Venture Capital Financing

Author(s): Sudip Bhattacharyya

Source: Economic and Political Weekly, Vol. 24, No. 47 (Nov. 25, 1989), pp. M157-M159
Published by: Economic and Political Weekly
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 Venture Capital Financing
This paper discusses the requirements of successful venture capitalfinancing in India in the light of experience
in the US and in some of the south-east Asian countries.
THIS paper endeavours to: (i) Trace the
origin and development of thN concept of
venture capital (VC) financing, with a focus
on the current status of such financing in
the US, south-east Asia and India. (ii) Tak-
ing cue from (i) define the concept and
develop an ideal model of a VC company.
(iii) Identify its requirements and suggest an tance was provided in the form of loan
approach for such financing.
HISTORICAL PERSPECTIVE
If VC fund is for supplementing en-
trepreneurial effort in risk taking, its origin
could be traced to the rise of merchant banks
in UK. These merchant banks, mainly pro-
moted by wealthy families, have supported
trade and commerce across the border by
providing the resources and/or risk par-
ticipation directly or through discount
houses and issue houses. They also facili-
tated setting up manufacturing units albeit
on a small scale. Such system manifested in
India in the form of managing agents. They
had a very important role in providing not
merely part capital but also input in the form
of overall management and they definitely
ventured into manufacturing areas.
Institutionalisation of VC financing took
place much later around 1950s in the US
with setting up, in 1946, of American
Research and Development (ARD) at MIT,
with the explicit objectives of promotion of
new technologies developed in universities.
Then, in 1958. Small Business Administra-
tion was set up to license small business in-
vestment companies in the private sector and
also to provide them with long-term loans.
There were subsequently private initiatives
like those of Xerox, 3M and General Elec-
tric to finance skill and technology based
projects. VCF in modern form really took
off in the US and primarily supported 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 in-
dicative risk perception in American VC
companies is of marked appreciation of in-
vestment in about 10 per cent- cases, but
failures in 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/commercialised tech-
nology, therefore the risk is predominant; Taiwan: Legislations were passed in 1983 found by VC companies in south-east Asia:
(c) by and large management also comes in
as an important input from the venture
capitalist, although majority share-
holding is not favoured for ensuring
such control; practice is to have written high technology. Besides the three govern-
agreement defining management role.
Economic and Political
This content downloaded from 14.139.69.32 on Mon, 02 Mar 2020 19:14:34 UTC
Sudip Bhattacharyya
The Indian experience started in 60s with pany, Han Tech Venture Capital Company,
initiatives by term-lending institutions like has already made a mark.
IFCI and IDBI. They promoted two schemes
Singapore: In 1981, the National Iron and
called Risk Capital Foundation Schenme and
Steel Mills launched into a corporate venture
Seed Capital Scheme, primarily to support
investment programme. This was followed
promoters/entrepreneurs in medium and
up by four other funds, viz, (a)South-East
small-scale industries, respectively. Assis-
Asian Investment Programme (SEAVI);
(b) Transtech Ventures; (c) Elders Pica
finance on very soft terms to the promoters
Growth Fund; (d) Economic Development
instead of the project. These ideas were
Board Venture Capital Funds.
mooted mainly as extension of their institu-
DBS Bank is the other major player in
tional role as apex developmental institu-
Singapore VC financing. The government
tions. One may also acknowledge efforts of
currently offers pioneer services and incen-
some banking institutions like the State
tives to encourage more locally-based ven-
Bank of India who ptovided loans to tech-
ture capital firms. Exemption from cor-
nical entrepreneurs in small projects without
porate tax for such companies is possible for
collaterals and sometimes without margin
a period of 10 years. A second tier stock
contribution from them. Currently, some
market for smaller companies started
developmental/financial institutions even at
operating since early 1987, providing a route
the state level are subscribing to equity
for 'Exit'. In Singapore they also look at
capital in new companies and disinvesting
more matured firms providing growth poten-
after some time. The significance of this will
tial rather than only start-ups. SEAVI's ap-
be apparent later.
proach is towards value-added investing. It
offers its network of contacts and expertise
CURRENT STATUS to help firms enhance their operations.
Hong Kong: In Hong Kong VC com-
From the US, VC financing travelled to
panies have been used as a base for tech-
Japan with a large measure of success. The
nology transfer to China which looks at VC
existence of large inter-corporate holdings
entirely in technology transfer terms. Also,
among financial institutions/bank and
in Hong Kong they get a lot of downstream
business houses and the shift in emphasis
engineering done on a cost-effective basis.
from large engineering enterprises to smaller
Thus VCF here is more application-oriented.
but value added high technology areas made
In December 1987, Hong Kong Venture
the task easier for VC companies in Japan.
Capital Association was formed with 20
More interesting is that VC financing has.
companies as full members.
now entered south-east Asia.
Thailand: In 1987, Business Venture Pro-
South Korea: Institutionalisation in South motion Company was promoted by a con-
Korea took the following course-(i) setting sortium of six local commercial banks and
up of Korea Technology Advancement Cor- USID. US $ 6 million was provided as a soft
poration in 1974 for implementing R and D loan by USID and an equivalent amount was
projects of public research institutes; (ii) set- raised as equity from the six participating
ting up of Korea Technology Development banks. What has been found imperative in
Corporation in 1981; (iii) setting up of Korea Thailand is that the VCF companies have
Development Investment Corporation and to involve themselves even in preparation of
Korea Technology Financing Corporation in business plans for prospective clients. Other
1983; (iv) passing of Small and Medium apprehension is with regard to existing
Business Establishment Assistance Law in legislations which may treat a VC fund as
1986 for equity investment by venture an investment dealing company, leading to
capitalists; (v) development of Technology higher tax incidence.
Credit Guarantee System designed to assist
Malaysia: In 1984 Malaysia Bhd Fund was
venture business lacking in collateral for
set up under SEAVI programme. There are
securing the borrowings. Finally, introduc-
incentives available to attract foreign direct
tion in 1987 of Over the Counter (OTC)
investors, although recession over the past
market for transacting in shares of promis-
three years has been an inhibitive factor.
ing venture businesses provided a great fillip.
The following impediments have been
offering attractive incentives for investors in (a) Business culture is family controlled or
VC funds. In 1985, a development fund of oriented.
NT$ 800 million for investing in VC fund (b) Market research is inadequate. There is
was established. The focus in Taiwan is on also no significant capability to evaluate
service ventures.
ment associated institutions, a private com- (c) Emphasis on collateral-based financing
Weekly November 25, 1989 M-157
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 and dearth of adequate mechanism for technology. (ICICI's real high technology in- industries with high entry barriers and pro-
'Exit' except in Singapore. stitution would however be the programme fit margins and rapid sales growth.
for Advanced Commercial Technology.) Diversification. The funds deployment in
SITUATION IN INDIA Sometimes the technology supported, even any one portfolio to be limited to say 7.5 per
if new in India, is already commercially suc- cent of the fund. In existing portfolio, this
The professed pioneers in VC fund in
cessfully tried abroad; the emphasis was on may be exceeded if needed.
India are the following:
extension of assistance to secured risks in- Business plan. The companies should have
(i) Risk Capital and Technology Finance
the sense that either assistance was in the reasonable business and financial plans to
Corporation (RCTFC): It was earlier an form of loan assistance which is strictly achieve their product, marketing and finan-
adjunct of IFCI. It has so far provided speaking not risk capital and the benefi- cial objectives in a realistic time-frame ac-
interest-free loan to promoters at a
ciaries have been well established, well ceptable to the funds.
nominal service charge of 1 per cent p a.
organised and larger companies. But then High return on investment. Companies
(ii) IDBI's venture capital fund: Under the VC companies can really expect returns only will be sought with a potential for high
terms of the research and development
after sa, 4 "` yeai and therefore initial cau- returns on investment commensurate with
cess act of 1986, companies importing tion may be welcome. the substantial risks of the investment.
technologies pay a 5 per cent cess to the
Potential liquidity. The ability to achieve
government. This goes to IDBI's fund. DEFINITION AND MODEL liquidity for individual investments will be
Such assistance is provided in the form
an important consideration. The maximisa-
of unsecured loans with minimum legal From the aforesaid, the following impor-
tion of portfolio return will in part depend
formalities. There is a concessional rate tant features emerge as the main components
upon the ability to effect a successful exit
of 6 per cent during the period of of a VC company:
strategy through the sale of stock into the
development of the technology/the Objectives: (a) capital appreciation;
public market or the sale or merger of the
pilot plant and trial production. This (b) roll over of funds.
company.
rate may rise to 17 per cent if and when Role: (a) providing risk capital; (b) pro-
Risk perception: High risk due to (a) con-
the product is accepted in the market. viding management.
centration in high risk illiquid investments
(iii) ICICI's TDIC: Technology Develop- Area of operation: (a} Unproven/not com-
in new or emerging companies; (b) no assu-
ment and Information Corporation was mercialised technology; (b) opportunities
rance of capital appreciation or any rate of
set up in 1986 and has raised its capital due to market distortions/structural ineffi-
return on investment; (c) illiquid investments
entirely out of internal resources. There ciencies in economy; (c) opportunities not
due to non-transferability of shares except
are no fixed terms for TDIC. Generally exercised due to lack of management and in special cases.
it provides funds to projects costing up organisational deficiencies; (d) service in-
to Rs 2.5 crore, either through conces- dustry as sunrise industry; (e) opportunities
REQUIREMENTS
sional finance or participation. Repav- emerging through liberalisation of economic
ment is proposed through a charge on process. For fulfilment of objectives, the venture
the sale. Only a cap on the amount to Therefore, typically, a VC company would capitalist must realise the gains of capital ap-
be repaid is fixed a priori, depending have the following programme: preciation. Once this gain is realisable, it will
on the profitability of the company. It Objectives and area of operations: Invest- also automatically lead to meeting of sup-
is possible to recover about three times ments in a diversified portfolio of early stage plementary objective of roll over of funds.
the original amount lent over an un- companies in technology-intensive enter- This would require fiscal incentives and 'exit'
specified veriod. Another option of- prises, consumer or other businesses and mechanism. VC financing in India has come
fered is loan with a base interest plus limited equity participation in leveraged through efforts of business associations,
a royalty on a1l sales. Loans are buyouts thereby generating substantial financial institutions with support from the
unsecured. The other lending instru- capital appreciation for roll over of capital government. In 1987, a senior government
ment is direct equity participation. and benefit to investors in the funds. official, Nitish Sengupta, had in an article
(iv) SBI Capital Market: Innovative ap- Role: To provide 'hands-on' managerial, in The Economic Times dwelt at length on
proach was brought by SBI Capital operational, technical and financial assist- a comprehensive package of possible incen-
Markets in this field through its ance for its portfolio companies. tives for growth of VC companies. He had
'bought-out-d'eals'. This is a way of pro- Investment criteria: The funds will seek suggested inter alia:
moting new capital issues in a bear to invest in emerging companies which have (a) Benefits of Section 80CC of Income
market. It is done by buying out new the following characteristics: Tax Act without any limit on investment in
issues with the objective of unloading Management. Management should pre- venture capital companies. This would lead
them at a later stage after the market ferably have seasoned and successful track to flow of funds to venture capital funds.
picks up. record in other companies with an appro- (b) Liberalising the relief under Section
It has recently been announccj that Credit priate balance of business and technical 80M for such companies to avoid or mini-
Capital Corporation of India has been per- skills, in addition to the ability to attract and
mise double taxation of dividends.
mitted to set up a venture capital fund of retain quality employees. The deficiency, if (c) Extension of benefit under Section
Rs 10 crore. This will be the first fully private
any, has to be made up by support of the 80HHC to, say, 50 per cent of profits earned
initiative in VC in India. Other players in the VC company or from external -sources. by such companies.
field are Grindlays Bank and Canara Bank Proprietary product and/or technology. (d) Reduction in capital gains tax for such
financial services and SICOM. Industrial The technology or product should have pro- companies.
Rehabilitation Bank of India has for some prietary features which will create a com- (e) Modification of Section 2(18) of In-
time been assisting sick units in their efforts petitive edge based on lead time, price come Tax Act so that benefit available to
at rejuvenation. In the sense that sick units and/or performance. companies in which public are substantially
are selected for financing through a process Market opportunity. The product or tech- interested could be extended to VCF
of identification of potentials and by pro- nology should have the potential to capture companies.
viding technical and managerial know-how a sizeable market position and establish (f) Alternatively, partnership can be
along with funds on soft terms, the role of channels of distribution in an emerging or amended to allow for formation of limited
IRBI has considerable significance. high growth market. Alternatively, the pro-. partnership as allowed in the US.
The three institution-backed funds have duct or technology should satisfy a basic For a proper exit route for venture capita-
made a mark in terms of quantum of assis- economic need in a definable market. The list, the options suggested are: Starting an
tance provided and they have focused on funds would also seek attractive business in unlisted security market and over the coSunter

M-158 Economic and Political Weekly November 25, 1989

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facility enabling quick transactions in shares by professionals such'as bankers, managers out of sale of post-acquisition assets. Fun-
held by venture capitalists at appropriate and administrators and persons with ade- ding method often involves junk bond issue.
price. It may be necessary also to examine quate experience of industry, finance, ac- These are bonds considered below invest-
capital issues control or Security Contract counts, etc. Foreign participation/tie-up may ment grade and therefore carry high coupon
Regulation Act so that premium could be bring in management expertise and export rates. But this leads to higher debt gearing
appropriately determined or even left to market intelligence for use by VC companies. and therefore risk goes up since expectations
market forces. There is already progress on behind acquisition may not really materialise
OTC operation. APPIROACH TO FINANCING
CONCLUSION
For the VC companies to identify ap-
GUIDELINES
propriate areas, understanding of the pro- In this paper two expectations from a VC
Recently the government of India has an- duct cycle concept together with its typical company have been highlighted: (a) it shall
nounced guidelines for venture capital com- 'S' curve pattern would be a great help. have entrepreneurial perception; and (b) It
panies and venture capital funds. The guide- Basically, it must distinguish between inven- shall provide management support.
lines have stressed high technology orienta- tion and innovation. Funding is to be made It is also to be noted that in India so far
tion of such venture. More relevant are the only at innovation and post-innovation the initiative has been predominantly from
following: stage, where commercialisation prospects the public sector. The question therefore
(i) The VCC/VCF may be listed according have been objectively established. Aspects arises whether such expectations can be
to the prescribed norms. Its issue may be such as technology obsolescence, product fulfilled in the typical public sector work
underwritten at the discretion of the maturity, international competitiveness, culture of rigid procedures and accountabili-
promoters. stages of business cycle have to be clearly ty and ratio fetishism in financial analysis.
(ii) For assisted units also, listing perceived. In other words, the VC company Further the VC fund would be illiquid in the
guidelines would apply. Investment by wide-
should: initial years for two reasons: (1) funds en-
ly held VCF would be treated as public par- (1) perceive commercialisation possibility; trusted in a new company would require
ticipation for this purpose. (2) sense new process of manufacture giving some time before it can show capital ap-
(iii) Exit-Pricing of the shares at the time cost advantage; preciation. (2) VC company could be ex-
of disinvestment by a public issue or general (3) see new use of existing products or utili- pected to yield returns to its investors only
offer of sale by the VCC/VCF, may be done ty of a new product; after it has built up a diversified portfolio
by them, subject to this being calculated on (4) spot virgin market or exploit market/ of a number of ventures, for hit ratio of suc-
objective criteria like book value, profit structural imbalance/imperfection; cess would be rather low in terms of
earning capacity, etc, and the basis being (5) visualise new possibilities emerging due numbers. Thus the management of a public
adequately disclosed to the public. to liberalisation process particularly in sector VC company may be held accountable
The latest budget speech incorporates the service sector. for losses in the initial years thereby effec-
intention of government to accord conces- A clear understanding of the aforesaid ting the motivation for VC financing. Thus
sional treatment in respect of levy of tax on would also help identification of stage of/ in a country like India, VC financing
capital gains by VC companies. The guide- financing like early stage financing, later although seen as one of the tools for deploy-
lines in principle recognised the need for in- stage financing and all-stage financing. ment of oapital, could perhaps be better ad-
centives towards this end as follows: ministered through private initiatives: unless
Seed finance is the earliest stage financ-
The preferential tax treatment would be adequate independence and authority are
ing entailing highest risk. Start up is perceiv-
available to the approved venture capital vested in public sector VC companies.
ed as the most fertile source for capital ap-
company/fund only in respect of financing
preciation. The risks is less than in seed
of such assisted units as are eligible to be [Views expressed in this paper are entirely those
financing but in absolute terms works out of the author.]
treated as venture capital units as defined in
paragraph 3. For this purpose, the unit seek-
higher because of larger quantum of invest-
ing equity support from the YCC/VCF ment involved. Management input may play
should obtain a letter of eligibility from a very complementary role in success of ven-
IDBI/ICICI, or any such agency that may ture at this stage.
be nominated by the government. Second round and later stage financing Texla
The specifics however, remain to be worked are done where start-up capital and debt
out. have been consumed but business is yet to TEXLA achieved a record production of
The guidelines provide for NRI participa- take off. Other types of financing possible
over 3,00,000 TV sets in 1988. Texla was
tion and also foreign participation in venture are bridge financing, take-over financing
the first to introduce 12" B and W TV sets
capital companies. Institutions like ADB, and turn-aroundfinancing. The last named
in 1979-80. In November 1983 Tex!a
is a rare form, but most relevant in Indian
IFC, CDC (Commonwealth Development
context. Here also management input by introduced a low cost 12" B and W TV
Corporation) are reportedly already evinc-
set for just Rs 1,265 in Delhi inclusive of
ing intrest in providing VC funds. For rais- venture capitalist companies would have
all taxes. Texla has diversified into manu-
ing such funds, even an instrument akin to paramount importance and therefore it must
zero coupon bonds with convertibility op-
have inhouse specialists, skill and expertise. facture of other consumer products allied
Here entrepreneurial aspects of venture to the TV, such as B and W picture tubqs
tion may be resorted to. The fiscal incentives
capital financing as brought out in previous through its associate, Mullard Tubes, and
under contemplation should also provide
paragraphs are brought to real challenge.
flow to venture capital funds. For emphasis plastic cabinets. It has its own full-fledged
by VC companies on exclusivity of venture Sick unit financing is one of the more critical
plastic moulding unit as well as tool room
area of turn-around financing.
capital funds, it has been stipulated that a for fabrication of moulds and production
level of 30 per cent should be reached for Take-over financing is in vogue only in the of cabinets. Texla commenced the assem-
venture capital activity by the end of the se- US and western European countries. The US
bly of VCRs in 1982 and since then it is
cond year, and 60 per cent by the end of the laws permit limited companies to buy their
regularly assembling/selling VCRs/VCPs.
third year, and 75 per cent by the end of the own shares. In leveraged buyouts, the com-
fifth year of operations.
The company has also entered the field
pany offers to buy its own shares from the
For providing management input by VC holders at a price well above the going of export of consumer products starting
companies, the onus is on them. The guide- with export of B and W TV sets and
market price, but obviously below the intrin-
lines recognises: it is required that the ven- sic value of shares. It borrows the funds from negotiations are on for export of colour
ture capital funds/companies are managed investment banks with hope of repayment TV sets.

Economic and Political Weekly November 25, 1989 M4159

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