership, further development work to get to the first product, assess manufacturability, and assess the potential of the technology's application. Establishing a proprietary position early in a technology's history is important because proprietary technology is what the entrepreneur is selling, and technology determines the value of business. The entrepreneur must be able to defend work that that was independently created. Ultimately, the entrepreneur's goal is to ensure that all the necessary steps are taken to segregate the development of new technology from all resources that could potentially claim ownership. Other aspects of technology risk, such as the technical feasibility and obsolescence, are typically well understood these should also be presented clearly in a proposal for funding. The Management Risk This criterion enables investors to determine the strengths and weaknesses of the entrepreneur or founding team, whether more managerial support is required; whether effective working relationships can be established, and whether the commercial objectives and expectations of the entrepreneur and the venture capitalist match. The problems that venture capitalists experiences rarely result from a technology failure or poor market exploitation but human resources issues, particularly higher level management problems, is the primary cause of failure. A problematic investment scenario is of an inventorturned entrepreneur who distrusts business partners and has limited business experience.
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CORPORATE VENTURING
Even though corporate venturing is an attractive alternative, most companies find it difficult to establish systems, capabilities and cultures that make good venture capital firms. Corporate managers seldom have the same freedom to fund innovative projects or to cancel them midstream. Their skills are honed for managing mature businesses and not nurturing start up companies. If a firm is to apply the venture capital model, it must understand the characteristics of the model and tailor its venture capital program to its own circumstances without losing sight of these essentials. Success of venture capital firms rest on the following characteristics: Focus on specific industry niches and look for business concepts that will Although corporate managers have a clear focus in their business, they run into ambiguity with venture programs. Their biggest challenge is to establish clear, prioritized objectives. Simply making a good financial return is not sufficient.
Manage portfolios ruthlessly; abandon losers, whereas abandoning ventures has never been easy for large corporations, whose projects are underpinned by personal relationships, political concerns.
Venture capital firms share several attributes with start up they fund. They tend to be small, flexible and quick to make decisions. They have flat hierarchies and rely heavily on equity and incentive pay.
Apple Computers established a venture fund in 1986 with the dual objectives of earning high financial return and supporting development of Macintosh software. They structured compensation mechanisms, decision criteria and operating procedures on those of top venture capital firms. While they considered Macintosh as an initial screening factor, its funding decisions were aimed at optimizing financial returns. The result was an IRR of 90 per cent but little success in improving the position of Macintosh. New ventures can be powerful source of revenues, diversification and flexibility in rapidly changing environments. The company should create an environment that encourages venturing. An innovative culture cannot be transplanted but must evolve within the company. Venture investing requires different mindset from typical corporate investors. How relevant is corporate venturing in the Indian scenario? The firms, which launched the successful corporate ventures had created new products in the market operating at the higher end of the value chain and had attained a certain size in the market. Most Indian companies are yet to move up the value chain and consolidate their position as players in the global market. Corporate venturing models would probably benefit Indian companies who are large players in the Indian market in another five to 10 years by enabling them to diversify and at the same time help start up companies. Multinationals led by Intel are the best examples of corporate venturing in an Indian context. Zarna Meswani MFM, NMIMS
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THE VENTURE CAPITAL PROCESS
Venture capitalists are a busy lot. This chapter aims to highlight the approach to an investor and the entire process that goes into the wooing the venture capital with your plan. First, an entrepreneur needs to work out a business plan. The business plan is a document that outlines the management team, product, marketing plan, capital costs and means of financing and profitability statements. The venture capital investment process has variances/features that are context specific and vary from industry, timing and region. However, activities in a venture capital fund follow a typical sequence. The typical stages in an investment cycle are as below:

Generating a deal flow Business Plan Development Due diligence Investment valuation Pricing and structuring the deal Value Addition and monitoring Exit
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Generating A Deal Flow In generating a deal flow, the venture capital investor creates a pipeline of deals or investment opportunities that he would consider for investing in. This is achieved primarily through plugging into an appropriate network. The most popular network obviously is the network of venture capital funds/investors. It is also common for venture capitals to develop working relationships with R&D institutions, academia, etc, which could potentially lead to business opportunities. Understandably the composition of the network would depend on the investment focus of the venture capital funds/company. Thus venture capital funds focussing on early stage technology based deals would develop a network of R&D centers working in those areas. The network is crucial to the success of the venture capital investor. It is almost imperative for the venture capital investor to receive a large number of investment proposals from which he can select a few good investment candidates
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finally. Successful venture capital investors in the USA examine hundreds of business plans in order to make three or four investments in a year. It is important to note the difference between the profile of the investment opportunities that a venture capital would examine and those pursued by a conventional credit oriented agency or an investment institution. By definition, the venture capital investor focuses on opportunities with a high degree of innovation. The deal flow composition and the technique of generating a deal flow can vary from country to country. In India, different venture capital funds/companies have their own methods varying from promotional seminars with R&D institutions and industry associations to direct advertising campaigns targeted at various segments. A clear pattern between the investment focus of a fund and the constitution of the deal generation network is discernible even in the Indian context. Business Plan Development Creating the business plan is the most important part of the venture capital process. Often a venture capitalist will look at the business plan first, and will then decide whether or not to proceed to actual discussion about funding the business venture. If the business plan is unorganized and poorly thought out, the business would never attract funding. An investor must be sold on the business plan and agree with the company's vision. Using the following points can convince a venture capitalist: The Company's business purpose, objectives, history, legal structure, and ownership. The product or service's general description, technical specifications, and proprietary position. The companys competitive advantages, such as management team strengths, market opportunity, product/service uniqueness and sustainability, and the business model. Operational Strategy: operational plans, strategic partners, and government regulations. An industry overview, detailing the description, structure, and size of targeted industry and markets. Description, segmentation, and size of targeted and future customer groups. Current and potential competitors, including their positioning and advantages. The company's marketing strategy, advertising, promotion, public relations, and media programs. Sales Strategy: distribution channels and strategic partnering. Revenue model - pricing and volume assumptions and revenue streams. Zarna Meswani MFM, NMIMS
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Financial statements for 3 to 5 years of key historical and projected statements of income, statements of cash flow, and balance sheets. Amount and timing of past capital investments and the type of provider. Amount of capital required for existing and future rounds; in addition to the distribution of the required capital. Exit Strategy- description and timeframe of probable liquidity event, such as an IPO or acquisition. Executive Officers/Senior Management/Board of Directors' professional and academic experience. Future Staffing: expansion and succession plans for key staff. Professional venture capital providers receive hundreds of investment opportunities a year, but they don't have the time or resources to read every corresponding business plan. They typically request and review the business plan's "executive summary" to expeditiously determine if the investment opportunity meets their investment preferences and has potential for success. Due Diligence Due diligence is the industry jargon for all the activities that are associated with evaluating an investment proposal. It includes carrying out reference checks on the proposal related aspects such as management team, products, technology and market. The important feature to note is that venture capital due diligence focuses on the qualitative aspects of an investment opportunity. It is also not unusual for venture capital fund/companies to set up an investment screen. The screen is a set of qualitative (sometimes quantitative criteria such as revenue are also used) criteria that help venture capital funds/companies to quickly decide on whether an investment opportunity warrants further diligence. Screens can be sometimes elaborate and rigorous and sometimes specific and brief. The nature of screen criteria is also a function of investment focus of the firm at that point. Venture capital investors rely extensively on reference checks with leading lights in the specific areas of concern being addressed in the due diligence. A venture capitalist tries to maximize the upside potential of any project. He tries to structure his investment in such a manner that he can get the benefit of the upside potential i.e. he would like to exit at a time when he can get maximum return on his investment in the project. Hence his due diligence appraisal has to keep this fact in mind.
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New Financing Sometimes, companies may have experienced operational problems during their early stages of growth or due to bad management. These could result in losses or cash flow drains on the company. Sometimes financing from venture capital may end up being used to finance these losses. They avoid this through due diligence and scrutiny of the business plan. Inter-Company Transactions When investments are made in a company that is part of a group, inter-company transactions must be analyzed. Investment Valuation The investment valuation process is an exercise aimed at arriving at an acceptable price for the deal. Typically in countries where free pricing regimes exist, the valuation process goes through the following steps: Evaluate future revenue and profitability
Forecast likely future value of the firm based on experienced market capitalization or expected acquisition proceeds depending upon the anticipated exit from the investment. Target an ownership position in the investee firm so as to achieve desired appreciation on the proposed investment. The appreciation desired should yield a hurdle rate of return on a Discounted Cash Flow basis. NPV = [(Cash)/(Post)] x [(PAT x PER)] x k, where
Symbolically the valuation exercise may be represented as follows:
NPV = Net Present Value of the cash flows relating to the investment comprising outflow by way of investment and inflows by way of interest/dividends (if any) and realization on exit. The rate of return used for discounting is the hurdle rate of return set by the venture capital investor. Cash represents the amount of cash being brought into the particular round of financing by the venture capital investor. Pre is the pre-money valuation of the firm estimated by the investor. While technically it is measured by the intrinsic value of the firm at the time of raising capital. It is more often a matter of negotiation driven by the ownership of the company that the venture capital investor desires and the ownership that founders/management team is prepared to give away for the required amount of capital
Post = Pre + Cash

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PAT is the forecast Profit after tax in a year and often agreed upon by the founders and the investors (as opposed to being arrived at unilaterally)? It would also be the net of preferred dividends, if any. PER is the Price-Earning multiple that could be expected of a comparable firm in the industry. It is not always possible to find such a comparable fit in venture capital situations. That necessitates, therefore, a significant degree of judgement on the part of the venture capital to arrive at alternate PER scenarios.
K is the present value interest factor (corresponding to a discount rate r) for the investment horizon. It is quite apparent that PER time PAT represents the value of the firm at that time and the complete expression really represents the investors share of the value of the investee firm. The following example illustrates this framework: Example: Best Mousetrap Limited (BML) has developed a prototype that needs to be commercialized. BML needs cash of Rs2mn to establish production facilities and set up a marketing program. BML expects the company will go public in the third year and have revenues of Rs70mn and a PAT margin of 10% on sales. Assume, for the sake of convenience that there would be no further addition to the equity capital of the company.
Prudent Fund Managers (PFM) propose to lead a syndicate of like minded investors with a hurdle rate of return of 75% (discounted) over a five year period based on BMLs sales and profitability expectations. Firms with comparable sales and profitability and risk profiles trade at 12 times earnings on the stock exchange. The following would be the sequence of computations: In order to get a 75% return p.a. the initial investment of Rs2 million must yield an accumulation of 2 x (1.75)5 = Rs32.8mn on disinvestment in year 5. BMLs market capitalization in five years is likely to be Rs (70 x 0.1 x 12) million = Rs84mn. Percentage ownership in BML that is required to yield the desired accumulation will be (32.8/84) x 100 = 39% Therefore the post money valuation of BML At the time of raising capital will be equal to Rs (2/0.39) million = Rs5.1 million which implies that a pre-money valuation of Rs3.1 million for BML Another popular variant of the above method is the First Chicago Method (FCM) developed by Stanley Golder, a leading professional venture capital manager. FCM assumes three possible scenarios success, sideways survival and failure. Outcomes under these three scenarios are probability weighted to arrive at an expected rate of return: In reality the valuation of the firm is driven by a number of factors. The more significant among these are: Overall economic conditions: A buoyant economy produces an optimistic long- term outlook for new products/services and therefore results in more liberal pre-money valuations. Zarna Meswani MFM, NMIMS
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Demand and supply of capital: when there is a surplus of venture capital of venture capital chasing a relatively limited number of venture capital deals, valuations go up. This can result in unhealthy levels of low returns for venture capital investors. Specific rates of deals: such as the founders/management teams track record, innovation/ unique selling propositions (USPs), the product/service size of the potential market, etc affects valuations in an obvious manner. The degree of popularity of the industry/technology in question also influences the pre-money. Computer Aided Skills Software Engineering (CASE) tools and Artificial Intelligence were one time darlings of the venture capital community that have now given place to biotech and retailing. The standing of the individual venture capital Well established venture capitals who are sought after by entrepreneurs for a number of reasons could get away with tighter valuations than their less known counterparts. Investors considerations could vary significantly. A study by an American venture capital, VentureOne, revealed the following trend. Large corporations who invest for strategic advantages such as access to technologies, products or markets pay twice as much as a professional venture capital investor, for a given ownership position in a company but only half as much as investors in a public offering.
Valuation offered on comparable deals around the time of investing in the deal. Quite obviously, valuation is one of the most critical activities in the investment process. It would not be improper to say that the success for a fund will be determined by its ability to value/price the investments correctly.
Sometimes the valuation process is broadly based on thumb rule metrics such as multiple of revenue. Though such methods would appear rough and ready, they are often based on fairly well established industry averages of operating profitability and assets/capital turnover ratios Such valuation as outlined above is possible only where complete freedom of pricing is available. In the Indian context, where until recently, the pricing of equity issues was heavily regulated, unfortunately valuation was heavily constrained.
Structuring A Deal Structuring refers to putting together the financial aspects of the deal and negotiating with the entrepreneurs to accept a venture capitals proposal and finally Zarna Meswani MFM, NMIMS
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closing the deal. To do a good job in structuring, one needs to be knowledgeable in areas of accounting, cash flow, finance, legal and taxation. Also the structure should take into consideration the various commercial issues (i.e. what the entrepreneur wants and what the venture capital would require to protect the investment). Documentation refers to the legal aspects of the paperwork in putting the deal together. The instruments to be used in structuring deals are many and varied. The objective in selecting the instrument would be to maximize (or optimize) venture capitals returns/protection and yet satisfy the entrepreneurs requirements. The instruments could be as follows:
Instrument Loan
Issues Clean vs. secured Interest bearing vs. non interest bearing Convertible Vs one with features (warrants) 1st Charge, 2nd Charge, Loan vs. loan stock Maturity
Preference shares
Redeemable (conditions under Company Act) Participating par value nominal shares
Warrants Common shares
exercise price, expiry period new or vendor shares
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par value partially-paid shares Options exercise price, expiry period, call, put
In India, straight equity and convertibles are popular and commonly used. Nowadays, warrants are issued as a tool to bring down pricing. A variation that was first used by PACT and TDICI was "royalty on sales". Under this, the company was given a conditional loan. If the project was successful, the company had to pay a % age of sales as royalty and if it failed then the amount was written off. In structuring a deal, it is important to listen to what the entrepreneur wants, but the venture capital comes up with his own solution. Even for the proposed investment amount, the venture capital decides whether or not the amount requested, is appropriate and consistent with the risk level of the investment. The risks should be analyzed, taking into consideration the stage at which the company is in and other factors relating to the project. (E.g. exit problems, etc). Promoter Shares As venture capital is to finance growth, venture capital investment should ideally be used for financing expansion projects (e.g. new plant, capital equipment, and additional working capital). On the other hand, entrepreneurs may want to sell away part of their interests in order to lock-in a profit for their work in building up the company. In such a case, the structuring may include some vendor shares, with the bulk of financing going into buying new shares to finance growth. Handling Directors And Shareholders Loans Frequently, a company has existing director and shareholders loans prior to inviting venture capitalists to invest. As the money from venture capital is put into the company to finance growth, it is preferable to structure the deal to require these loans to be repaid back to the shareholders/directors only upon IPOs/exits and at some mutually agreed period (e.g. 1 or 2 years after investment). This will increase the financial commitment of the entrepreneur and the shareholders of the project. A typical proposal may include a combination of several different instruments listed above. Under normal circumstances, entrepreneurs would prefer venture capitals to invest in equity, as this would be the lowest risk option for the company. However from the venture capitals point of view, the safest instrument, but with the least return, would be a secured loan. Hence, ultimately, what you end up with would be some instruments in between which are sold to the entrepreneur. Monitoring and Follow Up Zarna Meswani MFM, NMIMS
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The role of the venture capitalist does not stop after the investment is made in the project. The skills of the venture capitalist are most required once the investment is made. The venture capitalist gives ongoing advice to the promoters and monitors the project continuously. It is to be understood that the providers of venture capital are not just financiers or subscribers to the equity of the project they fund. They function as a dual capacity, as a financial partner and strategic advisor. Venture capitalists monitor and evaluate projects regularly. They keep a hand on the pulse of the project. They are actively involved in the management of the of the investee unit and provide expert business counsel, to ensure its survival and growth. Deviations or causes of worry may alert them to potential problems and they can suggest remedial actions or measures to avoid these problems. As professional in this unique method of financing, they may have innovative solutions to maximize the chances of success of the project. After all, the ultimate aim of the venture capitalist is the same as that of the promoters the long term profitability and viability of the investee company. Exit One of the most crucial issues is the exit from the investment. After all, the return to the venture capitalist can be realized only at the time of exit. Exit from the investment varies from the investment to investment and from venture capital to venture capital. There are several exit routes, buy-buck by the promoters, sale to another venture capitalist or sale at the time of Initial Public Offering, to name a few. In all cases specialists will work out the method of exit and decide on what are most profitable and suitable to both the venture capitalist and the investee unit and the promoters of the project. At present many investments of venture capitalists in India remain on paper, as they do not have any means of exit. Appropriate changes have to be made to the existing systems in order that venture capitalists find it easier to realize their investments after holding on to them for a certain period of time. This factor is even more critical to smaller and mid sized companies, which are unable to get listed on any stock exchange, as they do not meet the minimum requirements for such listings. Stock exchanges could consider how they could assist in this matter for listing of companies keeping in mind the requirement of the venture capital industry.
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ACCESSING VENTURE CAPITAL

Venture funds, both domestic and offshore, have been around in India for some years now. However it is only in the past 12 to 18 months, they have come into the limelight. The rejection ratio is very high, about 10 in 100 get beyond pre evaluation stage, and 1 gets funded. Venture capital funds are broadly of two kinds - generalists or specialists. It is critical for the company to access the right type of fund, i.e. who can add value. This backing is invaluable as focused/specialized funds open doors, assist in future rounds and help in strategy. Hence, it is important to choose the right venture capitalist. The standard parameters used by venture capitalists are very similar to any investment decision. The only difference being exit. If one buys a listed security, one can exit at a price but with an unlisted security, exit becomes difficult. The key factors which they look for in The Management Most businesses are people driven, with success or failure depending on the performance of the team. It is important to distinguish the entrepreneur from the professional management team. The value of the idea, the vision, putting the team together, getting the funding in place is amongst others, some key aspects of the role of the entrepreneur. Venture capitalists will insist on a professional team coming in, including a CEO to execute the idea. One-man armies are passe. Integrity and commitment are attributes sought for. The venture capitalist can provide the strategic vision, but the team executes it. As a famous Silicon Valley saying goes "Success is execution, strategy is a dream".
The Idea The idea and its potential for commercialization are critical. Venture funds look for a scalable model, at a country or a regional level. Otherwise the entire game would be reduced to a manpower or machine multiplication exercise. For example, it is very easy for Hindustan Lever to double sales of Liril - soap without incremental capital expenditure, while Gujarat Ambuja needs to spend at least Rs4bn before it can increase sales by 1mn ton. Distinctive competitive advantages must exist in the form of scale, technology, brands, distribution, etc which will make it difficult for competition to enter. Valuation Zarna Meswani MFM, NMIMS
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All investment decisions are sensitive to this. An old stock market saying "Every stock is a buy at a price and vice versa". Most deals fail because of valuation expectation mismatch. In India, while calculating returns, venture capital funds will take into account issues like rupee depreciation, political instability, which adds to the risk premia, thus suppressing valuations. Linked to valuation is the stake, which the fund takes. In India, entrepreneurs are still uncomfortable with the venture capital "taking control" in a seed stage project. Exit Without exit, gains cannot be booked. Exit may be in the form of a strategic sale or/and IPO. Taxation issues come up at the time. Any fund would discuss all exit options before closing a deal. Sometimes, the fund insists on a buy back clause to ensure an exit. Portfolio Balancing Most venture funds try and achieve portfolio balancing as they invest in different stages of the company life cycle. For example, a venture capital has invested in a portfolio of companies predominantly at seed stage; they will focus on expansion stage projects for future investments to balance the investment portfolio. This would enable them to have a phased exit. In summary, venture capital funds go through a certain due diligence to finalize the deal. This includes evaluation of the management team, strategy, execution and commercialization plans. This is supplemented by legal and accounting due diligence, typically carried out by an external agency. In India, the entire process takes about 6 months. Entrepreneurs are advised to keep that in mind before looking to raise funds. The actual cash inflow might get delayed because of regulatory issues. It is interesting to note that in USA, at times angels write checks across the table.
VENTURE CAPITAL IN INDIA

VC Scenario
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In the earlier years, individual investors and development financial institutions played the role of venture capitalists in India and entrepreneurs largely depended upon private placements; public offerings and the finance lend by financial institutions. In early seventies, the need to foster venture capital as a source of funding new entrepreneurs and technology was highlighted by the Committee on Development of Small and Medium Enterprises. In spite of some public sector funds being set up, the venture capital activity did not gather momentum. In 1988, the Government of India, based on a study undertaken by the World Bank, announced guidelines for setting up venture capital funds (VCFs). These guidelines were restricted to setting up of VCFs by banks or financial institutions only. Internationally, however, entrepreneurs who are willing to take higher risk, in anticipation of higher returns, usually set up venture capital funds. This is in contrast to banks and financial institutions, which are more averse to risk. The Background In September 1995, Government of India issued guidelines for overseas venture capital investment in India whereas the Central Board of Direct Taxes (CBDT) issued guidelines for tax exemption purposes. (The Reserve Bank of India governs the investment and flow of foreign currency in and out of India.) As a part of its mandate to regulate and to develop the Indian capital markets, Securities and Exchange Board of India (SEBI) framed the SEBI (Venture Capital Funds) Regulations, 1996. Pursuant to the regulatory framework, some domestic VCFs were registered with SEBI. Some overseas investments also came through the Mauritius route. However, the venture capital industry, understood globally as independently managed, dedicated pools of capital that focus on equity or equity linked investments in privately held, high growth companies is still relatively in a nascent stage in India. Figures from the Indian Venture Capital Association (IVCA) reveal that, till 2000, around Rs. 2,200 crore (US$ 500 million) had been committed by the domestic VCFs and offshore funds which are members of IVCA. Figures available from private sources indicate that overall funds committed are around US$ 1.3 billion. Funds that can be invested were less than 50 percent of the committed funds and actual investments were lower still. At the same time, due to economic liberalization and increasing global outlook in India, an increased awareness and interest of domestic as well as foreign investors in venture capital was observed. While only 8 domestic VCFs were registered with SEBI during 1996-98, more than 30 additional funds have already been registered in 2000-01. Institutional interest is growing and foreign venture investments are also on the increase. Given the proper environment and policy support, there is a tremendous potential for venture capital activity in India. The Finance Minister, in the Budget 2000 speech announced, "For boosting high tech sectors and supporting first generation entrepreneurs, there is an acute need for higher investments in venture capital activities." He also said that the guidelines for the registration of venture capital activity with the Central Board of Direct Taxes would be harmonized with those for registration with the Securities and Exchange Board of India. SEBI decided to set up a committee on venture capital to identify the impediments and suggest suitable measures to facilitate the growth of venture capital activity in Zarna Meswani MFM, NMIMS
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India. Keeping in view the need for global perspective, it was decided to associate Indian entrepreneur from Silicon Valley in the committee. The setting up of this committee was primarily motivated by the need to play a facilitating role in tune with the mandate of SEBI, to regulate as well as develop the market. The committee headed by K. B. Chandrasekhar, Chairman, Exodus Communications Inc., submitted its report on 8 January 2000. In his Budget Proposals 2000-01, the Finance Minister announced new regime for venture capital funds. And proclaimed SEBI as the single point nodal agency for registration and regulation of both domestic and overseas venture capital funds. The new regime stipulated that no approval of venture capital funds by tax authorities would be required and that the principle of "pass through" would be applied in tax treatment of venture capital funds. Recently, the Government of India has also announced the "exit policy" for venture capitalists. The venture capital industry in India is still at a nascent stage. With a view to promote innovation, enterprise and conversion of scientific technology and knowledge-based ideas into commercial production, it is very important to promote venture capital activity in India. Indias recent success story in the area of information technology has shown that there is a tremendous potential for growth of knowledge-based industries. This potential is not only confined to information technology but is equally relevant in several areas such as biotechnology, pharmaceuticals and drugs, agriculture, food processing, telecommunications, services, etc. Given the inherent strength by way of its skilled and cost competitive manpower, technology, research and entrepreneurship, with proper environment and policy support, India can achieve rapid economic growth and competitive global strength in a sustainable manner. A flourishing venture capital 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. The gap exists because such startups are necessarily based on intangible assets such as human capital and on a technology-enabled mission, often with the hope of changing the world. Very often, they use technology developed in university and government research laboratories that would otherwise not be converted to commercial use. 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. Along with this finance came smart advice, hand-on management support and other skills that helped the entrepreneurial vision to be converted to marketable products. India is a significant case study for a number of reasons. First, in contrast to the U.S., India had a history of state-directed institutional development that is similar, Zarna Meswani MFM, NMIMS
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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 emigrated to the U.S. 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 began to change after 1985, and continues to change. In the U.S. and in India the development of venture capital has been a coevolutionary 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. The actual development of the Indian venture capital is set forth chronologically. The first period is when government and multilateral lending agencies are the primary actors and investors in the Indian venture capital industry. The second period is the result of an increasing liberalization of the venture capital market and the entrance of more private venture capitalists particularly from the U.S. The final sections reflect upon the progress of the Indian venture capital industry, while also highlighting the institutional barriers to continuing expansion.
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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. Despite its many 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. The Indian Financial System India has a large, sophisticated financial system including private and public, formal and informal actors. In addition to formal financial institutions, informal institutions such as family and moneylenders are important sources of capital. India has substantial capital resources; 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 14 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, ever-strengthening 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 inflation rate. Also the banks lend only to safe customers or the big conglomerates. Thus the Indian banks did not provide funds for the small entrepreneurial firms.
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Equity The first Indian stock markets were established during the British Raj in the nineteenth century. 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 private-sector 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. 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. The reforms and loosening of regulations resulted in an increase in the number of listed companies. 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.
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In terms of experience, India contrasted favorably with most developing countries, which had small, inefficient stock markets listing only established firms. 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. Other Institutional Sources of Funds India has a strong mutual fund sector that began in 1964 with the formation of the Unit Trust of India (UTI), an open-ended mutual fund, promoted by a group of public sector financial institutions. Because UTIs investment portfolio was to consist of longerterm loans, it was meant to offer savers a return superior to bank rates. In keeping with the risk-averse Indian environment, initially UTI invested primarily in longterm corporate debt. However, UTI eventually became the countrys largest public equity owner as well. This was because the government controlled interest rates in order to reduce the borrowing costs of the large manufacturing firms that it owned. These rates were usually set well below market rates, yet UTI and other institutional lenders were forced to lend at these rates. In response, firms started issuing debt that was partially convertible into equity in order to attract institutional funds. Until April 1999, mutual funds were not allowed to invest in venture capital companies. Since then, the mutual funds have been allowed to commit up to 5 percent of their funds as venture capital, either through direct investments or through investment in venture capital firms. However, the mutual funds have not yet overcome their risk-averse nature and invested in venture capital, either directly or indirectly through investment in venture capital funds. Certainly, should the mutual funds decide to invest directly in firms, there would be operational issues regarding the capability of mutual funds to perform the venture capital function. The largest single source of funds for U.S. venture capital funds since the 1980s has been public-and private-sector pension funds. In India, there are large pension funds but they are prohibited from investing in either equity or venture capital vehicles. This means they cannot be a source of capital. In summation, prior to the late 1980s, though India did have a vibrant stock market, the rigid and numerous regulations made it nearly impossible for the existing financial institutions to invest in venture capital firms or to undertake the role of investing in startups. Nearly all of these institutions were politicized, and the government bureaucrats operating them were risk-adverse. On the positive side, there was a stock market with investors amenable to purchasing the equity in fairly early-stage companies. However, no financial intermediaries comfortable with backing small technology-based firms existed prior to the late 1980s. It is safe to say that little capital was available for any entrepreneurial initiatives. Any entrepreneur aiming to create a firm would have to draw upon familial capital or bootstrap their firm.
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THE INDIAN INFORMATION TECHNOLOGY INDUSTRY
An organizations ability to learn, and translate that learning into action rapidly, is the ultimate competitive advantage Jack Welch ex chairman GE. It is this competitive advantage that technology enables corporations with to cope up in a fast changing world. Rapid technological advancements have led to the emergence of what is known as the new economy where electronic media is increasingly used for communication and executing transactions. In this new economy, business takes place at the "speed of thought". The Internet has become an integral part of this business process. Dotcom companies are different from the traditional 'brick and mortar' companies in many ways specifically in terms of their rapidly changing and unpredictable business models as well as the composition of their assets, which are predominately intangible. The investor's need for adequate and timely information is critical than ever before. Quality information is the lifeblood of strong, vibrant markets. Without it, investor confidence erodes. Liquidity dries up. Fair and efficient markets simply cease to exist. As the quantity of information increases exponentially through the Internet and other technologies, the quality of that information must be the single priority. A viable venture capital industry depends upon a continuing flow of investment opportunities capable of growing sufficiently rapidly to the point at which they can be sold yielding a significant annual return on investment. If such opportunities do not exist, then the emergence of venture capital is unlikely. Since Independence, the Indian government had aimed for autarky and the protection of Indian markets and firms from multinational competition guided nearly every policy the information technology industries were no exceptions. In the mid-1970s, the Indian government demanded that IBM reduce the percentage ownership of its Indian operations to 40 percent, but IBM refused and left India in 1978. After this the government gave the state-run Computer Maintenance Corporation "a legal monopoly to service all foreign systems". IBM's retreat released 1,200 software personnel into the Indian market, and some of these established small software houses. The protectionist policy had benefits and costs. The benefit was that it contributed to the creation of an Indian IT industry; the cost was that the industry was backward despite the excellence of its personnel. After IBMs withdrawal, there was little further interest by multinational firms in the Indian market. Due to this lack of foreign investment and despite the presence of skilled Indian personnel, India was a technological backwater even while East Asia progressed rapidly. In 1984, in response to the failure of the government-run computer firms and the success of private firms such as Wipro, HCL, and Tata Consultancy Services, the Indian government began to liberalize the computer and software industry by encouraging exports. This was particularly timely because there was a worldwide shortage of software programmers. In 1986 Texas Instruments received government permission to establish a 100-percent foreign-owned software subsidiary in India. The excellence of the Indian personnel, Zarna Meswani MFM, NMIMS
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which was due, in large measure, to a wise decision in the 1960s by the government to increase its investments in education, soon attracted other foreign software engineering operations to India. Contemporaneously, entrepreneurs exploited the labor cost differential to "body-shop" Indian programmers overseas. By 1989, this accounted for over 90 percent of software revenues. The body shopping and the foreign-owned engineering operations provided a conduit through which Indian engineers could learn about the cutting-edge software techniques and developments in the West and particularly Silicon Valley. These activities created a network of contacts and an awareness of the state-of-the-art in global computing and software technology. By the early 1990s, Indian firms also began the development of a market for off-site contract programming. This market grew impressively in the 1990s, as shown below.
STATISTICS - IT INDUSTRY IN INDIA US US US US $MIO $MIO $MIO $MIO SOFTWARE 670 950 1083 1750 1753 2700
US $MIO
DOMESTIC EXPORTS TOTAL
350 485 835
490 734 1224
1250 2690 3940
590 177 767
HARDWARE 1037 1050 1205 35 286 201 1072 1336 1406 PERIPHERALS 196 181 229 6 14 19 202 195 248 OTHERS 183 182 156 521 3805
1026 4 1030
148 6 154
329 18 347
TRAINING MAINTAINANCE NETWORKING AND OTHERS TOTAL GRAND TOTAL
107 142 36 285 2041
145 172 710 1027 3525
263 221 193 677 5031
302 236 237 775 6092
Moreover, the percentage of on-site contract programming revenues fell from 90 percent in 1988 to 45 percent in 19992000 (NASSCOM 1998). Still, because an additional 35 percent of work is off-site contract programming, low value-added services remain dominant. High value-added next-stage businesses, including turnkey projects, consultancy and transformational outsourcing make up the balance, and branded product development for the export market is negligible. A Zarna Meswani MFM, NMIMS
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few of these firms, particularly Infosys and Wipro, grew to be quite large both in terms of manpower and revenue. They were successful on the Indian stock market in the 1990s, and in the late 1990s they listed their stock on the U.S. NASDAQ. Interestingly, in contrast to Taiwan, Korea, and, increasingly, China, the Indian hardware sector remains negligible, although there have been a few notable recent successes, such as Armedia and Ramp Networks.
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OBJECTIVE AND VISION FOR VENTURE CAPITAL IN INDIA
Venture Capital funding is different from traditional sources of financing. Finance innovation ideas have potential for high growth but with inherent uncertainties. This makes it a high-risk, high return investment for venture capitalists. Apart from finance, venture capitalists provide networking, management and marketing support as well. In the broadest sense, therefore, venture capital connotes risk finance as well as managerial support. In the global venture capital industry, investors and funded firms work closely together in an enabling environment that allows entrepreneurs to focus on value creating ideas and venture capitalists to drive the industry by the levers of control in return for the provision of capital, skills, information and complementary resources. Scientific, technological and knowledge-based ideas properly supported by venture capital can be propelled into a powerful engine of economic growth and wealth creation in a sustainable manner. In various developed and developing economies venture capital has played a significant developmental role. India, along with Israel, Taiwan and the United States, is recognized for its globally competitive high technology and human capital. The success India has achieved particularly in software and information technology against several odds such as inadequate infrastructure, expensive hardware, restricted access to foreign resources and limited domestic demand, is a pointer to the hidden potential it has in the field of knowledge and technology based industry. India has the second largest English speaking scientific and technical manpower in the world. Given this quality and magnitude of human capital India's potential to create enterprises is unlimited. The market capitalization of the listed software companies comprises of approximately 25 percent of the total market capitalization. Also greater visibility of the Indian companies globally is evident. Given such vast potential, which is, not only confined to IT and software but also in other sectors like biotechnology, telecommunications, media and entertainment, medical and health etc., venture capital industry is playing and shall continue to play a catalyst's role in industrial development. Thus, venture capital is valuable not only because it makes risk capital available at the early stages of a project but also because of the expertise of venture capitalist that leads to superior product development. And the big focus of venture capital worldwide is - technology. VCs as a whole invested US$ 79.9 billion in the first three-quarters of 2000, a 137 percent increase over the corresponding period during 1999. Out of this, technology firms reportedly got around 75 percent. Besides this huge supply from organized venture funds there is an even larger pool of "angel" funds provided by private investors.
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CRITICAL FACTORS FOR SUCCESS OF VENTURE CAPITAL INDUSTRY IN INDIA
In 1999, SEBI (Securities and Exchange Board of India) had set up a committee under the Chairmanship of Mr. K. B. Chandrasekhar to look into the issues of venture capital in India. The Report of the K. B. Chandrasekhar Committee on venture capital identified the following as critical factors for the success of VC industry in India: The regulatory, tax and legal environment should play an enabling role. This emphasizes the facilitating and promotional role of regulation. Internationally, venture funds have evolved in an atmosphere of structural flexibility, fiscal neutrality and operational adaptability. And we need to provide regulatory simplicity and structural flexibility on the same lines. There is also the need for a level playing field between domestic and offshore venture capital investors. This has already been done for the mutual fund industry in India. Investment, management and an exit option should provide flexibility to suit the business requirements and should also be driven by global trends. Venture capital investments have typically come from high net worth individuals who have risk taking capacity. Since high risk is involved in venture financing, venture investors globally seek investment and exit on very flexible terms, which provides them with certain levels of protection. Such exit should be possible through IPOs and mergers / acquisitions on a global basis and not just within India. There is also the need for identifying and increasing the domestic pool of funds for venture capital investment. In US, apart from high net worth individuals and angel investors, pension funds, insurance funds, mutual funds etc. provides a very big source of money. The share of corporate funding is also increasing and it was as high as 25.9 percent in the year 1998 as compared to 2 percent in 1995. Corporations are also setting up their own venture capital funds. Similar avenues need to be identified in India also. With increasing global integration and mobility of capital it is important that Indian venture capital firms as well as venture financed enterprises be able to have opportunities for investment abroad. This would not only enhance their ability to generate better returns but also add to their experience and expertise to function successfully in a global environment. We need our enterprises to become global and create their own success stories. Therefore, automatic, transparent and flexible norms need to be created for such investments by domestic firms and enterprises. Venture capital should become an institutionalized industry financed and managed by successful entrepreneurs, professional and sophisticated investors. Globally, venture capitalists are not merely finance providers but are also closely involved with the investee enterprises and provide expertise by way of management and marketing support. This industry has developed its own ethos and culture. Venture capital has only one common aspect that cuts across geography i.e. it is risk capital invested by experts in the field. It is important that venture capital in India be allowed to develop via professional and institutional management
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Infrastructure development also needs to be prioritized using government support and private management. This involves creation of technology as well as knowledge incubators for supporting innovation and ideas. R&D also need to be promoted by government as well as other organizations. The above report was well received by the Government and few issues have already been resolved.
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Venture Capital / Angel Investments for the IT Sector In India, the venture capital creation process has started taking off with all four stages receiving attention: Idea generation Start up Growth ramp up Exit processes
In 2000 alone, 20 new venture capital funds have registered with SEBI, taking the total number to 30. In fact, VC or Angel investments in high tech firms in India have grown by over 5,000 percent from Rs. 70 crore to projected Rs. 2,200 crore between 1996 and 2000. And this figure is expected to grow to Rs. 50,000 crore by 2008. An analysis of financing by investment stages indicate the following figures:
Further, the major contributors to the funds were:
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National Venture Capital Fund for Software and Information Technology Small Industries Development Bank of India (SIDBI), in association with Ministry of Information Technology, Govt. of India, has set up a 10 year close ended venture capital fund called the "National Venture Fund for Software and IT industry" (NFSIT). Many state governments have already set up venture capital funds for the IT sector in partnership with local state financial institutions and SIDBI. These states include Andhra Pradesh, Karnataka, Delhi, Kerala, Gujarat, and Tamil Nadu among others. Recognizing the importance of venture capital, the government introduced major liberalization of tax treatment for venture capital funds and simplification of procedures. These included the following: 1. SEBI was recognized as the single nodal agency. 2. A new clause (23FB) in Section 10 of Income Tax Act was introduced with effect from 1st March 2000. This clause stated that any income, of a venture capital company or a venture capital fund, from any investments made in venture capital undertaking, would not be included in computing the total income. 3. Section 115U was also introduced in the Income Tax Act with effect from the assessment year 2001-02 to establish a VC pass through. This means that the VC profits will not be taxed twice. The regulated VC Fund (with SEBI) would be exempted from tax (subject to certain conditions) but the VC investor will have to pay tax.
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VENTURE CAPITAL ENVIRONMENT IN INDIA
Initiatives/ Guidelines. There have been a number of initiatives by the Government as well as the industry to pave way for a business and regulatory environment that is conducive to new venture development and to innovation at the user end. Some of the initiatives in the past have included those by the Ministry of Finance, the Securities, Exchange Board of India (SEBI), Ministry of Information Technology (formerly Department of Electronics), State Governments, Financial Institutions, the Indian Venture Capital Association and Nasscom. These initiatives resulted in the availability of more than US$ 500 million of venture funds for Indian ventures during 1999-2000. With the growing realization of the immense potential offered by Indian technology companies, funding opportunities are rapidly increasing. The Government of India has already taken laudable steps to facilitate the creation of an environment that is conducive for venture capital funds and start-ups in India. These include: Introduction of sweat equity, Allowing venture capital funds to offset losses incurred in one company Against profits from another And establishment of government facilitated venture capital funds.
However, the present regulatory framework is still not enough to provide for an environment that lays stress on encouraging the flow of venture funds, easy exit options (for either party), mentoring, non-qualified availability of funds, and flow of public funds for enterprise building in India. India needs to encourage the growth of risk capital by acting on three fronts: The Government of India and Indian financial institutions should catalyze the process. This will stimulate competition but also protect entrepreneurs from inevitable risks. India should amend its regulatory framework so that the VC funds can earn a reasonable return on their risk capital.
Focusing on the areas of concern that merit an early redress, NASSCOM has prepared a 15-point action plan to provide a stronger thrust to entrepreneurship and the start-up culture in India. These points have already been taken up with the various Ministries / bodies within the Government of India and the industry. The action plan includes the following: Encourage participation of Provident Funds / Pension Funds etc. The Government must expedite legislation for LLC / LLP
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Venture capital fund to have first charge on company's proceeds, upon liquidation
Learn from the Israel and US experience Small business investment programs Encourage banks IPO norms for IT companies VCFs can partake various forms of funds Exit options Early implementation of OTCEI plans Incubation Engine Intricate linkages with the NRI community Introduction of Entrepreneurial course components Standing Committee of Government-Industry Venture Investment Fairs
Guidelines Issued By SEBI For Venture Capital Firms. The Securities and Exchange Board of India announced a set of venture capital guidelines on 14th Sept 2000. All Venture Capital Funds investing in India will have to be registered with SEBI. SEBI said that venture funds incorporated in India will have to exit a company within a year of it going public, but it could stay invested if it agrees to forego the tax pass through benefit. Foreign funds not incorporated in India will not get a tax pass through. The minimum investment in a Venture Capital Firm (VCF) has been fixed at Rs 5 lakhs. The minimum corpse of the fund will have to be Rs. 5 crore. The maximum a VCF can invest in a company cannot exceed 25 percent of the corpus. Investments in associated companies of the firm invested in are also not permitted. 75 percent of the corpus has to be invested in unlisted securities. The balance could be invested in companies proposed to be listed by way of an IPO subject to a 1-year lock in. Mutual Funds can invest 5 percent of the corpus of an open-ended scheme in a VCF and 10 percent in case of close-ended schemes. This will allow retail investors to invest in VCFs. Stipulating a time period, by which a VCF must exit, will deter a foreign VCF from coming to India.
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Indian Scenario - A Statistical Snapshot
Contributors of Funds Contributors Foreign Institutional Investors All India Financial Institutions Multilateral Development Agencies Other Banks Foreign Investors Private Sector Public Sector Nationalized Banks Non Resident Indians State Financial Institutions Other Public Insurance Companies Mutual Funds Total Rs mn 13,426.47 6,252.90 2,133.64 1,541.00 570 412.53 324.44 278.67 235.5 215 115.52 85 4.5 25,595.17 Per cent 52.46% 24.43% 8.34% 6.02% 2.23% 1.61% 1.27% 1.09% 0.92% 0.84% 0.45% 0.33% 0.02% 100.00%
Methods of Financing Instruments Equity Shares Redeemable Preference Shares Non Convertible Debt Convertible Instruments Other Instruments Rs million 6,318.12 2,154.46 873.01 580.02 75.85 Per cent 63.18 21.54 8.73 5.8 0.75
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Total 10,000.46 100
Financing By Investment Stage Investment Stages Start-up Later stage Other early stage Seed stage Turnaround financing Total Rs million 3,813.00 3,338.99 1,825.77 963.2 59.5 10,000.46 Number 297 154 124 107 9 691
Financing By Industry Industry Industrial products, machinery Computer Software Consumer Related Medical Food, food processing Other electronics Tel & Data Communications Biotechnology Energy related Computer Hardware Miscellaneous Total Rs million 2,599.32 1,832 1,412.74 623.8 500.06 436.54 385.09 376.46 249.56 203.36 1,380.85 10,000.46 Number 208 87 58 44 50 41 16 30 19 25 113 691
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Financing By States Investment Maharashtra Tamil Nadu Andhra Pradesh Gujarat Karnataka West Bengal Haryana Delhi Uttar Pradesh Madhya Pradesh Kerala Goa Rajasthan Punjab Orissa Dadra & Nagar Haveli Himachal Pradesh Pondicherry Bihar Overseas Total Source IVCA Rs million 2,566 1531 1372 1102 1046 312 300 294 283 231 135 105 87 84 35 32 28 22 16 413 9994 Number 161 119 89 49 93 22 22 21 29 2 15 16 11 6 5 1 3 2 3 12 691
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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 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 Zarna Meswani MFM, NMIMS
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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 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 bourse means that most companies are proponing their IPOs. Consequently, the number and quality of deals available to the venture funds gets reduced. Regulatory Issues The aim of this section is to give a bird's eyes view of the various guidelines a venture fund has to adhere to in India. There are a number of rules and regulation for venture capital and these would broadly come under either of the following heads:
The Indian Trust Act, 1882 or the Company Act, 1956 depending on whether the fund is set up as a trust or a company. (In the US, a venture capital firm is normally set up as a limited liability partnership) The Foreign Investment Promotion Board (FIPB) and the Reserve Bank of India (RBI) in case of an offshore fund. These funds have to secure the permission of the FIPB while setting up in India and need a clearance from the RBI for any repatriation of income. The Central Board of Direct Taxation (CBDT) governs the issues pertaining to income tax on the proceeds from venture capital funding activity. The long term capital gains tax is at around 10% in India and the relevant clauses to venture capital may be found in Section 10 (subsection 23). The Securities and Exchange Board of India has come out with a set of guidelines.
In addition to the above there are a number of arms of the Government of India Ministry of Finance that may have to be approached in certain situations. Also intervention allied agencies like the Department of Electronics, the National Zarna Meswani MFM, NMIMS
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Association of Software and Computers (NASSCOM) and various taskforces and standing committees is not uncommon. Probably this explains why most of the funds prefer to take the easy way out by listing as offshore funds operating out of tax havens like Mauritius (where the Avoidance of Double Taxation Treaty, incomes may be freely repatriated).
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SURVEY
In order to supplement the study on venture capital, India Infoline carried out a survey of some of the leading players in the venture capital environment today. As a part of the research, carried out in May and June 1999, 15 investing firms and intermediaries were interviewed about their expectations from the market and 30 promoters, CEOs or CFOs of IT companies were interviewed about their awareness of and perceptions about VC funding. The study was conducted in three cities Mumbai, Pune and Bangalore. The sample comprised of companies engaged in the IT segment job contracting software development, offshore services, on-site development, systems and application software, hardware services and vendoring and training institutes. A combination of judgment and convenience sampling was used and questionnaires were administered to the respondents after taking a prior telephonic appointment. The age-profile of the companies is included below. Company Age Profile Years <1 1-3 3-5 5-10 >10 No. of companies 7 6 9 6 4
What Do Entrepreneurs Expect In A Venture Capital Investment? Venture capital investors boast of bringing more than money to the projects that they fund. This part of the study aimed at eliciting a response from the promoters of the projects about their expectations of a helping hand. Listed below are the most common responses among the sample of IT investors and the percentage of people who agreed with them.
Expectation Assistance in terms of marketing advice, leads, networking Follow on/later stage financing Financial management and strategy Non executive governance Zarna Meswani MFM, NMIMS
Per cent 70% 66% 63% 57%
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Manpower planning, recruitment of personnel Doing away with legal hassles, red tape, bureaucracy Transfer of technology
47% 33% 20%
What Attributes Do Venture Capitalists Look For In A Deal? Unlike the entrepreneurs, the VCs seem to be more in unison as they agree on a few critical success parameters. The respondents have identified the following critical factors.
Attribute Management quality Promoters credentials and track record A focused development strategy A strong proprietary and competitive position A scalable business model An innovative concept, breakthrough technology Measurable milestones in the development strategy
Per cent 100% 86% 80% 73% 60% 40% 27%
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What Is The General Perception Of Venture Capital Investors In India? Entrepreneurs were asked to comment on the current scenario of venture capital and private equity activity in India, with their perceptions regarding the problems/pitfalls associated.
Perception Insensitive to very early stage projects Bankers with little practical technical knowledge Invest only in successful expanding companies Negotiations take too long Do not meet our funding needs (less then $1 million) Making an approach, business plan is difficult Valuations are unfair
Per cent 53% 47% 40% 40% 27% 27% 7%
Would You Consider/have You Considered Venture Capital Funding As A Source Of Capital For Your Project? As pointed out earlier, a large number of these firms have been funded or are currently in the process of working out a deal with venture capital firms. Keeping this in mind, 93% of the respondents proved to be inclined towards venture capital. The alternative to venture capital, not surprisingly was the IPO route.
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DOTCOMS
Definition A Dotcom is any Web site intended for business use and, in some usages, it's a term for any kind of Web site. The term is based on the com that forms the last part of the address for most commercial Web sites. The term is popular in news stories about how the business world is transforming itself to meet the opportunities and competitive challenges posed by the Internet and the World Wide Web. Beginning in mid-2000, as the stock market began to devalue many Internet stocks, the term became associated with a number of Web businesses that failed or suffered cutbacks. Features of dotcoms The business models of Dotcom companies are unpredictable and rapidly changing. Currently, the earnings of many Dotcom companies are negative. Valuations of these companies are often based on the assumption that these Dotcom companies will generate sustainable positive earnings in future. Absence of historical data as most of the Dotcom companies in a very early stage of their life cycle. Absence of comparable companies - Even if the companies operate in the same type of business they may not be comparable because of differences in the products/services provided, stages in their life cycles, size and scale of operations, etc. The "going-concern" assumption may not be valid for Dotcom companies. The continued ability of Dotcom companies to survive often depends on their future fund raising capabilities, through the issue of either debt/equity to meet their future financing requirements. The ability of the Dotcom company to raise funds from the public or private equity/debt markets depends on various factors including the background of the promoters, quality of senior managerial/technical personnel, the markets perception of the viability and soundness of the business model of the Dotcom company, etc. A substantial portion of the assets of Dotcom companies are of an intangible nature and consequently a high degree of uncertainty surrounds their identification of intangible assets and estimated future economic benefits that can be derived from their use. Difficulties in estimating future growth in revenues because of business uncertainties. Lack of availability of customer and usage statistics. Lack of comparable and reliable financial and non-financial data a variety of new valuation models such as price multiples of revenues or net income, discounted cash flows, etc are in use. When such valuation models are prepared with inaccurate underlying accounting and financial information, it may lead to wide distortions. Practice varies amongst Dotcom companies with respect to the definition of revenue, principles of revenue recognition,
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treatment of expenses as pre-paid or intangible assets as opposed to their recognition as period costs, etc.
CLASSIFICATION OF DOTCOMS
Business to Business In these Sites Company link itself with its suppliers and vendors. These sites help a company deal with the other businesses it is dependent upon. This is done by supply chain software, which is an integral part of a companys ERP application. Many B2B sites are company and industry specific catering to a community of users or a combination of forward and backward integration. Companies have achieved huge savings in distribution related costs due to their B2B applications. The example, which comes to mind immediately, is that of CISCO Systems, who sell the networking equipment, which powers the net. The future of B2B Dotcoms is bright with its major advantage being of connectivity. As most business nowadays have there own Webster so communicating with them on net becomes very easy. Secondly B2B also has a major benefit in saving of distribution costs. In developed countries it has come up nicely and giving companies of this category lots of advantage. Business to Consumer This is a direct application from a seller of products to an end consumer. This heavily depends that the customers of the company have access to Internet. In these sites the companies aim is to provide the customer with the information about the products of the companies and gather orders. These sites basically thrive on ability of a company to offer innovative products and convenience to the customers. Amazon.com is a typical example. Future of B2C is still the most vulnerable, with an average burn rate of 15 months compared to 23 months for business to business firms, which offer goods and services to other companies. This difference stems from continuing high marketing expenditure by the consumer-facing firms which, in some cases, equates to more than 400 percent of gross profit, The content and software sectors were weakest, containing the highest number of ``burning'' companies. Consolidation in these areas has continued as companys pair up to weather the storm by growing bigger. B2B may be where the money lies today. But B-to-C is what would propel Internet into a mind-boggling game. We believe that middle game or no middle game; the Internet is going to change our lives like nothing else will. In such a game many will love to join the queue, but in the true tradition of a market economy only the best will survive. Consumer to Business These refer to the applications emanating from a consumer to a business, which are actually consumer items but need a business intermediary. Most of the search engines are operating C to B models. Priceline.com offers named price product Zarna Meswani MFM, NMIMS
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offerings in travel, tickets, holidays etc is another example. The site asks for a price from the customer and goes and finds out the best match for that given price. These sorts of companies like B2C are vulnerable. Key of success in this sort of companies is innovation, ability to come up with a product which could provide value to the customer. Consumer to Consumer C to C applications is the ones involving consumers who deal with each other on the web. They need a site like an online auction site for example to transact with each other. E Bay is an example. Message boards, community sites, chat forums are also C2C applications. These sorts of sites still have to pick up but again the key of success lies in innovation. Various types of Dotcoms can further be classified into following categories: Click N Mortar Making the transition from a Brick and Mortar business to a "Click and Mortar" requires the investigation of all companies, regardless of size. This term is generally used to describe startups which emphasize the use of the Internet and its technologies to re-invent traditional commerce methods or provide new services altogether. Most of these startups promote services and products that were available before industries and their consumers became able to use computers as a global communication tool. To ensure their survival in the rapidly emerging Internet Economy, existing companies must leverage their customer base, brand recognition, and core expertise while efficiently evaluating areas in which the Internet can help their business. These businesses are fortunate in the fact that they can leverage the risks the Dotcoms and their investors have taken. By selecting an Internet development company to partner with a brick and mortar business can rapidly add to it's skill set and begin the transition to a more Internet savvy method of operation. Of course, with the exception of information based services, it will be a significant time before the Dotcoms replace entire industries with pure electronic commerce -- although we've already -- seen major transformation in everything from stock trading to PC sales. While consumers appreciate the touch and appearance of items they are considering for purchase. This desire shall not fade in the near future; from cars to produce, most people enjoy the experience of inspecting the merchandise before putting down their dollars. In the retail sector, existing business are embattled to maintain their market share. Most of these sites lack a complete roster of services that can be found in an actual store. A specific example is that the Brick and Mortars shortchange themselves by offering substantially fewer inventories online than in their stores and their Dotcom competitors. What seems to be generally overlooked is how existing businesses, the Brick and Mortars", are going to make the transition to this new avenue for commerce. Other than a few notable exceptions (Dell and Cisco being the largest), most traditional companies have struggled to integrate the Internet into their already successful operations. In many cases, it becomes the question of bypassing existing sales and distribution channels -Zarna Meswani MFM, NMIMS
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possibly cannibalizing revenue and relationships. Brick and Mortar companies: These terms refer to the existing companies with a website, which is just providing information about the company. The site of these companies is not very interactive and no transaction can take place using that site. Future of these companies more or less depends upon the company standing in its respective business. But a very important issue before this company is that whether they should go for being a click and mortar company or not. Incase they dont go for click and mortar status there is every danger of they being left out and lose business. There is every chance of that happening, so to fight the competition and to get that added advantage these companies would have to go for being a click and mortar company. Internet Startups: These are types of company, which started with the advent of Internet and through Internet. The main idea of these sites was to provide information, entertainment or to sell an idea. There was a proliferation in these sorts of sites in recent times. Many sites cropped up providing info and entertainment to the surfer. But these sites currently are facing major problems. These sites can be classified into two categories: a) Information or entertainment based Companies: which are usually just providing information or entertainment, comes into this category. These companies have links with the various content providers classify the information and provide that information on net. These companies cropped up as Internet become popular and has revenue model based on advertising revenues. These companies are facing major problems due to insufficient revenues from advertising. Along with their revenue model these sorts of companies are also planning to change their business model and plan to offer some sort of product based on the idea their site depend upon. The future of these companies until and unless they change their business and revenue model is bleak. These companies are loosing their exclusivity as lots of companies in the field of providing information and entertainment have cropped up. Other main issue is that their earlier projections of getting revenues on the bases of advertisements are majorly overvalued. Indiainfoline.com is one of the examples of these sorts of Dotcoms providing information. b) Dotcoms having backend services: These companies have some sort of back end service and provide the customers with tangible product. The major aim of these companies is to provide customer with the facility of choosing the product on the net and then to place order, which later is supplied to them. This is along with providing them with both information and entertainment. The future of these sites depends heavily upon the efficiency of their back end services. Though these sites again are not doing very well but there is a future for these sites incase they can come up with a unique idea and are efficiently apply it. Some key lessons for Internet startups to be successful in future are: a) Solve a problem (here's where Ariba succeeded and Industry.net failed) b) Solve a real problem and not an imaginary one (Iridum is a classic failure in this regard) Zarna Meswani MFM, NMIMS
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VALUING DOT.COMS
Valuation of any business has always been complicated. With the growing prominence of service businesses, valuing businesses has become all the trickier. Consider the straightforward issue of valuation of any manufacturing concern. The basic material required for such an exercise is readily available. For example, the financial records of the company, its product line the industry in which it operates its competitive position, etc. But even here, there are a number of thorny issues. For one, what should be the discounting rate? Even experts find it difficult to come to a conclusion on the most appropriate rate of discounting to be applied. Or for that matter, the method of valuation. To twist the tale a little further, what if a steel maker gets into the business of reselling computer hardware? On the other hand, service businesses are a different ball game all together. The investment required to set up a service business is generally far lesser than that required for a manufacturing business. Moreover, predominant assets deployed by service business are intangible. Human capital usually forms a very vital part of such intangible assets. And how do you value human capital? That is the question most accounting bodies the world over are grappling with. The fact is that most traditional parameters used to value companies simply cannot be applied to these new age companies! Most often, these companies operate in technologies. There are no precedents to There are only ideas and more ideas. entrepreneurs diligently implement their businesses. How do you value companies promise of the future? unknown markets and with brand new follow. There are no established norms. Only a very small percentage of the ideas and give birth to path breaking that have had no past and only hold the
It is in this context that valuation of software companies; Internet companies and Dotcoms have come to pose formidable challenges to both regulatory bodies and valuers. Regulators the world over have tried to set some guidelines, which will help in the valuation of such concerns. But don't traditional valuation methods focus on these anyway? Don't the existing statutory requirements necessitate the furnishing of such information through annual reports and statement of results and other declarations to various authorities? The point is this: you cannot differentiate a Dotcom from any another company. Ultimately, every business entity has to create and enhance stakeholder value. Any business that does not do this does not deserve to exist. Hence, all normal disclosure norms and valuation methods should be applied to Dotcom and Internet companies. In fact, only the strict application of investment prudence and normal business principles can safeguard the interests of all involved. For example, the management team factor is said to be the most important ingredient for the success of an Internet company or a Dotcom. Or for that matter, Zarna Meswani MFM, NMIMS
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for any business concern. Any business venture will be on a sticky wicket if its management team is not up to the mark. But, how will statutory norms ensure this? Therefore, regulators need to ensure that all pertinent information that is necessary for all companies disclose informed decision-making. Policy framework, accounting policies to be followed and stringent action plan against defaulters (that are implemented!) the other areas regulatory bodies need to put in place. As far as investors are concerned, one cardinal principle must never be forgotten: caveat emptor! After all, aren't valuation exercises a game of betting on the future? In early 2000, Internet entrepreneurs had succeeded in quickly transforming their business ideas into billion dollar valuations that seemed to defy common wisdom about profits, multiples, and the short tem focus on capital markets. Below mentioned is an attempt to understand how Dotcoms are valued. The most common critique one hears about the valuation of Internet companies is that their values balloon as their loss balloon. This relationship is driven by 2 factors: supernormal growth; and investments running through the income statement. Many Internet related start-ups experience annual growth rates exceeding 100 percent. This hyper-growth when fuelled by investments that have been expensed rather than capitalized will create ever-increasing losses until growth rates slow. Internet companies typically do not require heavy investments of the type that get capitalized, such as factories, plant and equipment, etc. their investment is in customer acquisition, which has to be expensed through the income statement. For e.g., if the acquisition cost per customer, through advertisements and direct mails of CD- ROMs is $40 per customer and a company successfully builds its customer base from 1 million in 1 year to 3 million in the second year, to 6 million in the third year, its acquisition costs will rise from $40 million in the first year to 120 million in the third year. In a bricks and mortar retailer case, much of the customer acquisition costs will comprise of costs consist of securing a store location, furniture fixtures etc. these expenses are largely capitalized and expensed over their useful life. Hence the physical retailer will break even years earlier than the virtual retailer with the same investment. Provided that the virtual retailer will earn a positive net present value on its customer acquisition investments, increasing losses because of accelerating customer acquisition will raise the value of the company. These conditions of super normal growth and investment through the income statement render short hand valuation approaches including price to earnings and revenue multiplies, meaningless. The best way of valuing Internet companies is the DCF (Discounted Cash Flow) approach, which makes the distinction between expensed and capitalized investments unimportant because Accounting treatments dont affect cash flows. The absence of meaningful historical data and positive earnings also dont matter, because the DCF approach relies
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solely on forecasts of performances and can easily capture the worth of value creating businesses that have had several years of initial losses. A three-stage approach is used to make DCF more useful for valuing Internet companies starting from a fixed point in the future and working back to the present using probability- weighted scenarios to address high uncertainty in an explicit way, and exploiting classic analytical techniques to understand the underlying economics of these companies and to forecast their future performance. The above approach is illustrated with a valuation of AMAZON.COM, the archetypal Internet company, as of November 1999. From its launch in 1995 it built a customer base of 10 million and expanded its offerings from books to toys, CDs, videos etc. it also invested in branded Internet players like pet.com and Drugstore.com. This company is a symbol of the new economy. It has a very high market capitalization of 25 US$ as at November 1999 and yet the company has never made profits and has lost $390 million in 1999. The company has become a focus of debate whether Internet stocks were greatly overvalued. Start From The Future Instead from starting from the present the usual practice in DCF valuations is to start from the future what the company and the industry could look like when they evolve from todays very high growth, unstable condition to a sustainable moderate growth state in the future and extrapolate it back to current performance. The future growth rate should be defined by metrics such as penetration rate, average revenue per customer, and sustainable growth margins. For the purpose of understanding this concept, let us create an optimistic scenario. Let Amazon.com be the next Wal-Mart. Say by 2010, Amazon.com continues to be; and has established itself as the leading on line retailer; in both online and off line markets. Assume the company has a 13% share of the total U.S books and music market; it would have revenues of appx. $60 billion (based on todays market share) by 2010. Let us assume that Amazon.com earns an average operating margin of 11% since due to its size will have a better purchasing power and also incur fewer associated costs. Also in the optimistic scenario Amazon.com will require less working capital and fewer fixed assets than traditional retailers do. We also assume that Amazon.coms capital turnover will be 3.4. Hence based on the above we get the following financials forecasts for Amazon.com for the year 2010. 1. Revenues - $60 billion. 2. Operating profit - $7 billion. 3. Total capital $ 18 billion. To estimate Amazon.coms current value we discount the projected free cash flows back to the present. Its present value is $37 billion.
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Weighing For Probability Uncertainty is the hardest part of valuing high growth technology companies. The use of probability -weighted scenarios is a simple and straightforward way to deal with it. The use of probability weighted scenarios requires repeating the process of estimating a future set of financials for a full range of scenarios ranging from more optimistic to less optimistic. 4 scenarios have been developed for Amazon.com. Scenario A Amazon.com becomes the largest retailer (off and online) in the U.S. It uses much less working capital compared to the traditional retailers, as it is primarily an online operation. Though it is competitively priced, its operating margins are much higher since it has better purchasing clout and lower operating costs. This implies that Amazon.com is worth $79 billion at the end of 1999. Scenario B Amazon.com has captured revenues almost as much it has in Scenario A, but its margins and its need for capital fall between those in Scenario A and those needed by traditional retailers. This implies that Amazon.com has a value of $37 billion at the end of 1999. Scenario C the companys economics are close to that of a traditional retailer. This scenario implies a value of $15 billion for Amazon.com for the same period. Scenario D Amazon.com becomes a fair sized retailer with traditional retailer economics. Online retailing mimics most other forms of the business, with many competitors in each field. Competition transfers most of the value of going online to the consumers. This scenario assumes that Amazon.com s worth only $3 billion. Hence there are 4 scenarios that have the companys value ranging from $3 billion to $79 billion. Probabilities have o be assigned to each scenario to arrive at the resulting values of Amazon.com. Scenario A a low probability of 5 % is assigned. Although the company might achieve outrageously high returns, competition is likely to prevent this. Scenario D - Amazon.coms current lead over its competitors also suggests that Scenario D too is improbable and hence assigns a probability of 25%. Scenario B and C assume attractive growth rates and reasonable returns and therefore are more likely so equal weights of 35% are assigned to them.
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EXPECTED VALUE OF AMAZON.COM DISCOUNTED CASH FLOW VALUES PROBABILITY EXPECTED VALUE ($ BILLION) SCENARIO A SCENARIO B SCENARIO C SCENARIO D TOTAL 79 37 15 3 134 (PERCENT) 5% 35% 35% 25% 100% ($ BILLION) 4.0 13.0 5.3 0.8 23
When the values of each scenario are weighed, depending on its probability and added, we get a market valuation for Amazon.com as $23 billion, which was the companys value as at October 1999. The above table shows the sensitivity of this valuation to change in probabilities. As seen from the table above relative small valuations lead to big swings in values. The share prices of companies like Amazon.com are extremely volatile because small changes in the markets view of the likelihood of different outcomes affect the current value of these shares quite significantly. Nothing can be done about this volatility. Customer Value Analysis The last difficult aspect of valuing very high- growth companies is relating future scenarios to current performance. Here, classic microeconomic and strategic skills play a critical role because building sound scenarios for a business requires knowledge of what actually drives the creation of value. Five factors drive the customer value analysis of a retailer like Amazon.com: 1. The average revenue per customer per year from purchases made by customers and the revenues from advertisements on its site and from retailers that rent space on it to sell their own products. 2. The total number of customers. 3. The contribution margin per customer 4. The average cost of acquiring a customer. 5. The turnover or churn rate of customers.( proportion of customers lost each year)
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CUSTOMER ECONOMICS - SCENARIO B YEAR UNITS 1999 2010 Average revenue per customer $ 140 500 No. of customers Contribution Margin Acquisition cost per customer Customer churn rate Million $ $ % 9 14 29 25 120 14 50 25
The above table shows how Amazon.com could achieve the financial performance predicted by Scenario B and is compared with the companys current performance. As seen from the above table, the biggest changes over the next 10 years will be the number of customers and the average revenues for each In Scenario B, Amazon.coms customers have increased from 9 million a year in 1999 to 120 million worldwide in the year 2010 84 million in the U.S. and 36 million outside the U.S. It is assumed that Amazon.com will retain its no.1 position in the U.S for online retailing. Also the average revenue per customer has risen from $140 in 1999 to $500 in 2010. It is assumed that Amazon.com will continue to dominate in its core business music and books and will also enter other businesses. The contribution margin per customer before the cost of acquisition is 14%. Though this seems a little high, it is possible in view of Amazon.coms ability to gain offsetting economics of scale; for e.g. by renting out space to other retailers on its website. The cost of acquiring new customers is closely linked to its churn rate of 25%. This churn rate suggests that once a customer is acquired, Amazon.com will be able to retain it for 4 years. The acquisition cost per customer is $50. Though costs will rise once all online customers have been claimed, this is a reasonable figure if the company can achieve brand dominance and advertising economies of scale. The difference in the values of a customer reflects the churn rate and is responsible for the cost of acquisition. Even if a company is not earning very high revenues and is able to retain its customers and hence keep the acquisition costs low, it will be more profitable in the long run viva vis its competitor earning higher revenues and having a higher churn rate. Uncertainty Is Here To Stay By using the DCF approach we can generate reasonable valuations for seemingly unreasonable businesses. Look at what could happen to an investor holding the stocks of Amazon.com for 10 years under all the 4 scenarios. If Scenario A plays out the investor will earn a Zarna Meswani MFM, NMIMS
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return of 23% annually and it will seem that the market has grossly undervalued the stocks of Amazon.com. If Scenario C plays out the investor will earn a return of 7% only and it will seem that the market had hugely overvalued Amazon.com. These high and low returns are not an indicator of irrational share prices but an indication of the uncertainty about the future. A great deal of the uncertainty is associated with the problem of identifying the winner in a highly competitive field. History shows that a small number of players will win while a vast majority of them will just toil away. Neither investors nor companies can do anything about these uncertainties that is investors diversify their portfolios and why companies dont pay cash while acquiring Internet companies.
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HAS THE BUBBLE BURST?
Every woman knows that blondes have more fun, but are rarely taken seriously. Now it seems that in Silicon Alley having a Dotcom attached to your name is a bit like being a blonde -- they've had their fun, but let's face it, with the market readjustment and thin business models, few people are taking them seriously. Companies are dropping the Dotcom for different reasons. Some think "Dotcom" smacks of free services with no revenue stream; others say it doesn't adequately show their offline interests. And for some companies Dotcom is about the static Internet, not appropriate at the dawn of the wireless Web. "Renaming is happening all over the space at the moment," says Alessandro Piol, managing director of Invesco Private Capital, a venture capital outfit based in New York. "We are rebranding now," Noam Bardin, chief executive and co-founder of deltathree says. Originally the Internet Telephony Company was called deltathree.com, but Bardin has since dropped the Dotcom. "Dotcom now has a negative implication and is seen as a b-to-c free service company. We didn't want to be lumped together with that group." After all, says Bardin, his company does have a revenue stream. "Dotcom now has negative connotations attached to it like weak business models, and excessive spending, which is why companies are changing their names," says Christine Loeber, senior analyst at The Yankee Group. Dotcom, is so strongly associated with the Internet -- as accessed on PCs -- that companies feel that it is time to drop the name because it see its future in being accessed on non-PC devices. Dotcoms has been the buzzword since the late 1990s.it has been said that the Dotcoms are to the 90s what music was to the 60s. Anyone and everyone have a Dotcom or are starting one. Chai.com, mouthshut.com, are some of the Dotcoms money was invested into. It was the latest buzzword in town. One word which was supposed to make everyone millionaires. It was the NEW ECONOMY; the coming of the digital age. It defied the current practices of conducting business and promised to revolutionize the world. All it took was an idea. Money was put into any venture, which had the remotest possibility of acquiring customers online. Valuations of Internet companies defied gravity. Satyam bought Indiaworld.com for a mindboggling price of Rs. 4.99 bn. Dotcoms were making losses but money was being pumped into these ventures. It seemed the higher the losses an Internet Company made the greater was its valuation by the market. The brick and motor companies were threatened. The stock prices of these companies plummeted. Everyone newspapers, magazines proclaimed that it was the end of the OLD ECONOMY and the driver of change into the new economy would be the Internet and everyone wanted to be the one driving that change and leading the rest of the world into a new future. But things did not work out quite that way.
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What went wrong? What happened to the multi million-dollar valuations? Where did all the money go? Let us try and first understand what the Internet stands for, what the Internet was intended for. The Internet is intended to increase efficiencies and effectiveness that would aid in business transactions. It is a tool to build efficiencies. How can one build a business model around it? It is like building a business model around a fax machine or a telephone. Some may argue that Direct Marketing is a business model built around the telephone. But Direct Marketing is a channel, a means for marketing and not the end and be all of the business functions. Direct Marketing is used to enhance current business. But what happened with the Internet? An entire business model was built around the Internet. The Internet was intended to take over all the functions in the supply chain and do away the human aspect of business. We must understand the Internet is intended to AID human beings, reduce human interference and hence the inefficiencies associated with it, NOT do away completely with them. No communication medium can become the root foundation of a business model besides that for a service provider of that communication medium. What was the main foundation of the Dotcoms? If you have an idea that can be converted into a web application that caters to most of the business functions the business will succeed. It was assumed that the people would prefer to buy online rather than off line. But what they forgot is that people dont buy a product because of good technology or that what the need is available just one click away. People need other people. They need the human aspect. These days, whenever I think of Dotcom, I think of a ticket to an overpriced experience race. More than 90 per cent of the Dotcom startups announced in the last 1-2 years, only a handful has even made it to the starting post - leave alone run the final race. Eventual failure is nothing new for sunrise industries in any sector. Old Economy or New. Most industries grow by kindling a hundred entrepreneurial dreams; only handfuls survive in the end. Nature's law will thus take care of the Dotcoms in the usual way. Most Indian Dotcoms have tried to mimic the assumed early success in US and elsewhere instead of asking series of fundamental questions: What is it that I am offering that is not already being offered by others? What will be my revenue sources? If there are many players in the field what will be the differentiating factor? The answer, currently, is very little. Whether it is groceries, or textiles, or anything I would require regularly, I don't see the net as a great place to buy. Given cheap Indian labor, almost all such things can be done more easily over the phone. I can order dinner - sometimes even a small order like a plate of idlis - from any nearby restaurant at no extra cost in most Indian cities. I can order groceries from shops in the vicinity of my home with a mere phone call. I would not order a shirt or jewellery over the net for fear of not getting what I want (who will I chase in case of wrong delivery as the word customer service is alien to most Indian companies). Would I buy a TV or PC on the net? Maybe. But only if the price advantage over the conventional showroom is very clear supported with a good customer service agreement. Not otherwise. Zarna Meswani MFM, NMIMS
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Net business models, especially in the B2C area, will work best in areas where there are no physical products to be moved. Meaning, they should work well in areas like broking, banking and financial trading-and not so well in grocery or garments. Reason: there is no physical product that I need to cart from factory to consumer, from Mumbai to Delhi. On the other hand, whether I am in Mumbai or Delhi, in areas like share trading the net clearly facilitates transactions and brings down costs. I can buy or sell a share more easily and at lower cost on the net. I can also do most of my banking from home or the office, or even through my cellphone. A business will work on the net if its products are sufficiently standardized. The reason why Dell sells a lot of PCs through the net is because the things going into PCs are no more than glorified commodities - the same Intel chips, the same Microsoft software, and the same add-on hardware. You can also sell high quality branded products through the net, but risk commoditisation in the process. The reason: the net allows the consumer to see all similar products on the same shelf. Thus it would put a Titan watch and a Piaget on the same pedestal. Good for Titan. But for Piaget? The once robust Dotcom sector has seen a stunning reversal of fortunes in the past several months. And no one knows how many more are quietly cutting expenses. Where has IndiaInfo gone now? What is SatyamOnline doing? Whether a company shuts down completely or simply cuts back, its advertising budget invariably suffers. Marketing is the first thing to go. Dotcoms can't live by ads alone. Dot-com closures are accelerating, with Internet startups now closing at the rate of about one a day, according to a new report. The figures bring clarity to the endless announcements of young companies shutting down -- some of which launched amid great fanfare only earlier this year. In the next five years, out of all the companies existing in the Indian Internet space (estimated to be around 500), 90 per cent will die and the rest 10 per cent will survive through consolidation. The consolidation will be done primarily through mergers and acquisitions activity between companies that are technology driven and those having strong business models. Only 12 per cent of all the Indian Internet companies have received a venture capital funding and these are primarily the ones that will experience consolidation activity. The reason why incubation of start-up companies has not taken off in India is that most of the incubator companies and venture capital funds themselves are less than one-year old. Primarily financial compulsions, rather than being driven by complimentary synergies between various companies drive the merger and acquisition activity in India. This is because the Indian start-up ecosystem is not yet mature, and the venture capitalists are themselves learning. The valuations of Dotcom companies have dropped by 50 per cent as compared to those six months back. In fact, the valuations have become more realistic today. There is no parameter to measure valuations, but the stock market. But this is also not real, as the stock market is not applicable to a Dotcom company (because the Zarna Meswani MFM, NMIMS
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presence of a Dotcom company in the stock market is very far away, only when it goes public Valuations of the Internet companies are more of a perception and are driven by sentiment. Then why was there a mad rush to invest in Dotcoms? Why were million of dollars pumped into these ventures? Didnt people realize that this might not work? Over 80 percent of the 350 companies that have gone public under the guise of the Internet are not showing profits. Because they don't have profits, its hard to know how to value them. Amazon.com has been valued like Microsoft on steroids. The reason that Microsoft has a high valuation is that it has 37 percent to 40 percent operating profit margins, whereas a company like Amazon, which is just a distribution company, can never expect those kinds of margins. Microsoft is an intellectual property company. An Amazon is just a distributor -- distribution companies typically generate 2 percent profit margins. But since they weren't generating any profits, people didn't know what to expect, so they thought -- oh, maybe they're going to be the next Microsoft. Now, people are starting to understand who are the real companies and what are the real business models. Clearly, the bubble has burst. Things will never be the same. What's happened is a lot of people have lost a lot of money and is going to scar them for a long time, and they're going to realize that it's now back to fundamentals. Its back to rationality. The bottom line is that there was this game of musical chairs that was being played. I think that intuitively people knew that the market was artificially propped up, but everyone has been making so much money in the market in the last two or three years, so no one wanted the music to stop and it kind of took on a life of its own. E-tailing companies plus the Web media companies got caught recently. The e-tailing companies were caught with people realizing that they're never going to make the kind of profits that a Microsoft or a technology company would. As for the Web media companies: When AOL merged with Time Warner, it was kind of like the smartest guy in the Web media business, As Steve Case, said that in order to move forward successfully I need old economy capability. So, a lot of these pureplay Internet media companies, such as TheStreet.com and iVillage, got kind of left hanging out there. Bubble or boom, the dot still fascinates, and the rush to set up Dotcom portals continues unabated. Evidently, the pot of gold at the end of a venture capital rainbow is too strong a temptation to resist.
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Does that mean that the Internet has failed? The Internet has not failed. It was our perception of what the Internet could do that has failed. Today the people are realizing and using the Internet for what it should be used. It should be used for - faster, efficient and a convenient medium for communication between 2 business partners. The way business is being done is changing. This is mainly due to the Internet. The way business is done in the real world differs from the way it is conducted on the net. Hence how does one assess the true value of a Dotcom? The Malegam Committee was set up to look into this.
MALEGAM COMMITTEE PANEL REPORT

The Indian Dotcoms can no longer hide under the cloak of good ideas. According to the Sub-Committee of the Malegam panel report on disclosure and valuations, Dotcoms will have to disclose their significant accounting policies. This includes revenue recognition, membership, subscription, merchandising activities; advertising services and services like web hosting, content selling, among others. The committee also takes into its fold companies that have a business segment in which interest in the principle distribution channel for delivery of products and services and the concept of materiality shall be applied to classify a company or a business segment as a Dotcom. The draft will be made public and placed before the entire committee for finalization. The final committee will then take the final draft, with feedback from the public Introduction The Committee was of the view that regulators need not determine whether a unit of a companys equity is correctly priced or not, this being a matter that should be left to the individual investor to assess whether the valuation was fair or not. However, the Committee was of the view that our regulators need to address the difficulties encountered by investors in making well-informed decisions regarding their investments in Dotcom companies. These problems mainly arise due to the lack of proper guidance relating to financial accounting and reporting by Dotcom companies, unavailability of adequate benchmark information for comparison purposes and inadequate disclosures regarding the critical elements and peculiar nature of the business of Dotcom companies. The Committee concluded that Dotcom companies are often valued based on estimates of future revenues or cash flows that would be generated by deploying their assets. These assets are mainly intangible in nature and therefore investors would need certain additional information to enable them to make an informed judgement of the qualitative factors related to a Dotcom companys business model such as the unique business idea, technology, quality of promoters and key managerial personnel, prime-mover advantage, etc.
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The Committee also believes that although fundamental accounting principles remain the same and are applicable to all entities, including Dotcom companies. There is however a need for formulating specific accounting guidance applicable to Dotcom companies to avoid any irrational application of fundamental accounting principles, to facilitate meaningful inter-firm comparison between different Dotcom companies, and to provide investors with robust and reliable financial information that could be applied to a variety of business valuation models such as price multiples of revenues or net income, discounted cash flows, etc. The sub-committee believes that in view of the rapidly changing and unpredictable business model of Dotcom companies, the following additional disclosures may be mandated to enable potential investors to understand the business model of the Dotcom company and determine the continued ability of Dotcom companies to survive and deploy their assets, which are mainly of an intangible nature, to generate future cash flows: A description of the nature of the companys operations and its principal activities, stating the nature of product sold and/or services provided for each of the last three financial years. If the company has been in existence for less than threeyears, this information may be provided for such shorter period. Information may be presented on the same basis as that used to determine the companys business segments under the same body of accounting principles used in preparing the companys financial statements. The nature of the companys operations could include internet portals, internet infrastructure, internet B2B software, internet commerce, internet consulting and application services, internet financial services, internet vertical portals, multi sector internet companies, internet direct marketing and advertising services, B2B commerce, B2C commerce etc in which the company will operate. The company should also disclose the percentage of composition of companys revenue and capital employed in each of the sectors. A description of the principal markets in which the company competes including a breakdown of total revenues by category of activity and geographic market for each of the last three financial years. If the company has been in existence for less than three years, this information may be provided for such shorter period. Industry size and structure for each of the business segments in which the company will be operating. Data on industry size and structure must be supported by corroborative sources. This recommendation could be extended to all companies that provide data on industry size and structure; Uniqueness of the idea- the proposed action plan (including the management systems and expertise proposed to be put in place) to fulfill the commitments made within the stipulated time, cost and qualitative targets; The management of the company shall identify and disclose all relevant qualitative and quantitative business information including the following for each of the last three financial years:
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Qualitative information: Market position, competition and managements assessment of the companys prime-mover advantage. The basis for any statements made by the company regarding its competitive position should also be clearly disclosed; Description of the underlying technological processes including summary information regarding the extent to which the company is dependent, if at all, on patents or licenses and/or industrial or commercial contracts or new technological processes, where such factors are material to the companys business or profitability; Terms of contracts and arrangements with customers and how revenue is earned on products sold and/or services provided to customers; Alliance and Partnerships; A description of the marketing channels used by the company including an explanation of any special sales methods employed by the company; Description of terms of contracts (generic and specific) entered into with customers and suppliers; Possibility to exploit opportunities such as charging fees for other products featured on the site, cross promotions, etc; Description of intangible assets and how they will be used to generate future cash flows; Multiple element arrangements (like upgrades, maintenance, services, etc); Quantitative information: Sources of revenue by business segment sub categorized as appropriate into heads including advertising income, subscription income and transaction income; Amounts, if any, of barter transactions recorded as a component of gross revenues and cost of revenues/selling and marketing expenses if such amounts exceed 5 per cent of either of total revenues or cost of revenues or selling and marketing expenses Operational statistics: Number of portals Average number of daily visitors to each portal. Number of pages viewed. Number of minutes spent to view the web page. Quarteron-quarter growth in the average number of daily visitors and pages viewed. Average number of daily impressions that are delivered i.e. number of times banner ads appear and click-through;
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Percentage of page hits that have historically translated into revenues by quarter. Duration of advertisements, minimum guaranteed impressions, etc. Recurring and non-recurring items of revenue. Cost of acquiring a customer and revenue per customer. Customer loyalty and customer churn rate (i.e. proportion of number of customers lost to the total number of customers during the past three years); Any other information that the company believes will be useful to an investor in assessing the performance of the company Risk factors in the offer document: The sub-committee was of the view that risk factors pertaining to Dotcom companies generally may be classified into four broad categories including global risks, general economic and political risks, risks attached to the industry and risks attached specifically to the company. Companies should be encouraged to list the risk factors in the order of their priority to the company. These risk factors include such factors that will make the offering speculative or one of risk. The management of the Dotcom Company and the Lead Merchant Bankers may be made responsible for identifying these risk factors. Risk factors that are required to be disclosed by Dotcom companies may include the following: Global risks Risks due to technological changes and obsolescence. Absence of cross border entry barriers Currency fluctuation risk Interest rate risk Impact of any global financial crises on the domestic market Risks related to Intellectual Property Rights transfers Competitive industry where innovation is immediately copied and there is entry barrier Liability to third parties and liability for unlawful/fraudulent activities by users under the laws of foreign countries.
General economic and political risks: Changes in economic and trade policies of the Government. Political instability or change in the Government. Regional conflicts with our political neighbors. Changes in fiscal policies of the government. Capital market timing risk.
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Risks attached to the Internet industry: Changes in government regulation relating to internet service companies Industry associated timing risk. High bandwidth costs of accessing the Internet in India and other technical obstacles. Limited installed personal computer base in India. Limited Internet connections in India. Uncertainty regarding the growth and acceptance of online advertising and e-commerce in India. High percentage of failures is common in Internet market. No comparable companies in the same segment with reasonable operating history for the purpose of bench marking. Liabilities, if any, to third parties for information retrieved from web sites. Liabilities for unlawful/fraudulent activities by web site users. Liability to third parties for the products sold through electronic means. Computer viruses. Year 2000 re mediation risks. Online commerce security risks. Lack of protection of the intellectual property rights due to inadequate legal provisions in the statutes. Risks attached to the company: Risks related to the financial condition and existing business model of the company. The future prospects of the company will depend on the following factors: Awareness of the companys unique selling proposition; Pricing models of competitor companies; Expansion of content and services on the portal; Ability of the company to attract and retain customers; Ability of the company to attract a larger number of advertisers from a variety of industries; Ability of the company to attract, maintain and motivate qualified staff; Ability of the company to maintain strategic; Relationships with business partners; Ability of the company to respond effectively to competitive pressures; Ability of the company to continue to develop and upgrade the technology;
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Ability of the company to promptly address the challenges faced by early stage and rapidly growing businesses, which do not have an experience or performance base to draw on. Risks related to competition; Risks related to unproven business models; Details of accumulated past losses and estimated future losses; Risks related to the following reasons: Timing of the expansion plans of the company. Changes in pricing policies or product and service offerings. Increases in personnel, marketing and other operating expenses to support the anticipated growth. Seasonality in revenues due to certain factors such as festivals, etc Failure of marketing campaign to establish brand recognition and loyalty for the brand. Failure to manage the growth effectively. Failure to cope with the intense competition in the Internet business. Failure of telecommunication and computer systems. Failure to retain the existing key personnel and hire additional skilled employees including risks related to competitive labor markets. Risks related to (sunk) investments in network infrastructure. Termination of agreements with third parties to provide products and services to the customers and termination of strategic alliances. Strain on managerial, operational and financial resources due to future acquisitions, investments, strategic partnerships or other ventures Failure to meet merchandising, inventory management and order fulfillment obligations for e-commerce business could disrupt the operations The number of shares offered to public will represent only __ percentage of the companys paid up equity capital and, therefore, the share price of the company will be volatile in view of the low floating stock. Risks associated with impairment of intangible assets. Risks in forecasting future cash flows due to: Difficulty in forecasting sales. Difficulty in forecasting size of the market. Difficulty in forecasting share of the market size. Difficulty in forecasting costs. Difficulty in forecasting re-investment needs. The company may not be able to pay dividend in the immediate future. The company may have to issue shares under Employees Stock Option Scheme in order to retain the skilled personnel that will dilute the holdings of the shareholders and limit returns. Project cost, means of financing and deployment of funds in the project:
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In July 2001, PricewaterhouseCoopers with Landwell commissioned a follow-up exercise with the same respondent companies to find out how the previous 12 months had affected the Dotcom sector. Out of 412 companies originally interviewed in 2000, we completed full interviews with 190 companies and checked whether the remaining 222 companies who did not respond were still in business. The 190 companies interviewed were spread across the four European countries included and consisted of an even spread of companies as in 2000.
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DOTCOM CULTURE IS DYING AS NEW REPORT REVEALS NEW FOCUS AMONG EUROPEAN DOTCOM CEOs
'Dotcom culture' is dying, and being replaced by a more traditional approach to business, according to a new study tracking the mindsets and attitudes of Europe's Dotcom CEOs. Evidence of this major shift in attitudes is revealed in the second annual PricewaterhouseCoopers European Dotcom study - "Focusing on fundamentals - Dotcoms mean business" - which revisited 400 European CEOs of 'pure-play' Internet businesses to establish their key issues and challenges. The 2000 report demonstrated that the priorities of CEOs were focused firmly on the issues of recruitment, brand-building and pan-European expansion, rather than profitability and customer service. In addition, when questioned, the CEOs placed a heavier emphasis on creativity and flexibility as desired traits for managers rather than a proven track record in business. The 2001 report, however, marks a fundamental shift in attitudes, as CEOs take stock of their businesses and face the realities of an increasingly tough operating environment. Key insights from the CEOs questioned for the 2001 study include: In 2000 one in three Dotcom managers highlighted finding the right staff as a key challenge facing their company. In 2001 this figure dropped to just one in 20 CEOs, with emphasis shifting instead to winning business and keeping the costs down; A clear focus on profitability and cash-flow is cited by CEOs in 2001 as one of the main challenges facing their business. Interestingly, tactics for increasing profitability vary from country to country. For example, the UK and Germany are concentrating on reducing costs and overheads (identified by, respectively 24 and 32 per cent of respondents in these two countries). In France, Dotcoms are looking for better product quality (22 per cent) and the Dutch see more focus on marketing (34 per cent) as a solution to boosting their business; A clear shift in emphasis towards experience and broad management skills. Management experience has moved from being one of the least valued traits to the most valued. (Ironically, though, it is now much harder for companies to hire experienced managers). Nick Drewett, director at PricewaterhouseCoopers says: "There used to be a tendency among some Dotcoms to see themselves as a breed apart and subject to a different set of business rules. "What is interesting about this new study is that we have seen a fundamental change in the attitudes of the CEOs running European Dotcoms as they are now prioritizing areas such as cost-cutting, profitability and acquiring and retaining customers, above creativity and risk-taking." According to PricewaterhouseCoopers, the challenge for many European Dotcoms now is to make the transition from venture start-ups to established businesses without losing the best elements of start-up culture, including a sense of fun and commitment to creativity and innovation. Interestingly, PwC found that 72% of CEOs claimed still to be having fun, suggesting they remain committed to their venture, enthused and motivated.
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It has put forward a 2001 survival checklist for Dotcoms including: Be realistic about future financing prospects and work within the funds available Focus on affordable growth Develop contingency plans in case original fundraising plans are unsuccessful Conduct a strategic review - re-appraise whether the venture will succeed Protect key assets and put in place robust internal controls Build realistic forecasts based on the real understanding of customers and costs Remember the fundamentals - your business model, cash-flow forecasts and management accounts are all vital ingredients Remain focused on the goal The shift in business thinking highlighted in the 2001 study will not entirely system the tide of Dotcom business failure. PricewaterhouseCoopers warns that neither raw talent nor the adoption of sound business thinking will matter if firms are pursuing a fatally flawed business model. Surprisingly, few companies surveyed have conducted any type of formal strategic review of their business.
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IF THE DOTCOM BUBBLE HAS BURST AND IT HAS FAILED THEN WHAT NEXT FOR VCs?
BIOTECHNOLOGY. The hottest thing today is biotechnology. What Is Biotechnology? Break biotechnology into its root words and you have bio the use of biological processes and technology to solve problems or make useful products. The rules of the game remain the same. But, chastened by the information technology experience, particularly of the Dotcom variety, venture capital fund managers appear to be have adopted a cautiously positive approach to the sunrise biotechnology industry. The capital intensive industry, where results cannot be achieved in the famous "18-month deadline" as was set for IT entrepreneurs, has attracted adequate attention from the venture capitalists as the prospects of proliferation of biotechnology startups brighten. The VCs are positive towards biotechnology. There is no doubt about that. But investments will be in areas that have no statutory or legal complications or impediments. The early investments will go into the safe biotechnology areas like genomics and proteinomics, two of the big areas that are happening, as well as bio-informatics that will help both these specialized areas. Bioinformatics is a growing field in all other aspects of biotech as well. All of biotech whether it concerns new drugs, genetically engineered crops, or vaccines requires hardware and software support. Without it modern biotech stands little or no chance of using the human genome to change our lives. And all this is relevant to the Indian IT industry. Caught in its first serious downturn after a decade of heady growth, the IT industry knows it must diversify its portfolio. Bioinformatics has been touted as the next big thing worldwide, offers the Indian IT industry a great chance to do just that. Indicators as to why is biotech so hot. The NASDAQ crash the battering of the Tech sector. The infotech sector lost 60 percent market cap and the biotech segment gained 28 percent. There were 80 regulatory approvals for biotech products in the last 5 years. There were less than 40 in the previous 13 years of research and development. The pace will accelerate, as the research will increase. Marketing approval of biotech products is likely to further with more than 350 products in clinical development. The decoding of the human genome has thrown up a mountain of data which needs to be refined, classified and to be useful in new drugs and therapies Protemonics, the study of proteins is best done by nimble, highly focused, market savvy star ups. So too with genomics. Biotech companies raised a record $40 billion worldwide in 2000.
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The opportunities from biotechnology are so vast that they are presenting themselves to IT companies, doing even lesser know niche applications seemingly unrelated to biotech. For instance Spectramind is a year old start up, with a first round of funding in excess of Rs 50 crore, which primarily uses the Internet to provide services to clients abroad web enabling outsourced services. But things are changing for the company. Today there is a small workforce who is working on biotechnology. They mine genomic data, validate it, and create a database for U.S. clients. Currently though Bioinformatics worldwide is in actual terms, probably no more than a 3 billion industry and in India $50 million, it is booming today with a CAGR of 30 per cent. Indian biotech is growing fast and given the right impetus could rake up export figures the same way as the software industry does, especially of the biotech infotech convergence takes off. There are a growing number of US drug companies that would like to send a bank of genomics and proteomics data for analysis to India. The key drivers for Bioinformatics are the same as those that created the software boom: a shortage of Bioinformatics personnel and the low cost of getting it done in India. Like IT English is the lingua franca of the Bioinformatics world. And also there is the flourishing IT sector. The emerging convergence of biotech and infotech is evident in the locations of some new projects. In December 2000, the Tamil Nadu Industrial Development Corporation and a US based company Genome Technologies set an Rs 450 crore biogenomics and Bioinformatics project at Chennai. In Karnataka, an Institute for Bioinformatics and Applied Biotechnology is coming up. The hype about biotechnology is not new. It was heralded as the glamour industry in the late 1980s in the US. Then the dream soured as less then a quarter of the 1000 companies were profitable and many did not even have a product. Early VCs endured losses. With the coming of the Internet age, VCs lost interest in biotech. But with the crashing of the NASDAQ due to tech stocks and the decoding of the genome, biotech has become hot again. ICICI Ventures has made an investment ranging from $1 million to $5 million in 6 biotech companies in the last 20 months. Biotech models are at this point in time in a state of evolution. VC money is still hard to come by, though worldwide VCs have invested $700 million in Bioinformatics companies in the last year. Walden International's Sudhir Sethi took the tough VC line. "Whether it is IT or BT (biotechnology) or brick and mortar, so far as the VC is concerned, the only rule that applies is return on investment. It is not necessary for the founders of the company to run the business. It is critical for the founders to leave it to professional managers," he said. In other words, VCs would prefer a management team to have a scientific background with managerial experience. The approach of VCs would be to invest in areas that are unique and create value like contract research, cancer, cardiovascular diseases, contract manufacturing and bio-informatics. But, if the government is involved, the VCs would not make investments, says Sethi. ICICI had set aside Rs 100 crore for biotechnology, Deshmukh said. He, however, made it Zarna Meswani MFM, NMIMS
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clear that the services sector in biotechnology would not get the same investment as IT services secured in the past. Investments in biotechnology could be anywhere from $5 million to $50 million. But, with the experience of IT behind them, VCs were again looking with interest towards biotechnology.
CONCLUSION
Any time there is change there is opportunity, and it is this opportunity that Venture Capitalists invest in. Imagine if there was no Hotmail, if venture capitalists hadnt invested in this idea of some unknown person, communication wouldnt have been, as we know it today. The return a venture capitalist gets is not as much about getting a high return for taking risk but more about picking a winner. As Richard Bach has said Look around you this moment: everything you see and touch was once invisible until someone chose to bring it into being. The venture capitalists are the ones who put good ideas into practice.
REFERENCES
McKinsey & Company - US Venture Capital Industry Industry Overview and Economics (Summary Document), September 1998 VALUATION Measuring and Managing the Value of Companies McKinsey & Company, Inc Howard Partners along with Price Waterhouse Coopers, Australia - The Economic Impact of Venture Capital 1998 Indian Venture Capital Association - IVCA Venture Activity 1997 Nasscom Report 1999 - Finance for the Software Industry, pages 115 to 125 The Securities and Exchange Board of India - SEBI (Venture Capital Funds) Regulations, 1996
Mr Girish Deshpande PriceWaterHouse Coopers Global. Mr. Neelesh Raheja Auriga Logic Pvt Ltd. Mr. William Rego Standard Chartered Bank. Mr. Atin Sharma FinVentures. Various Newspapers and Magazines and the World Wide Web.
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VENTURE CAPITAL IN THE INFORMATION TECHNOLOGY SECTOR OF INDIA

Venture Capital In India

Venture Capital In India

Zarna Meswani MFM, NMIMS

Venture Capital In India

Venture Capital In India

Zarna Meswani MFM, NMIMS

Venture Capital In India

Zarna Meswani MFM, NMIMS

Venture Capital In India

Zarna Meswani MFM, NMIMS

Venture Capital In India

Zarna Meswani MFM, NMIMS

Venture Capital In India

Zarna Meswani MFM, NMIMS

Venture Capital In India

Zarna Meswani MFM, NMIMS

Venture Capital In India

Private venture funds like Indus, etc.

Zarna Meswani MFM, NMIMS

Venture Capital In India

Microland, networking hardware and services company based in Bangalore

Planetasia.com, Microlands subsidiary, one of Indias leading portals

Zarna Meswani MFM, NMIMS

Venture Capital In India

Zarna Meswani MFM, NMIMS

Venture Capital In India

Zarna Meswani MFM, NMIMS

Venture Capital In India

Zarna Meswani MFM, NMIMS

Venture Capital In India

Venture Capital In India

Zarna Meswani MFM, NMIMS

Venture Capital In India

Zarna Meswani MFM, NMIMS

Venture Capital In India

Venture Capital In India

Zarna Meswani MFM, NMIMS

Venture Capital In India

Symbolically the valuation exercise may be represented as follows:

Post = Pre + Cash

Zarna Meswani MFM, NMIMS

Venture Capital In India

Venture Capital In India

Venture Capital In India

Warrants Common shares

exercise price, expiry period new or vendor shares

Zarna Meswani MFM, NMIMS

Venture Capital In India

Venture Capital In India

Zarna Meswani MFM, NMIMS

Venture Capital In India

ACCESSING VENTURE CAPITAL

Venture Capital In India

VENTURE CAPITAL IN INDIA

Zarna Meswani MFM, NMIMS

Venture Capital In India

Venture Capital In India

Venture Capital In India

Zarna Meswani MFM, NMIMS

Venture Capital In India

Zarna Meswani MFM, NMIMS

Venture Capital In India

Zarna Meswani MFM, NMIMS