Venture Capital Financing Author(s): Sudip Bhattacharyya Reviewed work(s): Source: Economic and Political Weekly, Vol.

24, No. 47 (Nov. 25, 1989), pp. M157-M159 Published by: Economic and Political Weekly Stable URL: http://www.jstor.org/stable/4395620 . Accessed: 27/08/2012 06:21
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Venture

Capital

Financing

Sudip Bhattacharyya

of Thispaper discussesthe requirements successfulventurecapitalfinancingin India in the light of experience in the US and in some of the south-eastAsian countries.
THIS paper endeavours to: (i) Trace the origin and development of thNconcept of venturecapital(VC) financing,with a focus on the current status of such financing in the US, south-east Asia and India. (ii) Taking cue from (i) define the concept and develop an ideal model of a VC company. and (iii) Identifyits requirements suggestan approach for such financing.
HISTORICAL PERSPECTIVE

If VC fund is for supplementing eneffort in risk taking, its origin trepreneurial banks could be tracedto the riseof merchant in UK. These merchantbanks, mainly promoted by wealthy families, have supported trade and commerce across the border by providing the resources and/or risk participation directly or through discount houses and issue houses. They also facilitated setting up manufacturingunits albeit on a small scale. Such systemmanifestedin India in the form of managingagents. They had a very important role in providing not merelypartcapitalbut also inputin the form of overall managementand they definitely ventured into manufacturingareas. Institutionalisation VC financingtook of place much later around 1950s in the US with setting up, in 1946, of American Researchand Development(ARD) at MIT, with the explicit objectivesof promotion of new technologies developed in universities. Then, in 1958. Small Business Administration was set up to license small business investmentcompaniesin the privatesectorand also to provide them with long-term loans. There were subsequentlyprivate initiatives like those of Xerox, 3M and General Electric to finance skill and technology based projects. VCF in modern form really took off in the US and primarilysupported new technology areas. In the US typically the beneficiaries of such funds are the whiz kids with ideas but hard off for cash. Therefore, a broad indicative risk perception in American VC companies is of markedappreciationof investment in about 10 per cent-cases, but failuresin 40 per cent. The three important features noticed here are: (a) organised set up or existing operations are not the target clients; (b) technglogy thrust is towards unproven and not proven/commercialisedtechthe nology,therefore riskis predominant; (c) by and largemanagementalso comes in as an importantinput from the venture capitalist, although majority shareholding is not favoured for ensuring such control; practiceis to have written agreementdefining management role.

The Indian experience started in 60s with initiatives by term-lending institutions like IFCI and IDBI. They promoted two schemes called Risk Capital Foundation Schenmeand Seed Capital Scheme, primarily to support promoters/entrepreneurs in medium and small-scale industries, respectively. Assistance was provided in the form of loan finance on very soft terms to the promoters instead of the project. These ideas were mooted mainly as extension of their institutional role as apex developmental institutions. One may also acknowledge efforts of some banking institutions like the State Bank of India who ptovided loans to technical entrepreneurs in small projects without collaterals and sometimes without margin contribution from them. Currently, some developmental/financial institutions even at the state level are subscribing to equity capital in new companies and disinvesting after some time. The significance of this will be apparent later.
CURRENT STATUS

pany, Han Tech VentureCapital Company, has already made a mark. Singapore:In 1981,the National Iron and Steel Mills launchedinto a corporateventure investmentprogramme.This was followed up by four other funds, viz, (a)South-East Asian Investment Programme (SEAVI); (b) Transtech Ventures; (c) Elders Pica Growth Fund; (d) Economic Development Board VentureCapital Funds. DBS Bank is the other major player in Singapore VC financing. The government currentlyoffers pioneer servicesand incentives to encourage more locally-basedventure capital firms. Exemption from corporatetax for such companiesis possiblefor a period of 10 years. A second tier stock market for smaller companies started operatingsince early 1987,providinga route for 'Exit'. In Singapore they also look at morematuredfirmsproviding growthpotential ratherthan only start-ups.SEAVI'sapproach is towardsvalue-addedinvesting. It offers its networkof contacts and expertise to help firms enhance their operations. Hong Kong: In Hong Kong VC companies have been used as a base for technology transferto China which looks at VC entirelyin technology transferterms. Also, in Hong Kongthey get a lot of downstream engineeringdone on a cost-effective basis. Thus VCFhereis moreapplication-oriented. In December 1987, Hong Kong Venture Capital Association was formed with 20 companies as full members. Thailand:In 1987, BusinessVenturePromotion Company was promoted by a consortium of six local commercialbanks and USID. US $ 6 million was providedas a soft loan by USID and an equivalent amountwas raised as equity from the six participating banks. What has been found imperativein Thailand is that the VCF companies have to involvethemselveseven in preparation of businessplans for prospectiveclients. Other apprehension is with regard to existing legislations which may treat a VC fund as an investmentdealing company, leading to higher tax incidence. Malaysia:In 1984MalaysiaBhd Fundwas set up under SEAVIprogramme.There are incentivesavailableto attractforeign direct investors, although recession over the past three years has been an inhibitive factor. The following impediments have been found by VC companiesin south-eastAsia: (a) Business cultureis family controlled or
oriented.

From the US, VC financing travelled to Japan with a large measure of success. The existence of large inter-corporate holdings and among financial institutions/bank business houses and the shift in emphasis from large engineering enterprises to smaller but value added high technology areas made the task easier for VC companies in Japan. More interesting is that VC financing has. now entered south-east Asia. South Korea: Institutionalisation in South Korea took the following course-(i) setting up of Korea Technology Advancement Corporation in 1974 for implementing R and D projects of public research institutes; (ii) setting up of Korea Technology Development Corporation in 1981; (iii) setting up of Korea Development Investment Corporation and Korea Technology Financing Corporation in 1983; (iv) passing of Small and Medium Business Establishment Assistance Law in 1986 for equity investment by venture capitalists; (v) development of Technology Credit Guarantee System designed to assist venture business lacking in collateral for securing the borrowings. Finally, introduction in 1987 of Over the Counter (OTC) market for transacting in shares of promising venture businesses provided a great fillip. Taiwan: Legislations were passed in 1983 offering attractive incentives for investors in VC funds. In 1985, a development fund of NT$ 800 million for investing in VC fund was established. The focus in Taiwan is on high technology. Besides the three government associated institutions, a private com-

(b) Marketresearchis inadequate.There is also no significantcapabilityto evaluate service ventures. (c) Emphasison collateral-basedfinancing M-157

Economic and Political Weekly November 25, 1989

and dearth of adequate mechanism for 'Exit' except in Singapore.

SITUATION IN INDIA

The professed pioneers in VC fund in India are the following: (i) Risk Capital and Technology Finance Corporation (RCTFC): It was earlier an adjunct of IFCI. It has so far provided interest-free loan to promoters at a nominal service charge of 1 per cent p a. (ii) IDBI's venture capital fund: Under the terms of the research and development cess act of 1986, companies importing technologies pay a 5 per cent cess to the government. This goes to IDBI's fund. Such assistance is provided in the form of unsecured loans with minimum legal formalities. There is a concessional rate of 6 per cent during the period of development of the technology/the pilot plant and trial production. This rate may rise to 17 per cent if and when the product is accepted in the market. (iii) ICICI's TDIC: Technology Development and Information Corporation was set up in 1986 and has raised its capital entirely out of internal resources. There are no fixed terms for TDIC. Generally it provides funds to projects costing up to Rs 2.5 crore, either through concessional finance or participation. Repavment is proposed through a charge on the sale. Only a cap on the amount to be repaid is fixed a priori, depending on the profitability of the company. It is possible to recover about three times the original amount lent over an unspecified veriod. Another option offered is loan with a base interest plus a royalty on a1l sales. Loans are unsecured. The other lending instrument is direct equity participation. (iv) SBI Capital Market: Innovative approach was brought by SBI Capital Markets in this field through its 'bought-out-d'eals'. This is a way of promoting new capital issues in a bear market. It is done by buying out new issues with the objective of unloading them at a later stage after the market picks up. It has recently been announccj that Credit Capital Corporation of India has been permitted to set up a venture capital fund of Rs 10 crore. This will be the first fully private initiative in VC in India. Other players in the field are Grindlays Bank and Canara Bank financial services and SICOM. Industrial Rehabilitation Bank of India has for some time been assisting sick units in their efforts at rejuvenation. In the sense that sick units are selected for financing through a process of identification of potentials and by providing technical and managerial know-how along with funds on soft terms, the role of IRBI has considerable significance. The three institution-backed funds have

technology.(ICICI'srealhigh technologyinstitution would howeverbe the programme for Advanced Commercial Technology.) Sometimes the technology supported, even if new in India, is alreadycommercially successfully tried abroad;the emphasiswas on extension of assistance to secured risks inthe sense that either assistance was in the form of loan assistance which is strictly speaking not risk capital and the beneficiaries have been well established, well organised and larger companies. But then VC companiescan reallyexpectreturnsonly after sa, 4 "` yeai and thereforeinitial caution may be welcome.
DEFINITIONAND MODEL

made a mark in terms of quantumof assistance provided and they have focused on
M-158

From the aforesaid,the following important features emergeas the maincomponents of a VC company: Objectives: (a) capital appreciation; (b) roll over of funds. Role: (a) providing risk capital; (b) providing management. Area of operation: Unproven/notcom(a} mercialised technology; (b) opportunities due to marketdistortions/structuralinefficiencies in economy; (c) opportunities not exerciseddue to lack of management and organisational deficiencies; (d) service industryas sunriseindustry;(e) opportunities emergingthroughliberalisation economic of process. Therefore, typically,a VC companywould have the following programme: Objectivesand area of operations:Investments in a diversified portfolioof earlystage companies in technology-intensive enterprises, consumer or other businesses and limited equity participation in leveraged buyouts thereby generating substantial capital appreciationfor roll over of capital and benefit to investors in the funds. Role: To provide 'hands-on' managerial, operational, technical and financial assistance for its portfolio companies. Investment criteria:The funds will seek to investin emergingcompanieswhich have the following characteristics: Management. Management should preferably have seasoned and successful track record in other companies with an appropriate balance of business and technical skills, in additionto the abilityto attractand retain quality employees.The deficiency,if any, has to be made up by support of the VC company or from external -sources. Proprietaryproduct and/or technology. The technologyor productshould haveproprietary features which will create a competitive edge based on lead time, price and/or performance. Marketopportunity. The productor technology should havethe potential to capture a sizeable market position and establish channels of distribution in an emergingor high growth market.Alternatively,the pro-. duct or technology should satisfy a basic economic need in a definable market.The funds would also seek attractivebusinessin

industrieswith high entry barriersand profit margins and rapid sales growth. Diversification.The funds deploymentin any one portfolio to be limitedto say 7.5 per cent of the fund. In existing portfolio, this may be exceeded if needed. Businessplan. The companiesshouldhave reasonable business and financial plans to achievetheir product,marketingand financial objectives in a realistic time-frameacceptable to the funds. High return on investment. Companies will be sought with a potential for high returns on investmentcommensuratewith the substantial risks of the investment. Potential liquidity.The ability to achieve liquidity for individual investmentswill be an importantconsideration.The maximisation of portfolio returnwill in part depend upon the ability to effect a successful exit strategy through the sale of stock into the public market or the sale or mergerof the company.
Risk perception: High risk due to (a) con-

centration in high risk illiquid investments in new or emergingcompanies;(b) no assuranceof capital appreciationor any rate of returnon investment; illiquidinvestments (c) due to non-transferability shares except of in special cases.
REQUIREMENTS

For fulfilment of objectives, the venture capitalistmust realisethe gains of capitalapit preciation.Once this gain is realisable, will also automatically lead to meeting of supplementaryobjective of roll over of funds. This wouldrequire and 'exit' fiscal incentives mechanism.VC financingin Indiahas come through efforts of business associations, financial institutionswith support from the government. In 1987, a senior government official, Nitish Sengupta, had in an article
in The Economic Times dwelt at length on

a comprehensive packageof possible incentives for growth of VC companies. He had

suggested inter alia:

(a) Benefits of Section 80CC of Income TaxAct without any limit on investmentin venturecapital companies. This would lead to flow of funds to venture capital funds. (b) Liberalisingthe relief under Section 80M for such companies to avoid or minimise double taxation of dividends. (c) Extension of benefit under Section 80HHC to, say, 50 per cent of profitsearned by such companies. (d) Reductionin capitalgains tax for such companies. (e) Modification of Section 2(18) of Income Tax Act so that benefit available to companiesin which public are substantially interested could be extended to VCF
companies.

(f) Alternatively, partnership can be amended to allow for formation of limited partnershipas allowed in the US. For a properexit route for venturecapitalist, the options suggested are: Starting an unlistedsecuritymarketand overthe coSunter
November 25, 1989

Economic and Political Weekly

facility enabling quick transactions in shares held by venture capitalists at appropriate price. It may be necessary also to examine capital issues control or Security Contract Regulation Act so that premium could be appropriately determined or even left to market forces. There is already progress on OTC operation.
GUIDELINES

by professionals such'as bankers, managers and administrators and persons with adequate experience of industry, finance, accounts, etc. Foreign participation/tie-up may bring in management expertise and export market intelligence for use by VC companies. TO APPIROACH FINANCING For the VC companies to identify appropriate areas, understanding of the product cycle concept together with its typical 'S' curve pattern would be a great help. Basically, it must distinguish between invention and innovation. Funding is to be made only at innovation and post-innovation stage, where commercialisation prospects have been objectively established. Aspects such as technology obsolescence, product maturity, international competitiveness, stages of business cycle have to be clearly perceived. In other words, the VC company should: (1) perceive commercialisation possibility; (2) sense new process of manufacture giving cost advantage; (3) see new use of existing products or utility of a new product; (4) spot virgin market or exploit market/ structural imbalance/imperfection; (5) visualise new possibilities emerging due to liberalisation process particularly in service sector. A clear understanding of the aforesaid would also help identification of stage of/ financing like early stage financing, later stage financing and all-stage financing. Seed finance is the earliest stage financing entailing highest risk. Start up is perceived as the most fertile source for capital appreciation. The risks is less than in seed financing but in absolute terms works out higher because of larger quantum of investment involved. Management input may play a very complementary role in success of venture at this stage.

out of sale of post-acquisitionassets. Funding method often involvesjunk bond issue. These are bonds considered below investcarryhigh coupon ment gradeand therefore rates. But this leads to higher debt gearing and thereforeriskgoes up sinceexpectations may not reallymaterialise behindacquisition
CONCLUSION

Recently the government of India has announced guidelines for venture capital companies and venture capital funds. The guidelines have stressed high technology orientation of such venture. More relevant are the following: (i) The VCC/VCF may be listed according to the prescribed norms. Its issue may be underwritten at the discretion of the promoters. (ii) For assisted units also, listing guidelines would apply. Investment by widely held VCF would be treated as public participation for this purpose. (iii) Exit-Pricing of the shares at the time of disinvestment by a public issue or general offer of sale by the VCC/VCF, may be done by them, subject to this being calculated on objective criteria like book value, profit earning capacity, etc, and the basis being adequately disclosed to the public. The latest budget speech incorporates the intention of government to accord concessional treatment in respect of levy of tax on capital gains by VC companies. The guidelines in principle recognised the need for incentives towards this end as follows: The preferential tax treatment would be available to the approved venture capital company/fund only in respect of financing of such assisted units as are eligible to be treated as venture capital units as defined in paragraph3. For this purpose, the unit seeking equity support from the YCC/VCF should obtain a letter of eligibility from IDBI/ICICI, or any such agency that may be nominated by the government. The specifics however, remain to be worked out. The guidelines provide for NRI participation and also foreign participation in venture capital companies. Institutions like ADB, IFC, CDC (Commonwealth Development Corporation) are reportedly already evincing intrest in providing VC funds. For raising such funds, even an instrument akin to zero coupon bonds with convertibility option may be resorted to. The fiscal incentives under contemplation should also provide flow to venture capital funds. For emphasis by VC companies on exclusivity of venture capital funds, it has been stipulated that a level of 30 per cent should be reached for venture capital activity by the end of the second year, and 60 per cent by the end of the third year, and 75 per cent by the end of the fifth year of operations. For providing management input by VC companies, the onus is on them. The guide-

In this papertwo expectationsfrom a VC company have been highlighted:(a) it shall perception;and (b) It have entrepreneurial shall provide management support. It is also to be noted that in India so far the initiative has been predominantlyfrom the public sector. The question therefore arises whether such expectations can be fulfilled in the typical public sector work and cultureof rigidprocedures accountability and ratio fetishism in financial analysis. Furtherthe VC fund would be illiquidin the initial years for two reasons: (1) funds entrusted in a new company would require some time before it can show capital appreciation. (2) VC company could be expected to yield returnsto its investorsonly after it has built up a diversifiedportfolio of a numberof ventures,for hit ratioof success would be rather low in terms of numbers.Thus the managementof a public sectorVCcompanymay be heldaccountable for losses in the initial years therebyeffecting the motivation for VC financing.Thus in a country like India, VC financing althoughseen as one of the tools for deployment of oapital,could perhapsbe betteradunless throughprivateinitiatives: ministered adequate independence and authority are vested in public sector VC companies. those in expressed thispaperareentirely [Views of the author.]

Second round and later stage financing

are done where start-up capital and debt have been consumed but business is yet to take off. Other types of financing possible

Texla TEXLA achieved a record production of over 3,00,000 TV sets in 1988. Texla was the first to introduce 12"B and W TV sets in 1979-80. In November 1983 Tex!a introduced a low cost 12" B and W TV set for just Rs 1,265 in Delhi inclusive of all taxes. Texla has diversified into manufacture of other consumer products allied to the TV, such as B and W picture tubqs through its associate, Mullard Tubes, and plastic cabinets. It has its own full-fledged plastic moulding unit as well as tool room for fabrication of moulds and production of cabinets. Texla commenced the assembly of VCRs in 1982 and since then it is regularlyassembling/selling VCRs/VCPs. The company has also entered the field of export of consumer products starting with export of B and W TV sets and negotiations are on for export of colour TV sets.
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are bridge financing, take-overfinancing and turn-aroundfinancing.The last named

is a rare form, but most relevant in Indian context. Here also management input by venture capitalist companies would have paramount importance and therefore it must have inhouse specialists, skill and expertise. Here entrepreneurial aspects of venture capital financing as brought out in previous paragraphs are brought to real challenge. Sick unit financing is one of the more critical area of turn-around financing. Take-overfinancing is in vogue only in the US and western European countries. The US laws permit limited companies to buy their own shares. In leveraged buyouts, the company offers to buy its own shares from the holders at a price well above the going market price, but obviously below the intrin-

lines recognises:it is requiredthat the venture capital funds/companies are managed

Economic and Political Weekly

sic valueof shares.It borrows fundsfrom the investmentbanks with hope of repayment

November 25, 1989