CHAPTER II

CONCEPTUAL AND LEGAL FRAMEWORK OF

VENTURE CAPITAL INVESTMENT

2.1. THE CONCEPT OF VENTURE CAPITAL

The concept of venture capital is new. Venture capitalists often relate the

concept to the story of Christopher Columbus. In the fifteenth century,

Christopher Columbus sought to travel westwards instead of eastwards from

Europe and so planned to reach India. His far-fetched idea did not find favor with

the king of Portugal, who refused to finance him. Finally, Queen Isabella of Spain

decided to fund him and the voyages of Christopher Columbus are not empanelled

in history. And thus evolved the concept of venture capital. The modern venture

capital industry began taking shape, however, in the post-world war II years.

Venture capital is an equity investment in a high-risk project related to

some innovations or new technological developments contemplated by a

company. Venture capital also means a combination of capital and management

expertise provided for the initial risks of a new and emerging company, which has

a good growth prospect in terms of products, technologies, business concepts or

services with the objective of retrieving the investment with a handsome reward at

a future date.63

63
K.J. Taori, “Venture Capital Funding”, The Journal of Indian Institute of
Bankers, Vol.72, No.2, April-June 2001, p.13.

38
 In the classical sense, venture capital financing or venturing simply means

investing in privately-owned technology based companies with a view to securing

the highest possible returns in the shortest possible time, notwithstanding the high

risk element involved.64

The concept of venture capital fund was born with the fundamental

objective to provide initial capital and support in building capital base to the

entrepreneurs having a sound background of professional education and expertise,

who take initiatives to launch the business, based on fast changing technology.65

Financial institutions and bankers primarily cater to projects with minimum

investment risk, maximum security of lending and uniform return from an early

stage investment. Conventional financing schemes are basically security-oriented

and are meant for projects based on proven technology.

Venture capital is providing long-term finance in the form of equity/quasi

equity to companies having high potential to grow. A venture capitalist is a

stakeholder in the company’s equity. The investment by the venture capitalist

generally has the high risk- high return profile.66

Venture capital broadly implies an investment made in a business or

industrial enterprise which carries elements of risk and insecurity and the

64
“Will They Be Truly Venturesome?”, Fortune India, December, 1-15, 1989,
p.18.
65
Sanjeev Sharma, “Venture Capital Key Source of Industrial Finance”,
Financial Express, Madras, June 21, 1992, p.4.
66
P.D. Shedde, “Venture Capital”, Touchdown India, May 1999, p.5.

39
probability of business hazards. To connote the risk and adventure the generic

name of “Venture Capital” was coined.

Venture capital is a high risk – high return business. The high risk is due to

the facts that projects are untested and are undertaken by the novices. The targeted

long-term returns from venture capital investment are naturally high. The seeking

of such potentially high returns had some analysts to term venture capital as

“Vulture Capital”.

There are many entrepreneurs with good product ideas, but lack the

necessary funds to commercialize them. Venture capital can open new avenues for

each entrepreneur. It plays an important role in financing high technology projects

and helps to turn research and development into commercial production. Besides

financing technology, venture capitalist is also involved in fostering the growth

and development of enterprises.

Venture capital is a significant financial innovation in the twentieth

century. As a new technique of financing to inject long term capital into the small

and medium sector, it has made notable contributions to its growth in the

developed countries. For some small firms for which a public issue is out of

question, a good alternative is venture capital. Venture capital in the sense is not

only an injection of funds into new firms but also an input of the skills needed to

set the firm up, design its marketing strategy, organize and manage it.

40
Definition of venture capital

According to Dominguez, “Venture Capital Financing is generally the first

capital invested by sources outside the firm, and the last to exit. In the parlance of

the market, it is the ‘front money’ or funds that are normally subordinated to all

other financial commitments of the enterprise. Aside from common stock

financing, the most common forms of alternative equity instruments issued in

venture capital investments are convertible debentures, warrants and letter stock

options”.67

“Venture capital can be defined as equity or equity-linked investments in

young, privately held companies, where the investor is a financial intermediary

who is typically active as a director, an advisor, or even a manager of the firm”.68

“Venture capital financing, generally implying long-term investment in

high risk industrial projects with high reward possibilities, may be at any stage of

implementation of the project or its production cycle, viz. to start up an economic

activity or an industrial or commercial project or to improve a process or a

product in an enterprise associated with both risk and reward”.69

67
P.C.K. Rao, Project Management and Control, Sultan Chand and Sons, New
Delhi, 1997, pp.11-30.
68
Samuel Kortum and Josh Lerner, National Bureau of Economic Research,
Working Paper, 6846, December, 1998, p.1.
69
J.C. Verma, Manual Merchant Banking, 3rd Edition, Bharat Law House, New
Delhi, 1994, p.1062.

41
 “Venture capital is the organized financing of relatively new enterprises to

achieve substantial capital gains. Such young companies are chosen because of

their potential for considerable growth due to advanced technology, new products

or services, or other valued innovations. A high level of risk is implied by the

term “Venture Capital’ and is implicit in this type of investment, since certain

ingredients necessary for success are missing and must be added later”.70

“Venture capital is the provision of risk-bearing capital, usually in the form

of a participation in equity, to companies with high growth potential. In addition,

the venture capital company provides some value-added in the form of

management advice and contribution to overall strategy. The relatively high risks

for the venture capitalists are compensated by the possibility of high return,

usually through substantial capital gains in the medium term”.71

“Venture capital is an investment in small or medium-sized unlisted

companies, with the investors participating, in some degree, in the management

process”. 72

70
Kenneth W. Ruid, Venture Capital Investment, in Leo Barkers and Stephen
Feldman, Hand Book of Wealth Management, McGraw Hill Book Company, 1990,
Totonto, p.46-I.
71
Neil Cross, Introduction to Venture Capital Finance, Chris Bovaid, Pitman,
London, 1990, p.3.
72
Asian Venture Capital Journal, “Guide to Venture Capital in Asia”, Hong
Kong, 1992-93, p.7.

42
 “Venture capital is the investment in long term, risk equity finance where

the primary reward for the providers is an eventual capital gain, rather than

interest income or dividend yield”.73

Venture capital investment is an activity by which investors support

entrepreneurial talent with finance and business skills to exploit market

opportunities and thus obtain long term capital gains.74

“Venture capital is a separate asset class, often labeled as private equity.

Private equity investment sits at the furthest end of the risk-reward spectrum from

government bonds and can broadly describe equity investment in private

companies not quoted on the stock market”.75

“Venture capital as equity or equity featured capital seeking investment in

new ideas, new companies, new products, new processes or new services that

offer the potential of high returns on investment. It may also include investment in

turnaround situations”.76

73
T. Lorenz, Venture Capital Today, 2nd Edition, Woodkead Faulkener, 1989,
quoted in Gordon C. Murray, ‘The Changing Nature of Competition in the UK Venture
Capital Industry’, National West Minister Bank Quarterly Review, November 1991,
p.65.
74
Journal of Central Bank, The Bank of England Quarterly Bulletin, 1984.
75
G. Anson, Venture Capital in Europe, Europe Venture Capital Association
Year Book (London), 1992, quoted in S. Ramesh and Arun Gupta, Venture Capital and
the Indian Financial Sector, Oxford University Press, New Delhi, 1995, p.49.
76
J.S. Saini and B.S. Rathore, Entrepreneurship Theory and Practice, Wheeler
Publishing, New Delhi, 2001, pp.483-484.

43
 “Venture capital is 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. Venture capital also provides

management/ leveraged buyout financing”.77

“Venture capital is equity to fund new concepts that involves a high risk

and at the same time has high growth and profit potential”.78

The Bank of England, which was the major promoter of the company

Investors in Industry, Britain, has defined venture capital as “an activity by which

investors support entrepreneurial talent with finance and business skills to exploit

capital gain”.79

The significant aspects of venture capital, as brought out in the definitions

are, first, the stress on equity rather than other forms of financial support and

secondly, the risk bearing nature of the assistance. The emphasis is on capital gain

rather than interest or dividend income as the return on the money invested by the

venture capitalist in the enterprise.

77
Jane Kolorki Morris, Editor, Venture Economics, quoted in Ibid., p.297.
78
Vasant Desai, Dynamics of Entrepreneurial Development and Management,
Himalaya Publishing House, Mumbai, 2000, p.458.
79
J.S. Saini and B.S. Rathore, Entrepreneurship Theory and Practice, Wheeler
Publishing, New Delhi, 2001, pp.483-484.

44
The Venture Capitalists
Every business and every product was funded by someone who stepped up

to the plate and invested, for better or for worse. The term venture capitalists

denotes institutional investors that provide equity financing to new projects and

play an active role in advising the management.

Venture capitalists are part riverboat gambler, part security analyst, and

part entrepreneurial voyeur. They are skeptics and business romantics; skeptics in

that their realism must often temper the optimistic fervor of the entrepreneur and

romantics, in that often they have little real control over operations, so must

suspend disbelief. This is a business of ambiguity and adversity- ambiguity in that

often the venture capitalist must read between the lines, based on his general

knowledge and experience, to derive the real state of affairs for an investment,

ambiguity in that the investments are often highly illiquid and must be held

through good times and bad-ambiguity in that most entrepreneurs have a love/hate

relationship with the venture capitalists. They want the money of venture

capitalists, and at times, their counsel, but want to be free of limitations and

controls. They, in most investments in this risky business go through the valley of

death at least once. Prior to becoming successful, venture capital investments go

many places most reasonable men would rather not. Creative business

development often depends on unreasonable men.80

80
I.M. Pandey, Venture Capital in the Indian Experience, Prentice Hall of India
Private Limited, New Delhi, 1999, p.3.

45
 For entrepreneurs the attractions of venture capital inevitably go beyond

the money. More than finance, the venture capitalist gives his marketing and

management skills for the development of the new firm. But the venture capitalist

takes a big risk. If a new venture fails, all the money poured into the enterprise is

lost. There are rarely any assets of inventory to be sold off. A venture capitalist is

not a lender, but an equity partner. He cannot survive on minimalism but he is

driven by wealth maximization.

Venture Capital Vs Seed Capital and Risk Capital

It is difficult to make a distinction between venture capital, seed capital and

risk capital as the latter two form part of a broader meaning of venture capital.

Difference between them arises on account of application of funds and terms and

conditions applicable. The seed capital and risk funds in India are being provided

basically to arrange promoter’s contribution to the project. The objective is to

provide finance and encourage professionals to become promoters of industrial

projects. The seed capital is provided to conventional projects on the

consideration of low risk and security and the use of conventional techniques for

appraisal. Seed capital is normally in the form of low interest-deferred loan as

against equity investment by venture capital. Unlike venture capital, seed capital

providers neither provide any value addition nor participate in the management of

the project.

46
 Risk capital is also provided to established companies for adapting new

technologies. Herein the approach is not business-oriented but developmental. As

a result on one hand the success rate of units assisted by seed capital/risk finance

has been lower than those provided with venture capital; on the other hand the

return to the seed/risk capital financier had been very low as compared to the

venture capitalist. The difference between the seed capital scheme and venture

capital scheme is given in the following Table 2.1

47
 TABLE 2.1

SEED CAPITAL SCHEME Vs VENTURE CAPITAL SCHEME

Scheme Seed Capital Scheme Venture Capital Scheme

Basis Incentive or aid Commercial viability

Beneficiaries Very small Medium and large entrepreneurs are

entrepreneurs also covered

Size of Restricted to Up to 40 per cent promoters’ equity

Assistance Rs.1.Million

Appraisal Normal Skilled and specialized

Estimated 20 per cent 30 per cent internal rate of return

returns

Flexibility Nil Highly flexible

Value addition Nil Multiple ways

Exit option Sell back to Several, including public offer

promoters

Funding Sources Owner funds Outside contribution allowed

Syndication Not done Possible

Tax concession Nil Fully exempted

Success rate Not good Very satisfactory

Source: Verma, J.C. “Venture Capital Financing in India”, Response Books, New

Delhi, 1997, p.23.

48
The Venture Capital Funds

A venture capital company and its venture funds are generally

different entities. The company usually floats a number of venture funds,

normally time-bound (close-ended), partly from its resources and partly with

major contributions from large corporations, pension funds, etc. The money is

then invested in a judicious mix of select high as well as low risk projects.

Venture capital companies do not invest in the firms where the credential

of the management appears to be doubtful. The most important investment

determinant of a venture capital fund is the quality of the management. George

Doriot, the most successful venture capital funds expert in the USA says, “we can

back a first rate management team with a second rate product and have success,

but if we back a first rate product with a second rate management team, we can

seldom achieve our objectives.

In the developed countries, fund is mainly provided by private sector,

pension funds, insurance companies and banks, along with subscriptions from

private individuals and some industrial companies. The availability of large pools

of private capital is fundamental to the development of venture capital industry.

The following figure depicts the source of venture capital funds in the developed

countries.

49
SOURCES OF VENTURE CAPITAL FUNDS

Venture Capital Short-term

Organizations Investments

Contributory Funds

Venture Capital

Investments

a. Pension Funds

b. Individual & Families

c. Insurance / Investment

Companies

d. Foreign sources

e. Corporate Sector

f. Trust Endowments

And Foundations

Source: Fortune India, July, 1986.

50
2.2. STAGES IN VENTURE CAPITAL FINANCING

Several distinct stages of a company’s (project) development are

recognized by the venture capital industry for investment purposes. Venture

capital firms all over the world follow more or less similar practices of financing.

The venture capital financing covers a wide range of investment opportunities. An

entrepreneur needs venture capital at different stages of his company’s growth.

Conceptually, there are three different stages at which a venture capital firm can

make investments.

Early Stage Financing

Ventures that seek finance for developing a new concept or exploiting a

new technology fall under this category. The management team is often

incomplete and does not have any proven track record. Finance may be provided

at seed stage, start-up stage or at the first stage.

Seed Finance

In the initial stage there is only an idea. The venture capitalist provides the

finance to the entrepreneurs to prove the concept. Seed capital is required to meet

the primary expenditures in respect of rent of the space, service charges of the

professionals and installation of requisite productive facilities. The seed capital

stage is essentially an ‘applied research’ phase associated with research and

development.

51
 Financing in this stage involves serious risk as the technology or

innovation being attempted may succeed or fail, after repeated investment.

Chances of success in high technology projects are meager. Seed capital finance is

warranted when there is enough evidence to show that the entrepreneur has used

up his own resources in carrying his idea to the point of acceptance and initiating

research.

At this stage, the venture capital firm has to see that the technology skill of

the entrepreneur is matched with market opportunities. The key risk at this stage is

marketing-related. The venture capital firm has to evaluate the commercial

acumen of the entrepreneur to take advantage of the market opportunity,

awareness of competition, the correct timing of launching the product and the

ability to motivate the staff to stay with the project rather than defect to rival

companies. The risk perception of investment at this stage is extremely high and

the investment may be realized in about 7 to 10 years.

Start-up Capital

Start-up capital is provided for financing product development and initial

marketing activities to launch a business. The companies may be in their initial

stages of development and finance may be extended for creation of new

infrastructure and meeting the working capital margin. In fact in the public eye,

the term ‘start-up’ appears t be synonymous with venture capital in that the

52
product/service is being commercialized for the first time in association with

venture capital firm.

At this stage some indication of the potential market for the new

product/service is available. There are certain inherent problems in start-up

investments, especially related to the structuring of the deal. The natural desire of

the entrepreneur is to exercise control over the business he is starting with

inadequate resources of his own.

Although the start-up stage is exposed to high risk, and the investment may

take 5 to 10 years to realize, venture capital firms, however, assess the managerial

ability and capacity of the entrepreneur before making any financial commitment

at this stage and if needed, supply managerial skills and supervise the

implementation.

First Stage Financing

In this stage the firm starts producing the product, but the prospects are still

uncertain as to whether the market will accept the product or reject it outright. The

venture capitalist who finances a firm at this stage has a very high risk and may

take 5 to 7 years to realize the investment.

Expansion Financing

An enterprise established in a given market increases its profits

exponentially by achieving the economies of scale. This expansion can be

achieved either through an organic growth, that is by expanding production

53
capacity and setting up proper distribution system or by way of acquisitions.

Anyhow, expansion needs finance and venture capitalists support both organic

growth as well as acquisitions for expansion.

Second Stage Financing

Financing is done when the firm has the product or the service but it has

yet to develop the marketing infrastructure to reach the consumer. During this

period, additional finance is required because the project faces competition and

the firms own profits are normally meager to help it to penetrate the market.

The entrepreneur has invested his own funds but further infusion of funds

by the venture capital firm is necessary. The venture capital firms provide larger

funds at this stage than at other early stage financing, because the time scale for

the investment is obviously shorter than in the start-up case and the second round

financing is partly in the form of debt instrument which will provide some income

to the venture capital firm.

Third Stage Financing/Mezzanine Financing/ Development Capital

Finance may be required by established and profitable companies for

development or expansion of plant/equipment, expanding marketing and

distribution capabilities, refinancing existing debt, penetrating new geographic

regions, induction of new management, and so on. Venture finance provided at

this stage has medium risk and can be realized in one to three years. It constitutes

a significant part of the activities of many venture capital firms.

54
Bridge Finance

Bridge finance may be provided when a company is expecting to go to the

public shortly or any other sanctioned financial assistance from the commercial

banks, financial institutions and the like. When the finance remains undisbursed

due to some bureaucratic reasons, venture capital firms come forward to finance

the projects of the ventures under such critical juncture. This is the last round of

financing before going public, hence it involves low risk and the investment may

be realized in one to three years. Often bridge financing is structured so that it can

be repaid from the proceeds of an initial public offering.

Turnaround/ Acquisition/Buy-out Financing

Ventures that seek finance for turning around or acquiring or buying out a

existing company fall under this category.

Turnaround Financing

Finance may be given to a specialized group to bring about a turnaround of

an ailing (sick) company. Two kinds of inputs are required in turn-around, namely

money and management. The company may face mounting debt burden and

slowing down of cash inflows and may need more funds from all sources. The

enterprise may seek a moratorium from creditors for unpaid liabilities. The

original entrepreneur may be compelled to relinquish the enterprise to a new

management.

55
 The venture capital firms play an active role in such a situation by

providing more equity investments and deploying managerial experts. Risk here is

medium to high and the investment can take three to five years to realize. It is

gaining widespread acceptance and increasingly becoming the focus of attention

of venture capital firms.

Acquisition Finance

Funds may be given to one company to finance its acquisition of another

company. Risk is medium to high and the investment may be realized in three to

five years in this case.

Management / Leveraged Buy-out Financing

The funds provided to the current operating management to acquire or

purchase a significant share holding in the business they manage are called

management buy-out. Management buy-in refers to the funds provided to enable a

manager or a group of managers from outside the company to buy into it. Buy-out

financed by other venture capitalists is known as leveraged buy-out.

Each of these stages in the life cycle has an inherent risk and time scale for

realization of the investment. However, the different stages of investment are

analytically distinct and vary as regards the time-scale, risk perceptions and other

related characteristics of the investment decision process. An overview of the

venture capital spectrum is given in table.

56
 TABLE 2.2

VENTURE CAPITAL SPECTRUM

Stages of Time-Scale Risk Finance for Expected

Investment by in years Perception the Activity Return
Venture Capital (From Involved (Indicative)
Firm Investment
to Public
Offering)
1. Early Stage
(i) Seed capital 7 – 10 Extremely High Manufacturing 60%
(usually prototype and research
development) based
(ii) Start-up (to 5 – 10 Very High Business 40 – 60%
commence Commitment
commercial)
(iii) Second round 3–7 High Marginal 30 – 40%
(not yet profitable Progress
enough for public
offering)
2. Later Stage
(i) Mezzanine 1–3 Medium Expansion 25 – 35%
development Finance
capital
(established, but
needs, expansion
finance)
(ii) Bridge (last 1–3 Low Planned Exit 20 – 30%
round before
planned exit)
(iii) Buy-out 1–3 Low New 20 – 30%
(MBOs and MBIs) Management
(iv) Turnaround 3–5 Medium to High Rescue 30 – 40%
Finance
Source: S. Ramesh and Arun Gupta, Venture Capital and the Indian Financial

Sector”, Oxford University Press, New Delhi, 1995, p.66.

57
2.3. VENTURE CAPITAL INVESTMENT PROCESS

Investment Procedure

In generating a deal flow, the venture capital investor creates a pipeline

of ‘deals’ or investment opportunities that he would consider investing in. This is

achieved primarily through plugging into an appropriate network. The most

popular network obviously is the network of venture capital funds/investors. It is

also common for venture capitals to develop working relationships with R&D

institutions, academia, etc, which could potentially lead to business opportunities.

Understandably the composition of the network would depend on the investment

focus of the venture capital funds/company. Thus venture capital funds focusing

on early stage technology based deals would develop a network of R&D centers

working in those areas.

The network is crucial to the success of the venture capital investor. It is

almost imperative for the venture capital investor to receive a large number of

investment proposals from which he can select a few good investment candidates

finally. Before making any investment, the goal as venture capitalists is to

understand virtually every aspect of the target company: the experience and

capabilities of the management team, the business plan, the nature of its

operations, its products and/or services, the methods by which sales are made, the

market for the products and/or services, the competitive landscape, and other

factors that may affect the outcome of the investment.

58
 While due diligence investigations are viewed by many as mundane and

irritating tasks, the process enables venture capitalists to address areas of concern,

is an important tool in determining a fair pre-investment valuation, and may help

to avoid significant and otherwise unexpected liability following the investment.

The venture capitalists view the due diligence process as a means of identifying

and becoming comfortable with the risks to which their capital will be exposed.

The due diligence process involves an assessment of both the

microeconomic and macroeconomic factors that can affect the earnings growth of

the target company. The due diligence process also includes a review of the

corporate and legal records, including the documentation supporting any previous

issuances of the company's securities. Only one or two business plans in 100

result in successful financing. And of every 10 investments made, only one or two

are successful. But this is enough to recover investments made by the venture

capital (VC) in all 10 start-ups in addition to an average 40-50% return! Securing

an investment from an institutional venture capital fund is extremely difficult. It is

estimated that only five business plans in 100 are viable investment opportunities

and only three in 100 results in successful financing.

In fact, the odds could be as low as one in 100. More than half of the

proposals to venture capitalists are usually rejected after a 20-30 minute scanning,

and 25 per cent are discarded after a lengthier review. The remaining 15 per cent

are looked at in more detail, but at least 10 per cent of these are dismissed due to

59
irreconcilable flaws in the management team or the business plan. A Venture

Capitalist looks at various aspects before investing in any venture. First, you need

to work out a business plan. The business plan is a document that outlines the

management team, product, marketing plan, capital costs and means of financing

and profitability statements.

1. Initial Evaluation: This involves the initial process of assessing the feasibility

of the project.

2. Due diligence: In this stage an in-depth study is conducted to analyze the

feasibility of the project.

3. Deal structuring and negotiation: Having established the feasibility, the

instruments that give the required return are structured.

4. Investment valuation: In this stage, final amount for deal is decided.

5. Documentation: This is the process of creating and executing legal documents

to protect the interest of the venture.

6. Monitoring and Value addition: In this stage, the project is monitored by

executives from the venture fund and undesirable variations from the business

plan are dealt with.

7. Exit Policies: There are mainly 3 exit policies followed by VCF’s in general.

1. Initial Evaluation:

Before any in depth analysis is done on a project, an initial screening is carried

out to satisfy the venture capitalist of certain aspects of the project. These include

60

Competitive aspects of the product or service

Outlook of the target market and their perception of the new product

Abilities of the management team

Availability of other sources of funding

Expected returns

Time and resources required from the venture capital firm .Through this

screening the venture firm builds an initial overview about the

Technical skills, experience, business sense, temperament and ethics of the

promoters

The stage of the technology being used, the drivers of the technology and

the direction in which it is moving Location and size of market and market

development costs, driving forces of the market, competitors and share,

distribution channels and other market related issues

Financial facts of the deal

Competitive edge available to the company and factors affecting it

significantly

Advantages from the deal for the venture capitalist

Exit options available

2. Due diligence

Due diligence is term used that includes all the activities that are associated

with investigating an investment proposal to assess feasibility. It includes carrying

61
out in depth reference checks on the proposal related aspects such as management

team, products, technology and market. Additional studies and collection of

project-based data are done during this stage. The important feature to note is that

venture capital due diligence focuses on the qualitative aspects of an investment

opportunity.

Areas of due diligence would include

General assessment

business plan analysis

contract details

collaborators

corporate objectives

SWOT analysis

Time scale of implementation

People

Managerial abilities, past performance and credibility of promoters

Financial background and feedback about promoters from bankers and

previous lenders

Details of Board of Directors and their role in the activities

Availability of skilled labour

Recruitment process

Products/services, technology and process

62
 In this category the type of questions asked will depend on the nature of the

industry into which the company is planning to enter. Some of the areas generally

considered are

Technical details, manufacturing process and patent rights

Competing technologies and comparisons

Raw materials to be used, their availability and major suppliers, reliability

of these suppliers

Machinery to be used and its availability

Details of various tests conducted regarding the new product

Product life-cycle

Environment and pollution related issues

Secondary data collection on the product and technology, if so available

Market

The questions asked under this head also vary depending on the type of

product. Some of the main questions asked are

 main customers

 future demand for the product

 competitors in the market for the same product category and their strategy

 pricing strategy

 supplier and buyer bargaining power

 channels of distribution

63
  marketing plan to be followed

 future sales forecast.

Market survey could be conducted to gather further more accurate and relevant

data.

Finance

Financial forecasts for the next 3-5 years

Analysis of financial reports and balance sheets of firms already

promoted or run by the promoters of the new venture

Cost of production

Wage structure details

Accounting process to be used

Financial report of critical suppliers

Returns for the next 3-5 years and thereby the returns to the venture

fund

Budgeting methods to be adopted and budgetary control systems

External financial audit if required

Sometimes, companies may have experienced operational problems during

their early stages of growth or due to bad management. These could result in

losses or cash flow drains on the company. Sometimes financing from venture

capital may end up being used to finance these losses. They avoid this through

due diligence and scrutiny of the business plan.

64
3. Structuring a deal

Structuring refers to putting together the financial aspects of the deal and

negotiating with the entrepreneurs to accept a venture capital’s proposal and

finally closing the deal. Also the structure should take into consideration the

various commercial issues (i.e. what the entrepreneur wants and what the venture

capital would require to protect the investment). The instruments to be used in

structuring deals are many and varied. The objective in selecting the instrument

would be to maximize (or optimize) venture capital’s returns/protection and yet

satisfy the entrepreneur’s requirements. The instruments could be as follows:

65
INSTRUMENT ISSUE

Equity shares new or vendor shares par value partially-paid shares

Preference shares redeemable (conditions under Company Act)

participating par value

nominal shares

Loan clean Vs secured

Interest bearing Vs noninterest bearing

convertible Vs one with features (warrants)

1st Charge, 2nd Charge,

loan Vs loan stock maturity

Warrants exercise price, expiry period

In India, straight equity and convertibles are popular and commonly used.

Nowadays, warrants are issued as a tool to bring down pricing. A variation that

was first used by PACT and TDICI was "royalty on sales". Under this, the

company was given a conditional loan. If the project was successful, the company

had to pay a percentage of sales as royalty and if it failed then the amount was

written off. In structuring a deal, it is important to listen to what the entrepreneur

wants, but the venture capital comes up with his own solution. Even for the

proposed investment amount, the venture capital decides whether or not the

amount requested, is appropriate and consistent with the risk level of the

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investment. The risks should be analyzed, taking into consideration the stage at

which the company is in and other factors relating to the project. (e.g. exit

problems, etc).

A typical proposal may include a combination of several different

instruments listed above. Under normal circumstances, entrepreneurs would prefer

venture capitals to invest in equity as this would be the lowest risk option for the

company. However from the venture capitals point of view, the safest instrument,

but with the least return, would be a secured loan. Hence, ultimately, what you

end up with would be some instruments in between which are sold to the

entrepreneur. A number of factors affect

the choice of instruments, such as –

Categories Factors influencing the choice of Instrument

Company specific Risk, current stage of operation, , expected profitability, future

cash flows, investment liquidity options

Promoter specific Current financial position of promoters, performance track-record,

willingness of promoters to dilute stake

Product/Project Future market potential, product life-cycle, gestation period

specific

Macro environment Tax options on different instruments, legal framework, policies

adopted by competition

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4. Investment valuation

The investment valuation process is an exercise aimed at arriving at ‘an

acceptable price’ for the deal. Typically in countries where free pricing regimes

exist, the valuation process goes through the following steps:

1. Evaluate future revenue and profitability

2. Forecast likely future value of the firm based on experienced market

capitalization or expected acquisition proceeds depending upon the anticipated

exit from the investment.

3. Target ownership positions in the investee firm so as to achieve desired

appreciation on the proposed investment. The appreciation desired should yield a

hurdle rate of return on a Discounted Cash Flow basis.

In certainty the valuation of the firm is driven by a number of factors. The

more significant among these are:

Overall economic conditions: A buoyant economy produces an optimistic

long- term outlook for new products/services and therefore results in more

liberal pre-money valuations.

Demand and supply of capital: when there is a surplus of venture capital of

venture capital chasing a relatively limited number of venture capital deals,

valuations go up.

This can result in unhealthy levels of low returns for venture capital investors.

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Specific rates of deals: such as the founder’s/management team’s track

record, innovation/ unique selling propositions (USPs), the product/service

size of the potential market, etc affects valuations in an obvious manner.

The degree of popularity of the industry/technology in question also

influences the pre-money. Computer Aided Skills Software Engineering

(CASE) tools and Artificial Intelligence were one time darlings of the

venture capital community that have now given place to biotech and

retailing.

The standing of the individual venture capital Well established venture

capitals who are sought after by entrepreneurs for a number of reasons

could get away with tighter valuations than their less known counterparts.

Investor’s considerations could vary significantly. A study by an American

venture capital, Venture One, revealed the following trend. Large

corporations who invest for strategic advantages such as access to

technologies, products or markets pay twice as much as a professional

venture capital investor, for a given ownership position in a company but

only half as much as investors in a public offering.

Valuation offered on comparable deals around the time of investing in the

deal.

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5. Documentation

It is the process of creating and executing legal agreements that are needed

by the venture fund for guarding of investment.

Based on the type of instrument used the different types of agreements are

 Equity Agreement

 Income Note Agreement

 Conditional Loan Agreement

 Optionally Convertible Debenture Agreement etc.

There are also different agreements based on whether the agreement is with

the promoters or the company. The different legal documents that are to be

created and executed by the venture firm are

Shareholders agreement - This agreement is made between the venture

capitalist, the company and the promoters. The agreement takes into account

Capital structure.

Transfer of shares: This lays the condition for transfer of equity between

the equity holders. The promoters cannot sell their shares without the prior

permission of the venture capitalist.

Appointment of Board of Directors

Provisions regarding suspension/cancellation of the investment. The issues

under which such cancellation or suspension takes place are default of

covenants and conditions, supply of misleading information, inability to

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 pay debts, disposal and removal of assets, refusal of disbursal by other

financial institutions, proceedings against the company, and liquidation or

dissolution of the company.

Equity subscription agreement - This is the agreement between the venture

capitalist and the company on

Number of shares to be subscribed by the venture capitalist

Purpose of the subscription

Pre-disbursement conditions that need to be met

Submission of reports to the venture capitalist

Currency of the agreement

Deed of Undertaking - The agreement is signed between the promoters and

the venture capitalist wherein the promoter agrees not to withdraw,

transfer, assign, pledge, hypothecate etc their investment without prior

permission of the venture capitalist. The promoters shall not diversify,

expand or change product mix without permission.

Income Note Agreement - It contains details of repayment, interest,

royalty, conversion, dividend etc.

Conditional Loan Agreement - It contains details on the terms and

conditions of the loan, security of loan, appointment of nominee directors

etc.

Deed of Hypothecation, Shortfall Undertaking, Joint and Several Personal

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Guarantee Power of Attorney etc.

Whenever there is a modification in any of the agreements, then a

Supplementary Agreement is created for the same.

6. Monitoring and follow up

The role of the venture capitalist does not stop after the investment is made

in the project. The skills of the venture capitalist are most required once the

investment is made. The venture capitalist gives ongoing advice to the promoters

and monitors the project continuously. It is to be understood that the providers of

venture capital are not just financiers or subscribers to the equity of the project

they fund. They function as a dual capacity, as a financial partner and strategic

advisor. Venture capitalists monitor and evaluate projects regularly.

They are actively involved in the management of the of the investor unit

and provide expert business counsel, to ensure its survival and growth. Deviations

or causes of worry may alert them to potential problems and they can suggest

remedial actions or measures to avoid these problems. As professional in this

unique method of financing, they may have innovative solutions to maximize the

chances of success of the project. After all, the ultimate aim of the venture

capitalist is the same as that of the promoters – the long term profitability and

viability of the investor company.

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Various styles

Hands-on Style suggests supportive and direct involvement of the venture

capitalist in the assisted firm through Board representation and regularly advising

the entrepreneur on matters of technology, marketing and general management.

Indian venture capitalists do not generally involve themselves on a hands-on basis

bit they do have board representations.

Hands-off Style involves occasional assessment of the assisted firms

management and its performance with no direct management assistance being

provided. Indian venture funds generally follow this approach.

Intermediate Style venture capital funds are entitled to obtain on a regular

basis information about the assisted projects. Venture capital target companies

with superior products or services focused at fast-growing or untapped markets.

Venture capitalists must be confident that the firm has the quality and depth in the

management team to achieve its aspirations. They will want to ensure that the

investee company has the willingness to adopt modern corporate governance

standards. Firms strong in factors relating to patents, management, idea, and

potential are more likely to obtain VC financing and willing partners to support

commercialization activities.

7. EXIT strategies adopted by VCF’s:

A venture capital firm enters a relationship with a company with the

expectation that a significant return of investment will result when the firm exits

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the investment. The firm plans for that exit to take place within a certain amount

of time, usually from three to six years, depending on the development stage of

the company in which it is investing. Depending on the investment focus and

strategy of the venture firm, it will seek to exit the investment in the portfolio

company. While the initial public offering may be the most glamorous and

heralded type of exit for the venture capitalist and owners of the company, most

successful exits of venture investments occur through a merger or acquisition of

the company by either the original founders or another company. Again, the

expertise of the venture firm in successfully exiting its investment will dictate the

success of the exit for themselves and the owner of the company.

There are several common exit strategies:

o IPO

o Mergers and Acquisitions

o Redemption

IPO

The initial public offering is the most glamorous and visible type of exit for

a venture investment. In recent years technology IPOs have been in the limelight

during the IPO boom of the last six years. At public offering, the venture firm is

considered an insider and will receive stock in the company, but the firm is

regulated and restricted in how that stock can be sold or liquidated for several

years. Once this stock is freely tradable, usually after about two years, the venture

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fund will distribute this stock or cash to its limited partner investor who may then

manage the public stock as a regular stock holding or may liquidate it upon

receipt. Over the last twenty-five years, almost 3000 companies financed by

venture funds have gone public.

Mergers and Acquisitions

Mergers and acquisitions represent the most common type of successful

exit for venture investments. In an era of large companies dominating industry

landscapes, acquisition is often the targeted and most common exit strategy.

Smaller companies have, in essence, become the research and development arm of

larger companies who often look to buy them once their innovations can

contribute to their own profitability. In the case of a merger or acquisition, the

venture firm will receive stock or cash from the acquiring company and the

venture investor will distribute the proceeds from the sale to its limited partners.

Redemption

Another alternative is that the company may be required to buy back a

venture capital firm's stock at cost plus a certain premium. Often a venture capital

firm will put a redemption clause (sometimes referred to as a "buy-back clause")

in the investment terms which allows them to exit their investment in your

company in the event that an IPO or acquisition does not happen within a

designated time period.

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2.4. LEGAL FRAMEWORK FOR VENTURE CAPITAL INVESTMENT

SEBI GUIDELINES AND REGULATIONS

Incentives

Recognizing the importance of venture capital, the government introduced

major liberilisation of tax treatment for venture capital funds and simplification of

procedures. These included the following:

• SEBI was recognized as the single nodal agency.

• A new clause (23FB) in Section 10 of Income Tax Act was introduced with

effect from 1st March 2000. This clause stated that any income, of a

venture capital company or a venture capital fund, from any investments

made in venture capital undertaking, would not be included in computing

the total income.

• Section 115U was also introduced in the Income Tax Act with effect from

the assessment year 2001-02 to establish a VC pass through. This means

that the VC profits will not be taxed twice. The regulated VC Fund (with

SEBI) would be exempted from tax (subject to certain conditions) but the

VC investor will have to pay tax.

• Earlier on, if a VCF wished to avail certain tax benefits, the VCF had to

exit from investments made in a venture capital undertaking (VCU) within

twelve months of the VCU obtaining a listing. However, this requirement

was done away around November 2000. The Finance Bill 2001, proposes

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 to amend section 10 (23 FB) so as to provide that a VCC / VCF will

continue to be eligible for exemption under section 10 (23 FB), even if the

shares of the VCU, in which the VCC / VCF has made the initial

investment, are subsequently listed in a recognized stock exchange in

India.

Initiatives

There have been a number of initiatives by the Government as well as the

industry to pave way for a business and regulatory environment that is conducive

to new venture development and to innovation at the user end. Some of the

initiatives in the past have included those by the Ministry of Finance, the

Securities, Exchange Board of India (SEBI), Ministry of Information Technology

(formerly Department of Electronics), State Governments, Financial Institutions,

the Indian Venture Capital Association. These initiatives resulted in the

availability of more than US$ 500 million of venture funds for Indian ventures

during 1999-2000. With the growing realization of the immense potential offered

by Indian technology companies, funding opportunities are rapidly increasing.

The Government of India has already taken laudable steps to facilitate the creation

of an environment that is conducive for venture capital funds and start-ups in

India.

These include:

• introduction of sweat equity,

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 • allowing venture capital funds to offset losses incurred in one company

against profits from another and establishment of government facilitated

venture capital funds.

However, the present regulatory framework is still not enough to provide for an

• environment that lays stress on

• encouraging the flow of venture funds,

• easy exit options (for either party),

• mentoring,

• non-qualified availability of funds,

• and flow of public funds for enterprise building in India.

India needs to encourage the growth of risk capital by acting on three fronts:

• The Government of India and Indian financial institutions should catalyze

the process by creating Israel's Yozma-like funds. This will stimulate

competition but also protect entrepreneurs from inevitable risks.

• India should amend its regulatory framework so that the VC funds can earn

a reasonable return on their risk capital.

• India should actively promote the infusion of VC skills and capabilities,

either by attracting global VC funds or attracting managers from these

funds.

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 However, the above moves need to be substantiated with the earliest

implementation of the recommendations of the SEBI Committee on Venture

Capital.

SEBI VENTURE CAPITAL FUNDS (VCFs) REGULATIONS,1996

According to this regulations, a VCF 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 VCU means a domestic company (i) whose shares are not listed on a

recognized stock exchange in India and (ii) which is engaged in the business of

providing services/production/manufacture of articles/things but doesn’t include

such activities/sectors as are specified in the negative list by SEBI with

governmental 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. The main elements of the

SEBI regulation are briefly outlined:

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 eligibility

criteria for registration is:

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Any company or trust[or a body corporate] proposing to carry on any

activity as a venture capital fund on or after the commencement of these

regulations shall make an application to the Board for grant of a certificate.

Any company or a body corporate], who on the date of commencement of

these regulations is carrying any activity as a venture capital fund without a

certificate shall make an application to the Board for grant of a certificate

within a period of three months from the date of such commencement:

Provided that the Board, in special cases, may extend the staid period up to

a maximum of six months from the date of such commencement.

An application for grant of certificate under sub-regulation or sub-

regulation shall be made to the Board in Form A and shall be accompanied

by a nonrefundable application fee as specified in Part A of the Second

Schedule to be paid in the manner specified in Part B thereof.

Any company or trust 3[or a body corporate] referred to in sub-regulation

who fails to make an application for grant of a certificate within the period

specified therein shall cease to carry on any activity as a venture capital

fund.

The Board may in the interest of the investors issue directions with regard

to the transfer of records, documents or securities or disposal of

investments relating to its activities as a venture capital fund.

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The Board may in order to protect the interests of investors appoint any

person to take charge of records, documents, securities and for this purpose

also determine the terms and conditions of such an appointment.

Eligibility Criteria.

For the purpose of the grant of a certificate by the Board the applicant shall

have to fulfill in particular the following conditions, namely:—

• if the application is made by a company memorandum of association as has

its main objective, the carrying on of the activity of a venture capital

fund;

• it is prohibited by its memorandum and articles of association from making

an invitation to the public to subscribe to its securities;

• its director or principal officer or employee is not involved in any litigation

connected with the securities market which may have an adverse bearing

on the business of the applicant;

• its director, principal officer or employee has not at any time been

convicted of any offence involving moral turpitude or any economic

offence;

• it is a fit and proper person

if the application is made by a trust—

the instrument of trust is in the form of a deed and has been duly registered

under the provisions of the Indian Registration Act, 1908 (16 of 1908);

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the main object of the trust is to carry on the activity of a venture capital

fund;

the directors of its trustee company, if any or any trustee is not involved in

any litigation connected with the securities market which may have an

adverse bearing on the business of the applicant inserted by the SEBI

(Venture Capital Funds) Amendment Regulations, 1998

the directors of its trustee company, if any, or a trustee has not at any time,

been convicted of any offence involving moral turpitude or of any

economic offence if the application is made by a body corporate

(i) it is set up or established under the laws of the Central or State Legislature,

(ii) the applicant is permitted to carry on the activities of a venture capital fund,

(iii) the applicant is a fit and proper person,

(iv) the directors or the trustees, as the case may be, of such body

corporate have not been convicted of any offence involving moral turpitude or of

any economic offence,

(v) the directors or the trustees, as the case may be, of such body corporate, if

any, are not involved in any litigation connected with the securities market which

may have an adverse bearing on the business of the applicant

INVESTMENT CONDITIONS AND RESTRICTIONS

Minimum investment in a Venture Capital Fund.

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 A venture capital fund may raise monies from any investor whether Indian,

Foreign or non-resident Indian. No venture capital fund set up as a company or

any scheme of a venture capital fund set up as a trust shall accept any investment

from any investor which is less than five lakhs rupees provided that nothing

contained in sub-regulation shall apply to investors who are,

(a) employees or the principal officer or directors of the venture capital fund, or

directors of the trustee company or trustees where the venture capital fund has

been established as a trust.

(b) the employees of the fund manager or asset management company;

Each scheme launched or fund set up by a venture capital fund shall have

firm commitment from the investors for contribution of an amount of at least

rupees five crores before the start of operations by the venture capital fund.

Restrictions on investment by VCF .

All investment made or to be made by a venture capital fund shall be

subject to the following conditions, namely:

(a) venture capital fund shall disclose the investment strategy at the time of

application for registration.

(b) venture capital fund shall not invest more than 25% corpus for the purpose,

one venture capital undertaking venture capital fund may invest in securities of

foreign companies subject to such conditions or guidelines that may be stipulated

or issued by the Reserve Bank of India and the Board from time to time.

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 Restrictions on investment by a venture capital fund-All investments made

or to be made by a venture capital fund shall be subject to the following

restrictions:

(a) the venture capital fund shall not invest in the equity shares of any company or

institution providing financial services;

(b) at least 80 percent of funds raised by a venture capital fund shall be invested in

the equity shares or equity related securities issued by a company whose securities

are not listed on any recognized stock exchange: Provided that a venture capital

fund may invest in equity shares or equity related securities of a company whose

securities are to be listed or are listed where the venture capital fund has made

these investments through private placements prior to the listing of the securities.

The equity shares or equity related securities of a financially weak

company or a sick industrial company, whose securities may or may not be listed

on any recognized stock-exchange.

Explanation: For the purposes of this regulation, a "financially weak company"

means a company, which has at the end of the previous financial year

accumulated losses, which has resulted in erosion of more than 50% but less than

100% of its network as at the beginning of the previous financial year.

Providing financial assistance in any other manner to companies in whose

equity shares the venture capital fund has invested under sub-clause.

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 As For the purposes of this regulation, "funds raised" means the actual

monies raised from investors for subscribing to the securities of the venture

capital fund and includes monies raised from the author of the trust in case the

venture capital fund has been established as a trust but shall not include the paid

up capital of the trustee company.

(i) at least [66.67%] of the investible funds shall be invested in unlisted equity

shares or equity linked instruments of venture capital undertaking.

(ii) Not more than 4[33.33%] of the investible funds may be invested.

Prohibition on listing

No VCF would be entitled to get its units listed on any recognized stock

exchange till the expiry of three years from the date of issuance of units by it.

GENERAL OBLIGATIONS AND RESPONSIBILITIES

A VCF is not permitted to issue any document /advertisement inviting

offers from public for subscription/purchase of any of its units. It may receive

money from investment in the VCF through only private placement of its units.

Placement memorandum/subscription agreement.

The venture capital fund should

(a) issue a placement memorandum which shall contain details of the terms and

conditions subject to which monies are proposed to be raised from investor or

85
(b) enter into contribution or subscription agreement with the investors which

shall specify the terms and conditions subject to which monies are proposed to be

raised.

(c) The Venture Capital Fund shall file with the Board for information, the copy

of the placement memorandum or the copy of the contribution or subscription

agreement entered with the investors along with a report of money actually

collected from the investor.

(d) the minimum amount to be raised for each scheme and the provision for

refund of monies to investor in the event of non-receipt of minimum amount.

Winding-up.

A scheme of a venture capital fund set up as a trust shall be wound up,

(a) when the period of the scheme, if any, mentioned in the placement

memorandum is over;

(b) if it is the opinion of the trustees or the trustee company, as the case may be,

that the scheme shall be wound up in the interests of investors in the units;

(c) if seventy-five per cent of the investors in the scheme pass a resolution at a

meeting of unit holders that the scheme be wound up; or (d) if the Board so directs

in the interests of investors.

A venture capital fund set up as a company shall be wound up in

accordance with the provisions of the Companies Act, 1956 (1 of 1956).

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A venture capital fund set up as a body corporate shall be wound up in

accordance with the provisions of the statute under which it is constituted.

As per the preference of investors, after obtaining approval of at least 75% of the

investors of the scheme.

INSPECTION AND INVESTIGATION

SEBI may, suomoto, or upon receipt of information/complaint appoint

one/more person(s) as inspecting /investigating officer(s) to undertake

inspection/investigation of the books of accounts/records/documents relating to a

VCF for any of the following reasons:

To ensure that the book of accounts, records and documents were being

maintained by it in the specified manner.

To inspect or investigate into complaints received from investors, clients or

any other person, on any matter having a bearing on its activities.

To ascertain whether it is complying with the provisions of the SEBI acts

and its regulations.

To inspect or investigate suomoto, into the affairs of the venture capital

fund, in the interest of the securities market/investors.

Obligations of VCFs

Obligations of venture capital fund on inspection or investigation by the

Board.-(1) It shall be the duty of the venture capital fund whose affairs are being

inspected or investigated, and of every director, officer and employee thereof, of

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its asset management company, if any, and of its trustees or directors or the

directors of the trustee company, if any, to produce before the inspecting or

investigating officer such books, securities, accounts, records and other

documents in its custody or control and furnish him with such statements and

information relating to the venture capital fund, as the inspecting or investigating

officer may require, within such reasonable period as the inspecting officer may

specify.

It shall be the duty of every officer of the Venture Capital Fund in respect

of whom an inspection or investigation has been ordered under regulation 25 and

any other associate person who is in possession of relevant information pertaining

to conduct and affairs of such Venture Capital Fund including Fund Manager or

asset management company, if any, to produce to the Investigating or Inspecting

Officer such books, accounts and other documents in his custody or control and

furnish him with such statements and information as the said officer may require

for the purposes of the investigation or inspection.

It shall be the duty of every officer of the Venture Capital Fund and any

other associate person who is in possession of relevant information pertaining to

conduct and affairs of the Venture Capital Fund to give to the Inspecting or

Investigating officer all such assistance and shall extend all such co-operation as

may be required in sought by the Inspecting or Investigating Officer in connection

with the inspection or investigation.

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 The Investigating or Inspecting Officer shall, for the purposes of inspection

or investigation, have power to examine on oath and record the statement of any

employees, directors or person responsible for or connected with the activities of

venture capital fund or any other associate person having relevant information

pertaining to such Venture Capital Fund.

The Inspecting or Investigating Officer shall, for the purposes of inspection or

investigation, have power to obtain authenticated copies of documents, books,

accounts of Venture Capital Fund, from any person having control or custody of

such documents, books or accounts. documents and computer data in the

possession of the venture capital fund or such other person and also provide

copies of documents or other materials which, in the opinion of the inspecting or

investigating officer are relevant for the purposes of the inspection or

investigation, as the case may be.

The inspecting or investigating officer, in the course of inspection or

investigation shall be entitled to examine or to record the statements of any

director, officer or employee of the venture capital fund.

It shall be the duty of every director, officer or employee, trustee or

director of the trustee company of the venture capital fund to give to the

inspecting or investigating officer all assistance in connection with the inspection

or investigation, which the inspecting or investigating officer may reasonably

require.”

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Action in case of default

SEBI can suspend/cancel the registration of a VCF on the basis of the due

procedure.

Suspension of registration

The certificate of registration granted to a VCF can be suspended by SEBI,

in addition to issuing of direction/measures specified above in the following

circumstances:

Contravention of any of the provisions of the SEBI Act or these

regulations.

Failure to furnish any information relating to its activity as a VCF as

required by SEBI.

Furnishing to SEBI information which is false/misleading in any material

particular.

Non-submission of periodic returns/reports as required by SEBI

Non-cooperation in any enquiry, inspection/investigation conducted by

SEBI

Failure to resolve the complaints of investors/to give a satisfactory reply to

SEBI in this behalf.

Cancellation of registration

The registration of a VCF can be cancelled by SEBI when it:

• Is guilty of fraud or is convicted of an offence involving moral turpitude;

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 • Has been guilty of repeated defaults which may result in suspension of the

registration;

• Contravenes any of the provisions of the SEBI Act or these regulations.

The order of suspension/cancellation of certificate of registration would

be published by SEBI in two newspapers. On and from the date of

suspension/cancellation, the VCF would cease to carry on any activity as a VCF

and would be subject to directions from concerning SEBI the transfer of records,

documents/securities that may be in its custody/control as it may specify.

Action Against Intermediaries

SEBI may initiate action for suspension/cancellation of registration of an

intermediary (registered with it) who fails to exercise due diligence in the

performance of its functions or fails to comply with its obligations under these

regulations.

Any person aggrieved by an order of SEBI under these regulations may

prefer an appeal to the securities appellate Tribunal (SAT).

Regulatory Reforms and Framework

SEBI (Venture Capital Funds) (Amendment) Regulations, 2000 and the SEBI

(Foreign Venture Capital Investors) Regulations, 2000.

1. Following are the salient features of SEBI (Venture Capital Funds)

(Amendment) Regulations, 2000:

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Definition of venture capital fund:

The venture capital fund is now defined as a fund established in the form of

a Trust, a company including a body corporate and registered with SEBI

which:

has a dedicated pool of capital;

raised in the manner specified under the Regulations; and

to invest in venture capital undertakings in accordance with the

Regulations.

Definition of venture capital undertaking:

Venture capital undertaking means a domestic company:

Whose shares are not listed on a recognized stock exchange in India.

Which is engaged in business including providing services, production or

manufacture of articles or things, or does not include such activities or

sectors which are specified in the negative list by the board with the

approval of the Central Government by notification in the Official Gazette

in this behalf. The negative list includes real estate, non-banking financial

services, gold financing, activities not permitted under the Industrial Policy

of the Government of India.

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Minimum contribution and fund size:

The minimum investment in a Venture Capital Fund from any investor will

not be less than Rs.5 lacks and the minimum corpus of the fund before the fund

can start activities shall be at least Rs.5 crores.

Investment criteria:

The earlier investment criteria has been substituted by a new investment

criteria which has the following requirements:

Disclosure of investment strategy;

Maximum investment in single venture capital undertaking not to

exceed 25% of the corpus of the fund;

Investment in the associated companies not permitted;

At least 75% of the investible funds to be invested equity shares or

equity linked instruments.

Not more than25% of the investible funds may be invested by way of:

(a) Subscription to initial public offer of a venture capital undertaking

whose shares are proposed to be listed subject to lock-in period of one

year;

(b) Debt or debt instrument of a venture capital fund has already made an

investment by way of equity.

It has also been provided that venture capital fund seeking to avail

benefit under the relevant provisions of the Income Tax Act will be

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 required to divest from the investment within a period of one year from the

listing of the venture capital undertaking.

Disclosure and information to investors:

In order to simplify and expedite the process of fund raising, the

requirement of filing the Placement memorandum with SEBI is dispensed with

and instead the fund will be required to submit a copy of Placement

Memorandum/copy of contribution agreement entered with the investors along

with the details of the fund raiser for information to SEBI. Further, the contents of

the Placement Memorandum are strengthened to provide adequate disclosure and

information to investors. SEBI will also prescribe suitable reporting requirement

from the fund on their investment activity.

2. QIB status for venture capital funds:

The venture capital funds will be eligible to participate in the IPO through

book building route as Qualified Institutional Buyer subject to compliance with

the SEBI (Venture Capital Fund) Regulations.

3. Relaxation in takeover code:

The acquisition of shares by the company or any of the promoters from the

Venture Capital Fund under the terms of agreement shall be treated on the same

footing as that of acquisition of shares by promoters/companies from the state

level financial institutions and shall be exempt from making an open offer to other

shareholders.

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4. Investments by mutual funds in venture capital funds:

In order to increase the resources for domestic venture capital funds,

mutual funds are permitted to invest up to 5% of its corpus in the case of open-

ended schemes and up to 10% of its corpus in the case of close-ended schemes.

Apart from raising the resources for venture capital funds this would provide an

opportunity to small investors to participate in venture capital activities through

mutual funds.

5. Government of India guidelines:

The government of India (MOF) guidelines for overseas venture capital

investment in India dated September 20, 1995 will be repealed by the MOF on

notification of SEBI Venture Capital Fund Regulations.

6. The following will be the salient features of SEBI (Foreign Venture Capital

investors) Regulations, 2000:

Definition of foreign venture capital investor:

Any entity incorporated and established outside India and proposes to

make investment in venture capital fund or venture capital undertaking and

registered with SEBI.

Eligibility criteria:

Entity incorporated and established outside India in the form of investment

company, trust, partnership, pension fund, mutual fund, university fund,

endowment fund, asset management company, investment manager, investment

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management company or other investment vehicle incorporated outside India

would be eligible for seeking registration from SEBI. SEBI for the purpose of

registration shall consider whether the applicant is regulated by an appropriate

foreign regulatory authority; or is an income tax payer; or submits a certificate

from its banker of its or its promoters’ track record where the applicant is neither

a regulated entity nor an income tax payer.

Investment criteria:

Disclosure of investment strategy;

Maximum investment in single venture capital undertaking not to exceed

25% of the funds committed for investment of India. However it can invest

its total fund committed in one venture capital fund;

At least 75% of the investible funds to be invested in unlisted equity shares

or equity linked instruments.

Not more than 25% of the investible funds may be invested by way of:

(a) Subscription to initial public offer of a venture capital undertaking

whose shares are proposed to be listed subject to lock-in period of one

year;

(b) Debt or debt instrument of a venture capital undertaking in which the

venture capital fund has already made an investment by way of equity.

The foreign venture capital investors proposing to make venture capital

investment under the Regulations would be granted registration by SEBI. SEBI

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registered foreign venture capital investors shall be permitted to make investment

on an automatic route within the overall sect oral ceiling of foreign investment

under Annexure III of statement of Industrial Policy without any approval from

FIPB.

Further, SEBI registered FVCIs shall be granted a general permission from

the exchange control angle for inflow and outflow of funds and no prior approval

of RBI would be required foe pricing, however, there would be ex-post reporting

requirement for the amount transacted.

8. Trading in unlisted equity:

The board also approved the proposal to permit OTCEI to develop a

trading window for unlisted securities where Qualified Institutional Buyers (QIB)

would be permitted to participate.

Some of the members of the Board felt that the mandated post listing exit

time frame of one year for availing tax pass through by a domestic venture capital

fund could be reconsidered by the Government in the light of international

experience and the need to avoid operational restrictions and optimize inflow of

venture capital in the country. The Board also desired that a small Group within

SEBI could be set up to codify the experience of the existing players, international

experience including tax treatment and potential areas for venture capital funding.

There have been tremendous legal and regulatory reforms in the Venture

Capital and Private Equity sectors, which have led to the present state of boom in

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the Private Equity scenario in India. Some of the major reforms impacting this

industry can be summarized as under:

Government if India issued guidelines in September 1995 for overseas

Venture Capital investment in India.

SEBI framed SEBI (Venture Capital Funds) Regulations, 1996.

In 1999-the companies (Amendment) Act, 1999, dispensed with prior

approval of Central Government for investment by a company exceeding

60 percent (paid-up share capital +free reserves) or 100 percent free

reserve, whichever is more, and enabled the company to make investment

by way of special resolution at general meeting.

In 2000-SEBI introduced an-other regulation for SEBI (Foreign Venture

Capital Investors) Regulations, 2000, enabling foreign Venture Capital and

Private Equity investors to register with SEBI and avail certain benefits

provided there under.

In 2000-amendments were made in SEBI (Substantial Acquisition of

Shares and Takeovers) Regulation, 1997; as a result, these regulations were

not to apply to the shares transferred from VCF or FVCI to the promoters

or to the company itself, if effected as per pre-existing agreement between

VCF or FVCI and the promoters of the company . If promoters buy back

the shares from FVCI, then there is no requirement of public offering.

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In 2000-as per FEMA, FVCI can acquire or sell any investment held by it

at a mutually acceptable price.

In 2001-The companies (Amendment) Act, 2001, reduced the period of

issue of fresh shares from 24 months to 6 months, from when the company

completes the buyback of its shares.

In 2001-The companies (Issue of share capital with differential voting

rights) Rules, 2001, allowed every company limited by shares to issue

shares with differential rights (voting or dividend).

In 2003-Qualified Institutional Buyer “QIB” status granted to VCF/FVCI,

as per SEBI (DIP) guidelines. VCF/FVCI can subscribe securities at IPO of

a VCU through book-building process.

In 2004-VCF/FVCI permitted to invest in NBFC registered with RBI and

engaged in equipment leasing or Hire Purchase. It permitted to invest in

companies engaged in gold financing for jeweler. FVCI allowed to invest

100 percent in one VCU, as compared to the 25 percent earlier.

In 2005-in the press note 1 of 2005, exemption was granted from prior

government approval under press note 18 of 1998.

India’s Security markets regulator SEBI (Securities Exchange Board of

India) has approved the SEBI (Alternative Investment Funds) Regulations, 2012

to bring unregulated funds under its purview, ensure systemic stability, increase

market efficiency and enable the formation of new capital. These regulations will

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be applicable to all pooled investment vehicles apart from Mutual Funds, CIS

Schemes, Family Trusts, ESOP Trusts, Employee Welfare Trusts, holding

companies, funds managed by Asset Reconstruction Companies, Securitization

Trust or funds directly regulated by any other regulator in India.

Some of the regulations approved by the board include:

Registration:

All Alternative Investment Funds (AIFs), whether operating as Private

Equity Funds, Real Estate Funds or Hedge Funds should be registered with SEBI.

Withdrawal of old VC Fund Regulations:

The SEBI (Venture Capital Funds) Regulations of 1996 will be officially

withdrawn, however existing venture capital funds will continue to be regulated

by the regulations until the fund winds down its operations and they will not be

allowed to raise any fresh funds, except for the previous investor commitments.

That being said, Venture Capital funds can also opt to re-register themselves

under the new AIF regulations, provided they receive the approval to do so from

66.67% of their investors and can seek exemption from the board from strictly

adhering to these regulations, in case they are not able to comply with all the new

regulations.

Unregistered funds will not be allowed to launch new schemes without

registering with SEBI under the new AIF regulations. The existing schemes which

were launched by funds prior to the AIF regulation announcement, will however

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continue to be governed till it matures by contractual terms, with no room for a

rollover or an extension.

Corpus:

AIFs should have a minimum corpus of Rs 20 crores and they shall not

accept any investment less than Rs 1 crores from an investor. The fund should not

have more than 1000 investors and the fund manager should have continuing

interest of minimum 2.5% of the initial corpus or Rs 5 crores, whichever is lower.

The fund manager is not allowed to continue the interest through the waiver of

management fees.

Filings:

Funds can launch schemes, following the filing of information

memorandum with the Board along with applicable fees, and fund units can be

listed on the stock exchange subject to a minimum tradable lot of Rs one crores,

however they are forbidden to raise funds through the exchange.

Limits To Investment:

AIFs are not allowed to invest more than 25% of the funds in one

Company and are forbidden to invest in associate companies. They should also

provide investors with financial information of portfolio companies as also

material risks and how these are managed on an annual basis.

All AIFs will have a Qualified Institutional Buyer (QIB) status as per

SEBI’s (Issue of Capital and Disclosure Requirements) Regulations of 2009.

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 SEBI will work with the Government of India to extend the tax pass-

through status to these AIFs. Currently, the tax pass-through status is only enjoyed

by investors who invest in select sectors such as bio-technology, nana-technology,

hardware and software development and many more. The regulator also has the

right to inspect or investigate any AIFs and take necessary action.

What Funds Are Under This New Regulation?

SEBI stated that the new regulations will broadly cover all types of funds

under three categories. All AIFs can apply for registration under one of the

categories below:

Category I AIFs:

These funds will be close ended, adhere to the investment restrictions as

instructed for each category and shall not engage in leverage i.e. any activity to

multiply gains and losses like borrowing money, buying fixed assets and using

derivatives. SEBI stated that they or Government of India or other Indian

regulators may consider certain incentives or concessions for these funds,

depending upon the specific need of each type of funds. Among the funds

included in this category are Venture Capital Funds, SME Funds, Social Venture

Funds and Infrastructure Funds and the minimum tenure of these funds should be

3 years.

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Category II AIFs:

These funds shall be close ended with no investment restrictions. However

these funds are not allowed to engage in leverage other than meeting day-to-day

operational requirements, as per the regulations and they will not attract any

specific incentives or concessions from SEBI, Government of India or any other

regulator. Among the funds included in this category include Private Equity

Funds, Debt Funds, Fund of Funds and unclassified funds that don’t fall under

either category I or category III and have a minimum tenure of 3 years.

Category III AIFs:

These funds can be open ended or closed ended and are allowed to engage

in leverage within the prescribed board limits. Among the funds included are

Hedge Funds which, according to SEBI, have negative externalities i.e. these

funds make decisions which may impose a negative effect on other funds, thereby

leading to inefficiencies in the market. These funds will be regulated through

Board’s directions in areas such as operational standards, conduct of business

rules, prudential requirements, restrictions on redemption, and conflict of interest.

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