VENTURE CAPITAL: A SUMMARY
By Meenal Sinha
I VENTURE CAPITAL
Introduction
The venture capital investment helps for the growth of innovative entrepreneurships in India. Venture capital has developed as a result of the need to provide non-conventional, risky finance to new ventures based on innovative entrepreneurship. Venture capital is an investment in the form of equity, quasi-equity and sometimes debt - straight or conditional, made in new or untried concepts, promoted by a technically or professionally qualified entrepreneur. Venture capital means risk capital. It refers to capital investment, both equity and debt, which carries 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 concept of Venture Capital
Venture capital means many things to many people. It is in fact nearly impossible to come across one single definition of the concept.
Jane Koloski Morris, editor of the well known industry publication, Venture Economics, defines venture capital as 'providing seed, start-up and first stage financing' and also 'funding the expansion of companies that have already demonstrated their business potential but do not yet have access to the public securities market or to credit oriented institutional funding sources.
The European Venture Capital Association describes it as risk finance for entrepreneurial growth oriented companies. It is investment for the medium or long term return seeking to maximize medium or long term for both parties. It is a partnership with the entrepreneur in which the investor can add value to the company because of his knowledge, experience and contact base.
From the above definitions we can conclude-
Venture Capital:
- an investment to create a new company, or expand a smaller company that has undeveloped or developing revenues
- Financing for new businesses. In other words, money provided by investors to startup firms and small businesses with perceived, long-term growth potential.
- This is a very important source of funding for startups that do not have access to capital markets. It typically entails high risk for the investor, but it has the potential for above-average returns.
- Venture capital can also include managerial and technical expertise. Most venture capital comes from a group of wealthy investors, investment banks and other financial institutions that pool such investments or partnerships.
- This form of raising capital is popular among new companies, or ventures, with limited operating history, who cannot raise funds through a debt issue. The downside for entrepreneurs is that venture capitalists usually get a say in company decisions, in addition to a portion of the equity.
Venture Capitalist
- An investor who either provides capital to startup ventures or supports small companies that wish to expand but do not have access to public funding.
- Venture capitalists usually expect higher returns for the additional risks taken.
Selecting the VC Investors
The members of the Indian Venture Capital Association comprise a number of venture capital firms in India. The IVCA Directory of Members provides basic information about each member's investment preferences and is available from the Association.Prior to selecting a venture capitalist, the entrepreneur should study the particular investment preferences set down by the venture capital firm. Often venture capitalists have preferences for particular stages of investment, amount of investment, industry sectors, and geographical location.An investment in an private, unlisted company has a long-term horizon, typically 4-6 years. It is important to select venture capitalists with whom it is possible to have a good working relationship. Often businesses do not meet their cash-flow forecasts and require additional funds, so an investor's ability to invest in additional financing rounds if required is also important. Finally, when choosing a venture capitalist, the entrepreneur should consider not just the amount and terms of investments, but also the additional value that the venture capitalist can bring to the company. These skills may include industry knowledge, fund raising, financial and strategic planning, recruitment of key personnel, mergers and acquisitions, and access to international markets and technology. Entrepreneurs should not hesitate to ask for references from investors.
SEBI Venture Capital Funds (VCFs) Regulations, 1996
A Venture Capital Fund means a fund established in the form of a trust/company; including a body corporate, and registered with SEBI which (i) has a dedicated pool of capital raised in a manner specified in the regulations and (ii) invests in venture capital undertakings (VCUs) in accordance with these regulations.
A Venture Capital Undertaking means a domestic company (i) whose shares are not listed on a recognised stock exchange in India and (ii) which is engaged in the business of providing services/production/manufacture of articles/things but does not include such activities/sectors as are specified in the negative list by SEBI with government approval-namely, real estate, non-banking financial companies (NBFCs), gold financing, activities not permitted under the industrial policy of the Government and any other activity which may be specified by SEBI in consultation with the Government from time to time.
Registration
All VCFs must be registered with SEBI and pay Rs.25,000 as application fee and Rs. 5,00,000 as registration fee for grant of certificate.
The Origin of Venture Capital
In the 1920's & 30's, the wealthy families of and individuals investors provided the start up money for companies that would later become famous. Eastern Airlines and Xerox are the more famous ventures they financed. Among the early VC funds set up was the one by the Rockfeller Family which started a special fund called VENROCK in 1950, to finance new technology companies. General Doriot, a professor at Harvard Business School, in 1946 set up the American Research and Development Corporation (ARD), the first firm, as opposed to a private individuals, at MIT to finance the commercial promotion of advanced technology developed in the US Universities. ARD's approach was a classic VC in the sense that it used only equity, invested for long term, and was prepared to live with losers. ARD's investment in Digital Equipment Corporation (DEC) in 1957 was a watershed in the history of VC financing. While in its early years vc may have been associated with high technology, over the years the concept has undergone a change and as it stands today it implies pooled investment in unlisted companies.
Venture Capital in India
In India the Venture Capital plays a vital role in the development and growth of innovative entrepreneurships. Venture Capital activity in the past was possibly done by the developmental financial institutions like IDBI, ICICI and State Financial Corporations. These institutions promoted entities in the private sector with debt as an instrument of funding. For a long time funds raised from public were used as a source of Venture Capital. This source however depended a lot on the market vagaries. And with the minimum paid up capital requirements being raised for listing at the stock exchanges, it became difficult for smaller firms with viable projects to raise funds from public. In India, the need for Venture Capital was recognised in the 7th five year plan and long term fiscal policy of GOI. In 1973 a committee on Development of small and medium enterprises highlighted the need to faster VC as a source of funding new entrepreneurs and technology. VC financing really started in India in 1988 with the formation of Technology Development and Information Company of India Ltd. (TDICI) - promoted by ICICI and UTI. The first private VC fund was sponsored by Credit Capital Finance Corporation (CFC) and promoted by Bank of India, Asian Development Bank and the Commonwealth Development Corporation viz. Credit Capital Venture Fund. At the same time Gujarat Venture Finance Ltd. and APIDC Venture Capital Ltd. were started by state level financial institutions. Sources of these funds were the financial institutions, foreign institutional investors or pension funds and high net-worth individuals. The venture capital funds in India are listed in Annexure I.Venture Capital Investments in India
The venture capital investment in India till the year 2001 was continuously increased and thereby drastically reduced. Chart I shows that there was a tremendous growth by almost 327 percent in 1998-99, 132 percent in 1999-00, and 40 percent in 2000-01 there after venture capital investors slow down their investment. Surprisingly, there was a negative growth of 4 percent in 2001-02 it was continued and a 54 percent drastic reduction was recorded in the year 2002-2003.
Venture Capital Investments
II Private Equity
- Equity capital that is made available to companies or investors, but not quoted on a stock market.
- The funds raised through private equity can be used to develop new products and technologies, to expand working capital, to make acquisitions, or to strengthen a company's balance sheet.
- The average individual investor will not have access to private equity because it requires a very large investment.
Private Equity sector-
The Private Equity sector is broadly defined as investing in a company through a negotiated process.
.Investments typically involve a transformational, value-added, active management strategy.
Private Equity investments can be divided into the following categories
Venture capital: an investment to create a new company, or expand a smaller company that has undeveloped or developing revenues [1]
Buy-out: acquisition of a significant portion or a majority control in a more mature company. The acquisition normally entails a change of ownership
Special situation: investments in a distressed company, or a company where value can be unlocked as a result of a one-time opportunity (Changing industry trends, government regulations etc.)
Private equity firms generally receive a return on their investments through one of three ways:
a)an IPO,
b)a sale or merger of the company they control,
c) a recapitalization.
Unlisted securities may be sold directly to investors by the company (called a private offering) or to a private equity fund, which pools contributions from smaller investors to create a capital pool.
Considerations for investing in private equity funds relative to other forms of investment include:
Substantial entry costs, with most private equity funds requiring significant initial investment (usually upwards of $1,000,000) plus further investment for the first few years of the fund.
Investments in limited partnership interests (which is the dominant legal form of private equity investments) are referred to as "illiquid" investments which should earn a premium over traditional securities, such as stocks and bonds. Once invested, it is very difficult to gain access to your money as it is locked-up in long-term investments which can last for as long as twelve years. Distributions are made only as investments are converted to cash; limited partners typically have no right to demand that sales be made.
If a private equity firm can't find good investment opportunities, it will not draw on an investor's commitment. Given the risks associated with private equity investments, an investor can lose all of its investment if the fund invests in failing companies. The risk of loss of capital is typically higher in venture capital funds, which invest in companies during the earliest phases of their development, and lower in mezzanine capital funds, which provide interim investments to companies which have already proven their viability but have yet to raise money from public markets.
Consistent with the risks outlined above, private equity can provide high returns, with the best private equity managers significantly outperforming the public markets.
For the above mentioned reasons, private equity fund investment is for those who can afford to have their capital locked in for long periods of time and who are able to risk losing significant amounts of money. This is balanced by the potential benefits of annual returns which range up to 30% for successful funds.
HISTORY
The seeds of the private equity industry were planted in 1946 when the American Research and Development Corporation (ARD) decided to form to encourage private sector institutions to help provide funding for soldiers that were returning from World War II. While the ARD had difficulty stimulating any private interest in the enterprise and ended up disbanding, they are significant because this marked the first recognized time in financial history that an enterprise of this type had been formed. In addition, they had an operating philosophy that was to become significant in the development of both private equity and venture capital: they believed that by providing management with skills and funding, they could encourage companies to succeed and in doing so, make a profit themselves. During the course of their unsuccessful journey, ARD did succeed in raising approximately $7.4 million, and they did have one rousing success; they funded Digital Equipment Corporation (DEC).
Most private equity funds are offered only to institutional investors and individuals of substantial net worth. This is often required by the law as well, since private equity funds are generally less regulated than ordinary mutual funds. For example in the US, most funds require potential investors to qualify as accredited investors, which requires $1 million of net worth, $200,000 of individual income, or $300,000 of joint income (with spouse) for two documented years and an expectation that such income level will continue.
Some examples of private equity owned organisations are The Automobile Association, Jimmy Choo Ltd and Boots the Chemist.
In 2007, Private Equity International magazine published a ranking of the largest 50 private equity firms in the world, called the PEI 50. The Carlyle Group was ranked the largest private equity firm.
Venture Capital is considered a subset of private equity focused on investments in new and maturing companies.
Private Equity Fund Performance
In the past the performance of private equity funds has been relatively difficult to track, as private equity firms are under no obligation to publicly reveal the returns that they have achieved from their investments. In the majority of cases the only groups with knowledge of fund performance were investors in the funds, academic institutes (as CEPRES Center of Private Equity Research) and the firms themselves, making comparisons between various different firms, and the establishment of market benchmarks to be a difficult challenge.
The introduction of the Freedom of Information Act (FOIA) in the United States and other countries such as the UK in the early 21st Century, has led to performance data for the industry becoming more readily available. It is also possible to view private equity performance data directly on the websites of certain investors.
The performance of the private equity industry over the past few years differs between funds of different types. Buyout and real estate funds have both performed strongly in the past few years in comparison with other asset classes such as public equities, certainly a factor in the bumper fundraising that both have enjoyed of late. In contrast other fund types such as venture have not shown such a strong overall performance. Manager selection in the private equity industry is definitely a vital factor for any investor seeking exposure to the market, with the performance of the top and bottom quartile managers varying dramatically, especially so in the high-risk venture capital world, and less so with real estate funds for example.
Private Equity Associations
The Association for Corporate Growth (ACG)-New York (www.acgnyc.org) is one of 53 Chapters of the Global ACG Community. Founded in 1954, the Association for Corporate Growth (ACG) is the premier global association for professionals involved in corporate growth, corporate development, and mergers and acquisitions. Leaders in corporations, private equity, finance, and professional service firms focused on building value in their organizations belong to ACG. They recognize the multiple benefits of networking within an influential community of executives growing public and private companies worldwide. For more than 50 years, ACG members have focused on strategic activities that increase revenues, profits and, ultimately, stakeholder value. Today ACG stands at nearly 12,000 members representing Fortune 500, Fortune 1000, FTSE 100, and mid-market companies in 53 chapters in North America and Europe.
Members of ACG have access to a variety of tools to enhance professional development, knowledge base and networking. ACG members receive a wealth of information and resources at both the global and local levels.
Private Equity Investments in India
2004 2005 2006
Types of Venture Capital Funds
Generally there are three types of organised or institutional venture capital funds: venture capital funds set up by angel investors, that is, high net worth individual investors; venture capital subsidiaries of corporations and private venture capital firms/ funds. Major corporations, commercial bank holding companies and other financial institutions establish venture capital subsidiaries. Venture funds in India can be classified on the basis of the type of promoters.
1 . VCFs promoted by the Central govt. controlled development financial institutions such as TDICI, by ICICI, Risk capital and Technology Finance Corporation Limited (RCTFC) by the Industrial Finance Corporation of India (IFCI) and Risk Capital Fund by IDBI.2. VCFs promoted by the state government-controlled development finance institutions such as Andhra Pradesh Venture Capital Limited (APVCL) by Andhra Pradesh State Finance Corporation (APSFC) and Gujarat Venture Finance Company Limited (GVCFL) by Gujarat Industrial Investment Corporation (GIIC)3. VCFs promoted by Public Sector banks such as Canfina by Canara Bank and SBI-Cap by State Bank of India.4. VCFs promoted by the foreign banks or private sector companies and financial institutions such as Indus Venture Fund, Credit Capital Venture Fund and Grindlay's India Development Fund.
Venture round
A venture round is a type of funding round used for venture capital financing, by which startup companies obtain investment, generally from venture capitalists and other institutional investors. The availability of venture funding is among the primary stimuli for the development of new companies and technologies.
Features
Parties
Finders or brokers. Introduce companies to investors. Generally disfavored.
A lead investor, typically the best known or most aggressive venture capital firm that is participating in the investment, or the one contributing the largest amount of cash. The lead investor typically oversees most of the negotiation, legal work, due diligence, and other formalities of the investment. It may also introduce the company to other investors, generally in an informal unpaid capacity.
Co-investors, other major investors who contribute alongside the lead investor
Follow-on or piggyback investors. Typically angel investors, rich individuals, institutions, and others who contribute money but take a passive role in the investment and company management
The company being funded
Law firms and accountants are typically retained by all parties to advise, negotiate, and document the transaction
Stages in a venture round
Introduction. Investors and companies seek each other out through formal and informal business networks, personal connections, paid or unpaid finders, researchers and advisers, and the like.
Offering. The company provides the investment firm a confidential business plan to secure initial interest
Private placement memorandum. A PPM/prospectus is generally not used in the Silicon Valley model
Negotiation of terms. Non-binding term sheets, letters of intent, and the like are exchanged back and forth as negotiation documents. Once the parties agree on terms they sign the term sheet as an expression of commitment.
Signed term sheet. These are usually non-binding and commit the parties only to good faith attempts to complete the transaction on specified terms, but may also contain some procedural promises of limited (30-60 day) duration like confidentiality, exclusivity on the part of the company (i.e. the company will not seek funding from other sources), and stand-still provisions (e.g. the company will not undertake any major business changes or enter agreements that would make the transaction infeasible).
Definitive transaction documents. A drawn-out (usually 2-4 weeks) process of negotiating and drafting a series of contracts and other legal papers used to implement the transaction. In theory these simply follow the terms of the term sheet. In practice they contain many important details that are beyond the scope of the major deal terms.
Definitive documents, the legal papers that document the final transaction. Generally includes:
· Stock purchase agreements - the primary contract by which investors exchange money for newly minted shares of preferred stock
· Buy-sell agreements, co-sale agreements, right of first refusal, etc. - agreements by which company founders and other owners of common stock agree to limit their individual ability to sell their shares in favor of the new investors
· Investor rights agreements - covenants the company makes to the new investors, generally include promises with respect to board seats, negative covenants not to obtain additional financing, sell the company, or make other specified business and financial decisions without the investors' approval, and positive covenants such as inspection rights and promises to provide ongoing financial disclosures
· Amended and restated articles of incorporation - formalize issues like authorization and classes of shares and certain investor protections
Due diligence. Simultaneously with negotiating the definitive agreements, the investors examine the financial statements and books and records of the company, and all aspects of its operations. They may require that certain matters be corrected before agreeing to the transaction, e.g. new employment contracts or stock vesting schedules for key executives. At the end of the process the company offers representations and warranties to the investors concerning the accuracy and sufficiency of the company's disclosures, as well as the existence of certain conditions (subject to enumerated exceptions), as part of the stock purchase agreement.
Final agreement occurs when the parties execute all of the transaction documents. This is generally when the funding is announced and the deal considered complete, although there are often rumors and leaks.
Closing occurs when the investors provide the funding and the company provides stock certificates to the investors. Ideally this would be simultaneous, and contemporaneous with the final agreement. However, conventions in the venture community are fairly lax with respect to timing and formality of closing, and generally depend on the goodwill of the parties and their attorneys. To reduce cost and speed up transactions, formalities common in other industries such as escrow of funds, signed original documents, and notarization, are rarely required. This creates some opportunity for incomplete and erroneous paperwork. However, disputes are rare and few if any deals unravel between final agreement and closing. Some transactions have "rolling closings" or multiple closing dates for different investors. Others are "tranched," meaning the investors only give part of the funds at a time, with the remainder disbursed over time subject to the company meeting specified milestones.
Post-closing. After the closing a few things may occur
Conversion of convertible notes. If there are outstanding notes they may convert at or after closing.
securities filing with relevant state and/or federal regulators
Filing of amended Articles of Incorporation
Preparation of closing binder - contains documentation of entire transaction
Rights and privileges
Venture investors obtain special privileges that are not granted to holders of common stock. These are embodied in the various transaction documents. Common rights include:
· Anti-dilution protection - if the company ever sells a significant amount of stock at a price lower than the investor paid, then to protect investors against stock dilution they are issued additional shares (usually by changing the "conversion ratio" used to calculate their liquidation preference). There are various formulas including full ratchet and "weighted average"
· guaranteed board seats
· positive and negative covenants by the company
· registration right - the investors have special rights to demand registration of their stock on public exchanges, and to participate in an initial public offering and subsequent public offerings
· representations and warranties as to the state of the company
· Liquidation preferences - in any liquidation event such as a merger or acquisition, the investors get their money back, often with interest and/or at a multiple, before common stock is paid any funds from liquidation. The preference may be "participating", in which case the investors get their preference and their proportionate share of the surplus, or "non-participating" in which case the preference is a floor.
· dividends - dividend amounts are usually stated but not mandatory on the part of the company, except that the investors will get their dividends before any dividends may be declared for common stock. Most venture-backed start-ups are initially unprofitable so dividends are rarely paid. Unpaid dividends are generally forgiven but they may be accumulated and are added to the liquidation preference.
Round names
Venture capital financing rounds typically have names relating to the class of stock being sold:
Seed round where company insiders provide start-up capital
Angel round where early outside investors buy common stock
Series A, Series B, Series C, etc. Generally, the progression and price of stock at these rounds is an indication that a company is progressing as expected. Investors become concerned when a company has raised too much money in too many rounds, considering it a sign of delayed progress.
Series A', B', and so on. Indicate small follow-on rounds that are integrated into the preceding round, generally on the same terms, to raise additional funds.
Series AA, BB, etc. Generally used to denote a new start after a crunchdown or down round, i.e. the company failed to meet its growth objectives and is essentially starting again under the umbrella of a new group of funders. This terminology my be used
mezzanine finance rounds, bridge loans, and other debt instruments used to support a company between venture rounds or before its initial public offeri
The Venture Capital Investment Process:
The venture capital activity is a sequential process involving the following six steps.1. Deal origination2. Screening3. Due diligence Evaluation)4. Deal structuring5. Post-investment activity6. Exist
Venture Capital Investment Process
Deal origination:
In generating a deal flow, the VC investor creates a pipeline of deals or investment opportunities that he would consider for investing in. Deal may originate in various ways. referral system, active search system, and intermediaries. Referral system is an important source of deals. Deals may be referred to VCFs by their parent organisaions, trade partners, industry associations, friends etc. Another deal flow is active search through networks, trade fairs, conferences, seminars, foreign visits etc. Intermediaries is used by venture capitalists in developed countries like USA, is certain intermediaries who match VCFs and the potential entrepreneurs.
Screening:
VCFs, before going for an in-depth analysis, carry out initial screening of all projects on the basis of some broad criteria. For example, the screening process may limit projects to areas in which the venture capitalist is familiar in terms of technology, or product, or market scope. The size of investment, geographical location and stage of financing could also be used as the broad screening criteria.
Due Diligence:
Due diligence is the industry jargon for all the activities that are associated with evaluating an investment proposal. The venture capitalists evaluate the quality of entrepreneur before appraising the characteristics of the product, market or technology. Most venture capitalists ask for a business plan to make an assessment of the possible risk and return on the venture. Business plan contains detailed information about the proposed venture. The evaluation of ventures by VCFs in India includes;
Preliminary evaluation: The applicant required to provide a brief profile of the proposed venture to establish prima facie eligibility.
Detailed evaluation: Once the preliminary evaluation is over, the proposal is evaluated in greater detail. VCFs in India expect the entrepreneur to have:- Integrity, long-term vision, urge to grow, managerial skills, commercial orientation.
VCFs in India also make the risk analysis of the proposed projects which includes: Product risk, Market risk, Technological risk and Entrepreneurial risk. The final decision is taken in terms of the expected risk-return trade-off as shown in Figure.
Deal Structuring:
In this process, the venture capitalist and the venture company negotiate the terms of the deals, that is, the amount, form and price of the investment. This process is termed as deal structuring. The agreement also include the venture capitalist's right to control the venture company and to change its management if needed, buyback arrangements, acquisition, making initial public offerings (IPOs), etc. Earned out arrangements specify the entrequreneur's equity share and the objectives to be achieved.
Post Investment Activities:
Once the deal has been structured and agreement finalised, the venture capitalist generally assumes the role of a partner and collaborator. He also gets involved in shaping of the direction of the venture. The degree of the venture capitalist's involvement depends on his policy. It may not, however, be desirable for a venture capitalist to get involved in the day-to-day operation of the venture. If a financial or managerial crisis occurs, the venture capitalist may intervene, and even install a new management team.
Exit:
Venture capitalists generally want to cash-out their gains in five to ten years after the initial investment. They play a positive role in directing the company towards particular exit routes. A venture may exit in one of the following ways:1. Initial Public Offerings (IPOs)2. Acquisition by another company3. Purchase of the venture capitalist's shares by the promoter, or4. Purchase of the venture capitalist's share by an outsider.
Methods of Venture Financing
Venture capital is typically available in three forms in India, they are:
Equity : All VCFs in India provide equity but generally their contribution does not exceed 49 percent of the total equity capital. Thus, the effective control and majority ownership of the firm remains with the entrepreneur. They buy shares of an enterprise with an intention to ultimately sell them off to make capital gains.
Conditional Loan: It is repayable in the form of a royalty after the venture is able to generate sales. No interest is paid on such loans. In India, VCFs charge royalty ranging between 2 to 15 percent; actual rate depends on other factors of the venture such as gestation period, cost-flow patterns, riskiness and other factors of the enterprise.
Income Note : It is a hybrid security which combines the features of both conventional loan and conditional loan. The entrepreneur has to pay both interest and royalty on sales, but at substantially low rates.
Other Financing Methods: A few venture capitalists, particularly in the private sector, have started introducing innovative financial securities like participating debentures, introduced by TCFC is an example.
Venture capital fund operations
Roles within a VC firm
Venture capital general partners (also known in this case as "venture capitalists" or "VCs") are the executives in the firm, in other words the investment professionals. Typical career backgrounds vary, but many are former chief executives at firms similar to those which the partnership finances and other senior executives in technology companies.
Investors in venture capital funds are known as limited partners. This constituency comprises both high net worth individuals and institutions with large amounts of available capital, such as state and private pension funds, university financial endowments, foundations, insurance companies, and pooled investment vehicles, called fund of funds.
Other positions at venture capital firms include venture partners and entrepreneur-in-residence (EIR). Venture partners "bring in deals" and receive income only on deals they work on (as opposed to general partners who receive income on all deals). EIRs are experts in a particular domain and perform due diligence on potential deals. EIRs are engaged by VC firms temporarily (six to 18 months) and are expected to develop and pitch startup ideas to their host firm (although neither party is bound to work with each other). Some EIR's move on to roles such as Chief Technology Officer (CTO) at a portfolio company. According to the National Venture Capital Association the typical individual believes that a venture capitalist is a rich individual ready to invest in a new business venture, an investment into a "change-the-world" idea. On the contrary the investors look for a high interest yielding opportunity.
Venture Capital may be a viable source of financing for a business. While they generally invest in businesses that are more established and ongoing, some do fund start-ups. In general they tend to invest in high-technology businesses such as research and development, electronics and computers. Venture Capitalists deal more in large sums of money, numbering into the millions of dollars, so they are generally well suited to businesses that are going grand from the start or have grown and require gigantic expansion.
Structure of the funds
Most venture capital funds have a fixed life of 10 years, with the possibility of a few years of extensions to allow for private companies still seeking liquidity. The investing cycle for most funds is generally three to five years, after which the focus is managing and making follow-on investments in an existing portfolio. This model was pioneered by successful funds in Silicon Valley through the 1980s to invest in technological trends broadly but only during their period of ascendance, and to cut exposure to management and marketing risks of any individual firm or its product.
In such a fund, the investors have a fixed commitment to the fund that is "called down" by the VCs over time as the fund makes its investments. There are substantial penalties for a Limited Partner (or investor) that fails to participate in a capital call.
Raising substantial venture capital
Venture capital is not generally suitable for all entrepreneurs. Venture capitalists are typically very selective in deciding what to invest in; as a rule of thumb, a fund may invest in as few as one in four hundred opportunities presented to it. Funds are most interested in ventures with exceptionally high growth potential, as only such opportunities are likely capable of providing the financial returns and successful exit event within the required timeframe (typically 3-7 years) that venture capitalists expect.
This need for high returns makes venture funding an expensive capital source for companies, and most suitable for businesses having large up-front capital requirements which cannot be financed by cheaper alternatives such as debt. That is most commonly the case for intangible assets such as software, and other intellectual property, whose value is unproven. In turn this explains why venture capital is most prevalent in the fast-growing technology and life sciences or biotechnology fields.
If a company does have the qualities venture capitalists seek such as a solid business plan, a good management team, investment and passion from the founders, a good potential to exit the investment before the end of their funding cycle, and target minimum returns in excess of 40% per year, it will find it easier to raise venture capital.
What do venture capitalist look for-
Venture capitalists are higher risk investors and, in accepting these risks, they desire a higher return on their investment. The venture capitalist manages the risk/reward ratio by only investing in businesses which fit their investment criteria and after having completed extensive due diligence.Venture capitalists have differing operating approaches. These differences may relate to location of the business, the size of the investment, the stage of the company, industry specialization, structure of the investment and involvement of the venture capitalists in the companies activities. The entrepreneur should not be discouraged if one venture capitalist does not wish to proceed with an investment in the company. The rejection may not be a reflection of the quality of the business, but rather a matter of the business not fitting with the venture capitalist's particular investment criteria. Often entrepreneurs may want to ask the venture capitalist for other firms that might be interested in the investment opportunity.
Venture capital is not suitable for all businesses, as a venture capitalist typically seeks :
Superior Businesses- Venture capitalists look for companies with superior products or services targeted at large, fast growing or untapped markets with a defensible strategic position such as intellectual property or patents.
Quality and Depth of Management- Venture capitalists must be confident that the firm has the quality and depth in the management team to achieve its aspirations. Venture capitalists seldom seek managerial control, rather they want to add value to the investment where they have particular skills including fund raising, mergers and acquisitions, international marketing, product development, and networks.
Appropriate Investment Structure- As well as the requirement of being an attractive business opportunity, the venture capitalist will also seek to structure a deal to produce the anticipated financial returns to investors. This includes making an investment at a reasonable price per share (valuation).
Exit Opportunity- Lastly, venture capitalists look for the clear exit opportunity for their investment such as public listing or a third party acquisition of the investee company.Once a short list of appropriate venture capitalists has been selected, the entrepreneur can proceed to identify which investors match their funding requirements. At this point, the entrepreneur should contact the venture capital firm and identify an investment manager as an initial contact point. The venture capital firm will ask prospective investee companies for information concerning the product or service, the market analysis, how the company operates, the investment required and how it is to be used, financial projections, and importantly questions about the management team. In reality, all of the above questions should be answered in the Business Plan. Assuming the venture capitalist expresses interest in the investment opportunity, a good business plan is a pre-requisite.
Venture capital and development
-Venture capital can be used as a financial tool for development, within the range of small and medium enterprises (SME) finance, by playing a key role in business start-ups, existing small and medium enterprises and overall growth in developing economies. Venture capital acts most directly by being a source of job creation, facilitating access to finance for small and growing companies which otherwise would not qualify for receiving loans in a bank, and improving the corporate governance and accounting standards of the companies.
-Venture capital is used as a tool for economic development in areas such as Latin America and the Caribbean.
Recent Developments
Investments by venture capital funds in realty sector is under the government scanner- 13th November, 2007: Investments by venture capital funds, especially in the realty sector, have come under the government scanner. Following a communiqué from the central bank, the government and market regulator Sebi are examining the norms governing investments by the funds.
The central bank, worried over large capital inflows into the realty sector, has asked the government to take various measures, including making Foreign Investment Promotion Board approval mandatory for foreign investment. Though the concern may be centred around realty, sources said a need has been felt to look at investments by venture capital funds in general, especially in sectoral guidelines.
Sebi has a negative list of sectors in which venture capital investment is not allowed. Real estate was taken off the list in 2004, when the government allowed foreign investment into the sector. Sources said, downstream investments by a venture capital fund which has foreign investors need to be looked at.
“The law does not place any FDI restrictions on downstream investment by a VCF which invites foreign investments. VCF, being an Indian entity, such restrictions logically should not apply,” says Pricewaterhouse Coopers financial services tax practice head Punit Shah.
This is particularly so for investments in the real estate sector where there are sectoral guidelines. The foreign direct investment in the real estate sector is subject to a three year lock-in. Venture capital investments made ahead of the initial public offer were is not subject to a lock-in. Though the department of industrial policy & promotion and finance ministry has held consultations on application of a three year lock-in on pre-IPO placements to foreign institutional investors, the foreign venture capital funds investments were not included in it.
“Foreign venture capital investors registered with Sebi are not subject to any lock – in period, if they invest in a company more than 12 months before its IPO. If the investment is within 12 months prior to the IPO, then there is a lock in period of 1 year. Promoters are locked in for 3 years following an IPO. As such, different lock-in periods apply to different categories of investors,” says Majumdar & Co managing partner Akil Hirani.
The government had taken away tax benefit by way of pass-through status from venture capital funds in the last budget while allowing it only for select sectors like biotechnology. This was primarily done to discourage flow of funds into realty.
Angel investor
An angel investor or angel (known as a business angel in Europe), is an affluent individual who provides capital for a business start-up, usually in exchange for convertible debt or ownership equity. A small but increasing number of angel investors are organizing themselves into angel networks or angel groups to share research and pool their investment capital.
Source and extent of funding
Angels typically invest their own funds, unlike venture capitalists, who manage the pooled money of others in a professionally-managed fund. Although typically thought of as individuals, the actual entity that provides the funding may be a trust, business, investment fund, etc.
Angel capital fills the gap in start-up financing between "friends and family" (sometimes humorously called friends, family, and fools) who provide seed funding, and venture capital. Although it is usually difficult to raise more than a few hundred thousand dollars from friends and family, most traditional venture capital funds are usually not able to consider investments under US$1–2 million. Thus, angel investment is a common second round of financing for high-growth start-ups, and accounts in total for almost as much money invested annually as all venture capital funds combined, but into more than ten times as many companies.
Investment profile
Angel investments bear extremely high risk, and thus require a very high return on investment. Because a large percentage of angel investments are lost completely when early stage companies fail, professional angel investors seek investments that have the potential to return at least 10 or more times their original investment within 5 years, through a defined exit strategy, such as plans for an initial public offering or an acquisition.
While the investor's need for high rates of return on any given investment can thus make angel financing an expensive source of funds, cheaper sources of capital, such as bank financing, are usually not available for most early-stage ventures.
Angel investors are often retired entrepreneurs or executives, who may be interested in angel investing for reasons that go beyond pure monetary return. These include wanting to keep abreast of current developments in a particular business arena, mentoring another generation of entrepreneurs, and making use of their experience and networks on a less-than-full-time basis. Thus, in addition to funds, angel investors can often provide valuable management advice and important contacts.
Financial bootstrapping
Financial bootstrapping is a term used to cover different methods for avoiding using the financial resources of external investors. Bootstrapping can be defined as “a collection of methods used to minimize the amount of outside debt and equity financing needed from banks and investors” (Ebben and Johnsen, 2006:853). The use of private credit cards is the most known form of bootstrapping, but a wide variety of methods are available for entrepreneurs. While bootstrapping involves a risk for the founders, the absence of any other stakeholder gives the founders more freedom to develop the company. Many successful companies including Dell Computers were founded this way. Bootstrapping has been used as an explanation for how companies get resources when they can not get external investors or debt finance.
Corporate Venturing
The term 'corporate venturing' covers a range of mutually beneficial relationships between companies. The relationships range from those between companies within the same group, through those between unrelated companies, to collective investment by companies in other companies through a fund. The companies involved may be of any size, but such relationships are commonly formed between a larger company and a smaller independent one, usually in a related line of business.
The larger company may invest in the smaller company, and so provide an alternative or supplementary source of finance. It may, instead or as well as,
make available particular skills or knowledge, perhaps in technical or management areas, which a smaller company would otherwise not have access to, and
provide access to established marketing and distribution channels, or complementary technologies.
In addition to any financial return it receives from an investment the larger company may gain a competitive advantage by
being able to make better use of its own resources, and
gain access to
research or development, or other work in an area it is interested in
new ideas
a more entrepreneurial culture.
Forming corporate venturing relationships can be a way for large companies to develop and broaden their business without acquiring other companies, and a way for small companies to grow faster than they otherwise would. A typical outcome would be the development of a new product or process, perhaps involving an exclusive licensing deal between the two companies.
An overview of the Corporate Venturing Scheme
The CVS is aimed at companies considering direct investment, in the form of a minority shareholding, in small independent higher-risk trading companies or groups of such companies. It provides tax incentives for corporate equity investment in the same types of companies as those qualifying under the Enterprise Investment Scheme (EIS) and Venture Capital Trust (VCT) scheme. The incentives are available in respect of qualifying shares issued between 1 April 2000 and 31 March 2010. The aims of the Corporate Venturing Scheme (CVS) are to
· increase the availability of venture capital to small higher-risk trading companies from corporate investors, and through this
· foster wider corporate venturing relationships between otherwise unconnected companies.
The tax reliefs available are
· investment relief - relief against corporation tax of up to 20% of the amount subscribed for full-risk ordinary shares, provided that the shares are held throughout a qualification period
· deferral relief - deferral of tax on chargeable gains arising on the disposal of shares on which investment relief has been obtained and not withdrawn in full, if the gains are reinvested in new shares for which investment relief is obtained
· loss relief - relief against income for capital losses arising on most disposals of shares on which investment relief has been obtained and not withdrawn in full, net of the investment relief remaining after the disposal.
A summary of the main rules
There are rules applying to
· the investing company - the company making the equity investment
· the issuing company - the company receiving the investment
· the investment process - the issue of shares to the investing company by the issuing company, and the use of the money raised by it.
A number of the rules must be satisfied throughout the 'qualification period' related to the shares. The qualification period related to the shares is a period starting with their issue and ending
· immediately before the third anniversary of the issue date where the qualifying trade for which the funds have been raised is already being carried on, or
· immediately before the third anniversary of the date on which the trade commences where the company issues the shares to raise money for a trade which is not already being carried on.
If a company is carrying on research and development from which a qualifying trade will be derived or will benefit, this activity will be treated as carrying on a qualifying trade.
The investing company
The investing company must not be party to any arrangements for purchasing shares in another company which are conditional on the purchase of shares in the investing company, and throughout the qualification period must
· not own more than 30% of the issuing company, nor be able to exercise control of the issuing company
· exist wholly for the purpose of carrying on non-financial trades, or if it is a member of a non-financial trading group, exist wholly for the purpose of carrying on non-financial trades, investment (or other non-trade businesses), or be the parent company.
The issuing company
When the shares are issued the issuing company
must be an unquoted company and must not have made any arrangements to become a quoted company
must have gross assets of no more than £15 million immediately before, and £16 million immediately after the issue (if the issuing company is the parent company of a group, this test is applied to the group as a whole).
Throughout the qualification period the issuing company must not be a member of a group of companies, unless it is the parent company of the group, and must not be under the control of another company.
At least 20% of the issuing company's ordinary share capital must be held by individuals other than directors or employees (or their relatives) of an investing company, or any company connected with it.
An issuing company which is not a group member must exist wholly for the purpose of carrying on one or more qualifying trades (broadly, all but certain lower-risk trades) and either be carrying on a qualifying trade or be preparing to do so.
Where the issuing company is the parent company of a group, the business of the group as a whole must consist wholly, or to a substantial extent, of qualifying activities. At least one company of the group must exist wholly for the purpose of carrying on one or more qualifying trades, and either be carrying on a qualifying trade or be preparing to do so.
The investment process
The subscription for shares must be wholly in cash, for full-risk ordinary shares, which are fully paid-up at the time they are issued.
The money raised from issuing the shares must be used for the purposes of a qualifying trade, or for research and development intended to lead to or benefit a qualifying trade, within 12 months of the issue of the shares. Where it is to be used for a trade, which is not being carried on at the time the shares are issued, it must be used within 12 months after the date on which the trade commences.
There are also restrictions on the issuing arrangements for the shares, so that they do not include arrangements that provide protection to investors against the normal commercial risks attached to investing in the issuing company.
All Venture Capital Funds Registered with SEBI
Guidelines for Overseas Investments by Venture Capital Funds
SEBI registered Venture Capital Fund (VCFs) are permitted to invest in
securities of foreign companies in terms of regulation 12(ba) of the SEBI
(Venture Capital Funds) Regulations 1996. Reserve Bank of India (RBI) vide
its Circulars dated April 30, 2007 and May 04,2007, issued in this regard, has
permitted these VCFs to invest in equity and equity linked instruments only of
off-shore venture capital undertakings, subject to overall limit of USD 500
million and applicable SEBI regulations.
Accordingly, SEBI registered VCFs, desirous of making investments in offshore
Venture Capital Undertakings may submit their proposal for investment
(in the attached format) to SEBI for its prior approval. It is clarified that no
separate permission from RBI is necessary in this regard.
For the purpose of such investment, it is clarified that –
i. Offshore Venture Capital Undertakings means a foreign company whose
shares are not listed on any of the recognized stock exchange in India or
abroad.
ii. Investments would be made only in those companies which have an
Indian connection (i.e. company which has a front office overseas, while
back office operations are in India) and such investments would be upto
10% of the investible funds of a VCF.
iii. The allocation of investment limits would be done on ‘first come- first
serve’ basis, depending on the availability in the overall limit of USD 500
million.
iv. It is clarified that in case a VCF who is allocated certain investment limit,
wishes to apply for allocation of further investment limit, the fresh
application shall be dealt with on the basis of the date of its receipt and no
preference shall be granted to it in fresh allocation of investment limit.
v. An applicant VCF shall have a time limit of 6 months for making allocated
investments in offshore venture capital undertakings. In case the applicant
does not utilize the limits allocated in the stipulated period of 6 months
from the date of its approval, SEBI may allocate such unutilized limit to
other VCFs/applicants whose applications are pending with it.
These investments would be subject to necessary amendments to Notification
No. FEMA120/RB-2004 dated July 7, 2004 [Foreign Exchange Management
(Transfer or Issue of Any Foreign Security) Regulations, 2004], and will also
be governed by the related directions issued by the RBI from time to time.
This circular is being issued in exercise of the powers conferred under subsection
(1) of Section 11 of the Securities and Exchange Board of India Act,
1992 and is without prejudice to compliances/permissions/approvals, if any,
required under any other law.
Proposed amendments to the Finance Bill, 2007 approved by the Lok Sabha
The Finance Bill, 2007 (the Bill), was presented by the Finance Minister (FM) before the Parliament on 28 February 2007. The Bill inter alia proposed to levy a fringe benefit tax on stock options granted to employees.The FM received a lot of representations on this and certain other proposals in the Bill. Considering the representations received the FM proposed certain changes to the proposals in the Bill during the debate thereon before the Lok Sabha, the lower house of the Parliament. After debate and after considering the amendments, the Lok Sabha has passed the Bill on 3 May 2007, with amendments.options were granted.allotment/transfer of the security.actually given to the employees.
Venture Capital Undertaking
The Bill has proposed to restrict the tax exemption on income of a Venture Capital Company or Venture Capital Fund (VCF) only for investment made in a Venture Capital Undertaking (VCU) engaged in the specified businesses/industries for example. IT development (hardware & software), bio-technology, dairy and poultry
industry, etc.
The same has now been extended to income from investment in a VCU engaged in developing or operating and
maintaining or developing, operating and maintaining any “infrastructure facility”. Infrastructure facility is
defined as:-
• a road including toll road, a bridge or a rail system;
• a highway project including housing or other activities being an integral part of the highway project;
• a water supply project, water treatment system, irrigation project, sanitation and sewerage system or solid waste management system;
• a port, airport, inland waterway or inland port.
1
Venture capital fund- with respect to a banking company
The Reserve Bank has revised the prudential framework governing banks’ exposure to venture capital funds (VCFs). All scheduled commercial banks (excluding RRBs) have been advised to comply with the prudential requirements relating to financing of VCFs as indicated below :
Prudential Exposure Limits
(i) All exposures to VCFs (both registered and unregistered) will be deemed to be on par with equity and hence will be reckoned for compliance with the capital market exposure ceilings (ceiling for direct investment in equity and equity linked instruments as well as ceiling for overall capital market exposure).
(ii) Banks will not hold more than 30 per cent of the paid up capital of the investee company or 30 per cent of their own paid up share capital and reserves, whichever is lower.
(iii) Investments in VCFs in the form of equity/units etc., will also be subjected to the limits stipulated in the Reserve Bank’s Master Circular on Para Banking Activities of July 1, 2005 in terms of which, the investment by a bank in a subsidiary company, financial services company, financial institution, stock and other exchanges should not exceed 10 per cent of the bank’s paid-up capital and reserves and investments
in all such companies, financial institutions, stock and other exchanges put together should not exceed 20 per cent of the bank’s paid-up capital and reserves.
Valuation/Classification
(i) The quoted equity shares/bonds/units of VCFs in the bank’s portfolio should be held under ‘available for sale’ (AFS) category and marked to market preferably on a daily basis, but at least on a weekly basis in line with valuation norms for other equity shares as per existing instructions.
(ii) Henceforth, banks’ investments in unquoted shares/bonds/ units of VCFs will be classified under held to maturity (HTM) category for the initial period of three years and will be valued at cost during this period. For investments made before issuance of these guidelines, the classification would
be done as per the existing norms.
(iii) For this purpose, the period of three years will be reckoned separately for each disbursement made by the bank to VCF as and when the committed capital is called up. To ensure conformity with the existing norms for transferring securities from HTM category, transfer of all securities which have completed three years as mentioned above will be effected at the beginning of the next accounting year in one lot to coincide with the annual transfer of investments from HTM category.
(iv) After three years, the unquoted units/shares/bonds should be transferred to AFS category and valued as under:
Units
In the case of investments in the form of units, the valuation will be done at the net asset value (NAV) shown by the VCF in its financial statements. Depreciation, if any, on the units based 2 Monetary and Credit Information Review, September, 2006 on NAV has to be provided at the time of shifting the investments
to AFS category from HTM category as also on subsequent valuations which should be done at quarterly or more frequent intervals based on the financial statements received from the VCF. At least once in a year, the units should be valued based on the audited results. If the audited balance sheet/financial statements showing NAV figures are not available continuously for more than 18 months as on the date of valuation, the
investments should be valued at Rupee 1.00 per VCF.
Equity
In the case of investments in the form of shares, the valuation can be done at the required frequency based on the break-up value (without considering ‘revaluation reserves’, if any) which is to be ascertained from the company’s (VCF’s) latest balance sheet (which should not be more than 18 months prior to the date of valuation). Depreciation, if any, on the shares has to be provided at the time of shifting the investments to AFS category as also on subsequent valuations which should be done at quarterly or more frequent intervals. If the latest balance sheet available is more than 18 months old, the shares should be
valued at Rupee 1.00 per company.
Bonds
Investments in bonds of VCFs, if any, should be valued as per prudential norms for classification, valuation and operation of investment portfolio issued by the Reserve Bank from time to
time.
Risk Weight/Capital Charge for Market Risk
Shares/Units
Investments in shares/units of VCFs should be assigned 150 per cent risk weight for measuring the credit risk during the first three years when these are held under HTM category. When these are held under or transferred to AFS, the capital charge for specific risk component of the market risk should be fixed at 13.5
per cent to reflect the risk weight of 150 per cent. The charge for general market risk component should be at 9 per cent as in the case of other equities.
Bonds
Investments in bonds of VCFs will attract risk weight of 150 per cent for measuring the credit risk during the first three years when these are held under HTM category. When the bonds are held under or transferred to AFS category, these would attract specific risk capital charge of 13.5 per cent. The charge for general market risk should be computed as in the case of investment in any other kind of bonds as per existing guidelines.
VCFs other than Investments
Exposures to VCFs other than investments should also be assigned a risk weight of 150 per cent.
Exemption
Investments in unlisted and unrated bonds of VCFs will be exempted from the extant guidelines relating to non-SLR securities, in terms of which, a bank’s investment in unlisted non- SLR securities should not exceed 10 per cent of its total investment in non-SLR securities as on March 31, of the previous year; and banks must not invest in unrated non-SLR securities.
Approval for Strategic Investments
Banks should obtain the Reserve Bank’s prior approval for making strategic investment in VCFs i.e., investments equivalent to more than 10 per cent of the equity/unit capital of a VCF.
Internet Banking
On a review of the guidelines on Internet Banking in India, the Reserve Bank has decided to permit banks to offer Internet based foreign exchange services for permitted underlying transactions, in addition to the local currency products already allowed to be offered on Internet based platforms. Such permission is subject to the terms and conditions as follows :
(i) Banks would remain responsible for secrecy, confidentiality and integrity of data.
(ii) The data relating to Indian operations should be kept segregated.
(iii) The data should be made available to the Reserve Bank for inspection/ audit as and when called for.
(iv) The service should allow only reporting and initiation of foreign exchange related transactions, with the actual trade transactions being permitted only after verification of
physical documents.
(v) Banks should comply with FEMA regulations relating to cross-border transactions.
In all other matters relating to Internet banking services, banks may continue to be guided by the instructions contained in the Reserve Bank’s circular of June 14, 2001.
Appropriation from Reserve Fund
In order to ensure that banks’ recourse to drawing down the ‘statutory reserve’ is done prudently and is not in violation of any of the regulatory prescriptions, they have been advised in their own interest to take the Reserve Bank’s prior approval before any appropriation is made from the statutory reserve or any other
reserves. Banks have been further advised that -
(i) all expenses including provisions and write-offs recognized in a period, whether mandatory or prudential, should be reflected in the profit and loss account for the period as an ‘above the line’ item (i.e., before arriving at the net profit);
(ii) wherever draw down from reserves takes place with the Reserve Bank’s prior approval, it should be effected only ‘below the line’ (i.e., after arriving at the profit/loss for the
year); and
(iii) it should be ensured that suitable disclosures are made of such draw down of reserves in the ‘Notes on Accounts’ to the balance sheet.
It may be recalled that in terms of section 17 (1) and 11(1)(b) (ii) of the Banking Regulation Act, 1949 banks are required to transfer, out of the balance of profit as disclosed in the profit and loss account, a sum equivalent to not less than 20 per cent of such profit to ‘Reserve Fund’. This provision is a minimum
requirement. Considering the imperative need for augmenting the reserves, all scheduled commercial banks operating in India (including foreign banks) were advised in September 2000 to transfer not less than 25 per cent of the ‘net profit’ (before Monetary and Credit Information Review, September, 2006 3 appropriations) to the Reserve Fund with effect from the year ending March 31, 2001. In terms of Sec 17(2), where a banking company appropriates any sum or sums from the reserve fund or the share premium account, it should, within twenty-one days from the date of such appropriation, report the fact to the Reserve Bankexplaining the circumstances relating to such appropriation
Regulatory Structure of RBI for domestic and offshore VCs
The Union Budget 2007-08 proposed to limit exemption from tax given to venture capital fund only to investments in venture capital undertakings in biotechnology; information technology relating to hardware and software development; nanotechnology; seed research and development; research and development of new chemical entities in the pharmaceutical sector; dairy industry; poultry industry and production of bio-fuels.
2008-09 and subsequent assessment years up to assessment year 2012-13.
Measures To Promote Socioeconomic Development
Exemption for certain incomes of a venture capital company or venture capital fund from specified businesses or industries
Under the existing provisions of clause (23FB) of section 10, any income of a venture capital company or venture capital fund set up to raise funds for investment in a venture capital undertaking is exempted from tax.
In Union Budget 2007-08, it is proposed to amend the said clause so as to provide that such exemption will now be available only in respect of income of a venture capital company or venture capital fund from investment in a venture capital undertaking engaged in certain specified businesses or industries. For this purpose, it is also proposed to amend the aforesaid definition of venture capital undertaking to mean such domestic company whose shares are not listed in a recognised stock exchange in India and which is engaged in the business of nanotechnology, information technology relating to hardware and software development, seed research and development, bio-technology, research and development of new chemical entities in the pharmaceutical sector, production of bio-fuels, or building and operating composite hotel-cum-convention centre with seating capacity of more than 3,000, or engaged in the dairy industry or poultry industry.
This amendment will take effect from 1st April, 2008 and will accordingly apply in relation to the assessment year 2008-09 and subsequent years.
Jul 02, 2007 : Master Circular - Disclosure in Financial Statements - Notes to Accounts
Exposure to Capital Market
Particulars
Current year
Previous Year
(i). direct investment in equity shares, convertible bonds, convertible debentures and units of equity-oriented mutual funds the corpus of which is not exclusively invested in corporate debt;
advances against shares/bonds/ debentures or other securities or on clean basis to individuals for investment in shares (including IPOs/ESOPs), convertible bonds, convertible debentures, and units of equity-oriented mutual funds;
advances for any other purposes where shares or convertible bonds or convertible debentures or units of equity oriented mutual funds are taken as primary security;
advances for any other purposes to the extent secured by the collateral security of shares or convertible bonds or convertible debentures or units of equity oriented mutual funds i.e. where the primary security other than shares/convertible bonds/convertible debentures/units of equity oriented mutual funds `does not fully cover the advances;
secured and unsecured advances to stockbrokers and guarantees issued on behalf of stockbrokers and market makers;
loans sanctioned to corporates against the security of shares / bonds/debentures or other securities or on clean basis for meeting promoter’s contribution to the equity of new companies in anticipation of raising resources;
bridge loans to companies against expected equity flows/issues;
underwriting commitments taken up by the banks in respect of primary issue of shares or convertible bonds or convertible debentures or units of equity oriented mutual funds;
financing to stockbrokers for margin trading;
all exposures to Venture Capital Funds (both registered and unregistered) will be deemed to be on par with equity and hence will be reckoned for compliance with the capital market exposure ceilings (both direct and indirect)
Total Exposure to Capital Market
Jul 02, 2007 : Master Circular - Exposure Norms for Financial Institutions
1.2 Investments not covered1.2.1 The guidelines, however, do not apply to the following categories of investments of the FIs:a) government securities and the units of Gilt Funds;b) securities which are in the nature of advance under the extant prudential norms of RBI;c) units of the equity oriented schemes of Mutual Funds, viz., the schemes wherein a major part of their corpus is invested in equity shares;d) units of the “Balanced Funds”, which invest in debt as well as equities, provided a major part of the corpus is invested in equity shares. In case of predominance of investments in debt securities by the Fund, these guidelines would be attracted; e) Units of venture capital funds and the money market mutual funds;f) Commercial Paper; and g) Certificates of Deposits.
Jul 02, 2007 : Master Circular – Exposure Norms
5.10 Investments in Venture Capital Funds (VCFs)As announced in the Annual Policy Statement for the year 2006-2007 and advised in our circulars DBOD.BP.BC.84 & 27/21.01.002/2005-2006 dated May 25 and August 23, 2006 respectively, banks’ exposures to VCFs (both registered and unregistered) will be deemed to be on par with equity and hence will be reckoned for compliance with the capital market exposure ceilings (both direct and indirect).
Jul 02, 2007 : Master Circular – Prudential norms for classification, valuation and operation of investment portfolio by FIs
Coverage These guidelines apply to the FIs’ investments in debt instruments, both in the primary market (public issue as also private placement) as well as the secondary market, in the following categories: a) debt instruments issued by companies, banks, FIs and State and Central Government sponsored institutions, SPVs, etc.; b) debt instruments/ bond issued by Central or State Public Sector Undertakings, with or without government guarantee;
c) units of debt-oriented schemes of Mutual Funds i.e., the schemes whose major part the corpus is invested in debt securities; d) Capital gains bonds and the bonds eligible for priority sector status;
The guidelines, however, do not apply to the following categories of investments of the FIs: a) government securities and the units of Gilt Funds; b) securities which are in the nature of advance under the extant prudential norms of RBI; c) units of the equity oriented schemes of Mutual Funds, viz., the schemes wherein a major part of their corpus is invested in equity shares; d) units of the “Balanced Funds”, which invest in debt as well as equities, provided a major part of the corpus is invested in equity shares. In case of predominance of investments in debt securities by the Fund, these guidelines would be attracted. e) Units of venture capital funds and the money market mutual funds; f) Commercial Paper; and g) Certificates of Deposits
Monitoring of subsidiaries / mutual funds Over the years, financial institutions have diversified their activities into financial services such as merchant banking, venture capital, mutual funds, investment banking, housing finance, etc. and some others are in the process of doing so. Some financial institutions have set up subsidiaries or companies in which they have a significant stake, to carry out such activities. The parent FIs have considerable stake in the health of these institutions and any setback in their working could have an adverse effect on the parent FIs. It is therefore, important that the FIs should keep themselves informed about their activities and exercise adequate supervision over them.
Exclusions from the 25% ceiling The following investments will be included under “Held to Maturity” but will not be counted for the purpose of ceiling of 25% for the category: a) Investment in subsidiaries and joint ventures: A Joint Venture would be an entity in which a FI (along with the holdings, if any, by its subsidiary) holds more than 25% of equity capital pursuant to a Joint Venture agreement duly entered into between / amongst the FI and the joint venture partner(s) for furtherance of a commercial objective. Besides, the companies floated by the FIs and in which the FI (along with the holdings, if any, by its subsidiaries) holds more than 25 per cent of the equity share capital, would also be classified as a Joint Venture. A distinction ought to be made between the transfer of an investment and transmission of an investment to an FI on account of the operation of a statute. Thus, if the shares of a corporate entity were transmitted to an FI on account of operation of a statute, and were not acquired of its own volition, such entities could be treated as a Joint Venture and the shares held therein classified and valued accordingly, as per the extant RBI norms. Only such equity holdings, as also the equity held in subsidiaries, should be placed in the HTM category – and not where a FI, along with its subsidiaries, acquires equity in excess of 25% on account of conversion of loan, venture capital assistance, etc.
Jul 02, 2007 : Master Circular – Prudential norms for classification, valuation and operation of investment portfolio by FIs
Regulatory Restrictions
Granting loans and advances to relatives of Directors
Without prior approval of the Board or without the knowledge of the Board, no loans and advances should be granted to relatives of the bank's Chairman/Managing Director or other Directors, Directors (including Chairman/Managing Director) of other banks and their relatives, Directors of Scheduled Co-operative Banks and their relatives, Directors of Subsidiaries/Trustees of Mutual Funds/Venture Capital Funds set up by the financing banks or other banks.
Regulatory Restrictions
Granting loans and advances to relatives of Directors
Without prior approval of the Board or without the knowledge of the Board, no loans and advances should be granted to relatives of the bank's Chairman/Managing Director or other Directors, Directors (including Chairman/Managing Director) of other banks and their relatives, Directors of Scheduled Co-operative Banks and their relatives, Directors of Subsidiaries/Trustees of Mutual Funds/Venture Capital Funds set up by the financing banks or other banks, as per details given below.
Lending to directors and their relatives on reciprocal basis
There have been instances where certain banks have developed an informal understanding or mutual/reciprocal arrangement among themselves for extending credit facilities to each other’s directors, their relatives, etc. By and large, they did not follow the usual procedures and norms in sanctioning credit limits to the borrowers, particularly those belonging to certain groups or directors, their relatives, etc. Facilities far in excess of the sanctioned limits and concessions were allowed in the course of operation of individual accounts of the parties. Although, there is no legal prohibition on a bank from giving credit facilities to a director of some other banks or his relatives, serious concern was expressed in Parliament that such quid pro quo arrangements are not considered to be ethical. The banks should, therefore, follow the guidelines indicated below in regard to grant of loans and advances and award of contracts to the relatives of their directors and directors of other banks and their relatives:
Unless sanctioned by the Board of Directors/Management Committee, banks should not grant loans and advances aggregating Rs. 25 lakhs and above to -
(a) directors (including the Chairman/Managing Director) of other banks *;(b) any firm in which any of the directors of other banks * is interested as a partner or guarantor; and(c) any company in which any of the directors of other banks * holds substantial interest or is interested as a director or as a guarantor.Unless sanctioned by the Board of Directors/Management Committee, banks should also not grant loans and advances aggregating Rs.25 lakhs and above to -
(a) any relatives of their own Chairmen/Managing Directors or other Directors;(b) any relatives of the Chairman/Managing Director or other directors of other banks *;(c) any firm in which any of the relatives as mentioned in (a) & (b) above is interested as a partner or guarantor; and(d) any company in which any of the relatives as mentioned in (a) & (b) above hold substantial interest or is interested as a director or as a guarantor.
* including directors of Scheduled Co-operative Banks, directors of subsidiaries/trustees of mutual funds/venture capital funds.
Banks should not grant bridge loans of any nature, or interim finance against capital/debenture issues and/or in the form of loans of a bridging nature pending raising of long-term funds from the market by way of capital, deposits, etc. to all categories of Non-Banking Financial Companies, i.e. equipment leasing and hire-purchase finance companies, loan and investment companies, Residuary Non-Banking Companies (RNBCs) and Venture Capital Funds (VCFs).
Main alternatives to venture capital
Because of the strict requirements venture capitalists have for potential investments, many entrepreneurs seek initial funding from angel investors, who may be more willing to invest in highly speculative opportunities, or may have a prior relationship with the entrepreneur.
Furthermore, many venture capital firms will only seriously evaluate an investment in a start-up otherwise unknown to them if the company can prove at least some of its claims about the technology and/or market potential for its product or services. To achieve this, or even just to avoid the dilutive effects of receiving funding before such claims are proven, many start-ups seek to self-finance until they reach a point where they can credibly approach outside capital providers such as VCs or angels. This practice is called "bootstrapping".
There has been some debate since the dot com boom that a "funding gap" has developed between the friends and family investments typically in the $0 to $250,000 range and the amounts that most Venture Capital Funds prefer to invest between $1 to $2m. This funding gap may be accentuated by the fact that some successful Venture Capital funds have been drawn to raise ever-larger funds, requiring them to search for correspondingly larger investment opportunities. This 'gap' is often filled by angel investors as well as equity investment companies who specialize in investments in startups from the range of $250,000 to $1m. The National Venture Capital association estimates that the latter now invest more than $30 billion a year in the USA in contrast to the $20 billion a year invested by organized Venture Capital funds.
In industries where assets can be securitized effectively because they reliably generate future revenue streams or have a good potential for resale in case of foreclosure, businesses may more cheaply be able to raise debt to finance their growth. Good examples would include asset-intensive extractive industries such as mining, or manufacturing industries. Offshore funding is provided via specialist venture capital trusts which seek to utilise securitization in structuring hybrid multi market transactions via an SPV (special purpose vehicle): a corporate entity that is designed solely for the purpose of the financing.
In addition to traditional venture capital and angel networks, groups such as The Angel Project have emerged which allow groups of small investors or entrepreneurs themselves to compete in a privatized business plan competition where the group itself serves as the investor through a democratic process.
Sumamry
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. India’s 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 bio-technology, 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.
In its present role, venture capital not only encompasses information technology, but all high-growth technology and knowledge-based enterprises.
Let us now take a look at its meaning, its background, its role in the various sectors etc.
[1] [1](Venture Capital is considered a subset of private equity focused on investments in new and maturing companies.)
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