Venture Capital in India: Still a Long Way to Go….

Venture capital implies different meaning to different categories of users. Though there is no one particular definition to explain the concept, different investment gurus have tried to throw light on it. The editor of well- known industry publication Venture Economics, Jane Koloski Morris defines Venture Capital as:

“Providing seed start up and first stage financing and also funding the expansion of companies that have already demonstrated their business potential but not yet have access to the public securities market or to credit oriented institutional funding sources…”

In India this industry is at a nascent stage and it has to cover a long distance to reach wider acceptance. Here the industry is completely under the control of Securities and Exchange Board of India (SEBI). From time to time it intervenes in the industry and imposes new rules and regulations for better functioning. According to SEBI (Venture Capital Funds) (Amendment) Regulations, 2000 published in the Official Gazette of India dated September 15.09.2000-

“Venture capital fund means a fund established in the form of a company or trust which raises monies through loans, donations, issue of securities or units as the case may be, and makes or proposes to make investments in accordance with these regulations.”

SEBI’s recent amendments on 14.04.2004

Recently SEBI has amended its existing regulations on VC funds and foreign venture capital investors along with revision of the minimum investment limit norms and allowing funds to invest in financially weak companies or listed sick industrial companies. In addition, the apex body has permitted registered venture capital funds/foreign venture capital investors to invest in companies in the real estate sector, companies engaged in gold financing for jewellery and RBI registered non-banking finance companies that have been categorized as equipment leasing or hire-purchasing companies.

With regard to the investment norms, SEBI has made it mandatory for a fund to invest at least 66.67 per cent of its investible funds in unlisted equity shares or equity-linked instruments. And the remaining 33.33 per cent or less can now be invested in the preferential allotment of equity shares of a listed company subject to the lock-in period of one-year. Further it has now granted permission such funds to subscribe to IPO of a venture capital enterprise without any lock-in-period for such shares after they are listed as against the 1-year lock-in period from the date of their listing in the bourses previously.

Stages in VC Financing

Initially SEBI explained venture capital as an equity support for the projects launched by first generation entrepreneurs using viably unproven but sophisticated expertise. However this has been later relaxed and the limiting features concerning technology financing were failed. Venture Capital is now seen as covering all kinds of funding of a high risk undertakings at any stage of its life. Let us discuss the different stages of financing where venture capital finds its significance.

Seed Financing– It is a small amount of initial funding in order to enable entrepreneur for product development and market research activities. And if the unit is through with the initial stage then the funds may be offered for developing the business plans too.

Start-up Financing– Once the business plans are drawn, it is the time to launch its product on a small scale to note the consumer response and market for the product. So to ensure the initial marketing of products and other operations, funds are required.

First Stage Financing- Normally the companies spent their start-up capital in the initial marketing operations and they require fresh capital to start the production on a full scale, if the initial response from the market holds good. Hence first stage financing takes care of that.

Second Stage Financing–When the company literally starts full scale productions and markets its product; it’s quite obvious that it will find debtors and creditors on its set of accounts. Though the company has made advancement, it is yet to make substantial profits. Here the company needs working capital finance to continue its effort smoothly without any liquidity constraints.

Mezzanine Financing-  It is needed when the company experiences rising sales and is able to cover its variable costs i.e. achieved break even point then it may plan further expansion of its production capacity or development of its existing product base.

Bridge Financing- It is provided when the firms plans to go public in the near future. It is structured in such a way that initial investors have the option to liquidate their stake and reorganizes the major stake holder’s position through secondary operations.

Investment Philosophy

The basic principal driving the venture capital is investment in high-risk projects with the anticipation of high returns. These funds are then invested in several fledging enterprises, which require funding, but are unable to access it through the conventional sources such as banks and financial institutions. Such enterprises generally do not have any major collateral to offer as security, hence
banks and financial institutions are averse to funding them. Venture capital funding may be by way of investment in the equity of the new enterprise or a combination of debt and equity, though equity is the most preferred route.

Indian scenario- a snapshot

Indian History of Venture Capital

In the year 1988 the Finance Minister formally introduced the venture capital industry in his budget speech. In this direction the venture capital fund was created to be managed by IDBI in order to provide financial assistance to industrial concerns looking for commercial applications of indigenous technologies. Over the decades many Developmental Finance Institutions such as Industrial Credit and Investment Corporation of India (ICICI), Industrial Development Bank of India (IDBI), and Industrial Finance Corporation of India Ltd (IFCI) etc have been providing financial assistance but due to their core business of lending they were denied permission for VC investing as their key business. Later on most of them have incorporated a new entity exclusively for venture capital financing. IFCI Venture Capital Funds Ltd. was originally set up by IFCI by the name of Risk Capital Foundation (RCF) in 1975 to provide institutional support to first generation professionals. But in 1988, RCF was converted into a company, Risk Capital and Technology Finance Corporation Ltd. (RCTC), and it also introduced the ‘Technology Finance and Development Scheme’ for commercialization of home-grown technology. Hence, to make the changes in the company’s activities evident, the name was changed to IFCI Venture Capital Funds Ltd in February 2000. Again ICICI incorporated ICICI Ventures in 1988, and is the largest venture fund management company in India with aggregate funds currently under management in excess of Rs.20 billion. As we proceed further we would discuss the investment basics of Venture Capital.

Investment Valuation

With the word venture capital the first thing that comes in the mind of people is risk. As the name suggests these investments are more risky than other investments. Investors often ignore the fact that risk and return go hand in hand and are generally driven by the proverb ‘to err is human, to hedge divine’.  But remember one can’t make profit if perfectly hedged. As a venture capital investment is exposed to a high magnitude of risk so it is necessary to value the investments cautiously. The valuation process aims at deriving the agreeable price for the transaction. Mathematically the valuation process can be expressed as under-

NPV = [C/V] x [(PAT x PE)] x i

Where,

NPV is the net present value of the cash flows discounted at the required rate of return by the Venture Capital Company

C is the amount of cash brought in for financing at that particular time

V is the sum of cash brought in and the intrinsic value of the firm at the time of raising capital

PAT is the forecasted profit after tax net of preference dividends if any.

PE is the price earning ratio of the industry

i is the present value interest factor that depends on the investment horizon and the required rate of return by the VC company

Let us discuss the above mathematical equation with the help of an illustration. Flankey Infocom Ltd. has come with a project of providing telecommunication services through optical fibre with the cost of Rs. 200 crores. It expects to go public at the end of 4th year with revenues of Rs. 8000 crores and a PAT margin of 9% on sales. The fund managers expects a return a return of 70%  over a 4 year period considering the sales and profit forecast of the company. Further the P/E multiple of the similar firms in the same industry is 11. The calculation is as follows;

Step I

Let us first calculate the terminal value at the end of the 4th Year:

TV== 200(1.7)4 =1670.42 crores

It implies that the initial investment of Rs.200 crores will grow to Rs1670.42 crores when the fund managers will liquidate the investment at the end of 4th year. Please note that the rate of return required by the fund managers is 70%.

Step II

From the forecasted data given in the illustration we can calculate the expected market value of the company at the end of 4th year:

V= (8000*0.09*11) =Rs.7920 crores

This is the total market capitalization of Garg Infocom Ltd. that has been calculated based on the Price Earning Approach. Since the company’s stock is not traded on the exchange so we have taken the average P/E multiple of the comparable firms in the same industry.

Step III

Now we will calculate the proportion of ownership stake of the fund at the end of the 4th year:

% Stake= 1670.42/7920=0.2109 or 21.09%

It implies that at the time of liquidation the fund is holding 21.09% of the company’s stake. So now we can estimate the post capital valuation of the company.

Step IV

As per the ownership stake of the fund at the time of entering into the investment at t=0 (where t=year), the total valuation of the company would have been as under;

V= 200/0.2109=Rs.948.31 crores

This indicates that after providing capital to Garg Infocom the total value of the company stood at Rs.948.31 crores. Hence the value of the firm before providing capital would be:

V= 948.31-200=Rs.748.31 crores

It is pre capital value of the firm. Though the pre capital valuation is determined by the investor but technically it is the intrinsic value of the firm at the time of seeking the capital. We can further cross check the total valuation of the firm derived in Step IV directly by discounting the expected total market capitalization of the firm at the end of 4th year:

V=7920 PVIF (70%, 4) =7920*0.11973=Rs.948.26 crores

The figure derived above is approximately same as the one we have calculated in Step IV

Though quantitative study is the integral part of the investment analysis it is also necessary to examine the qualitative factors such as growth prospect of the company as well as the industry, the market for its product, consumer’s mind set etc.

Sources of Risk

When the venture capital firm launches a product that is new to the market, there is always a risk that it may not be acceptable to the consumers. Initially it is very difficult to anticipate the demand of such products as the consumers are not aware of its benefits and uses in the real sense. And if the product is not up to the satisfaction of the target buyers then the company will have to bear the brunt. The risk associated with the venture firms can be summarized as under:

• It involves the management risk as the people behind the venture capital have little experience of the business management.
• It doesn’t provide exit route to the investors due to lack of buyers. Thus the investments are highly illiquid.
• It takes time for the venture capital unit to establish itself in the today’s competitive market. So there is always a problem of inconsistent cash inflows in the initial years.

Moreover there exist a threat from the sound existing players to copy the concept and innovations of the venture capital unit thereby impairing the plans.

Valuation in INDIA

In India as such there is no single approach to value a venture capital investments, the fund mangers generally rely on the traditional methodologies of project appraisal. Basically the fund mangers resort to the basics followed by the developmental financial institutions. Moreover there is a focus on the P/E valuation as the Indian markets are inefficient in the semi strong form i.e. one can make abnormal profits in the short run by using the publicly available information. Though there is a dependence on quantitative analysis but still the venture capital funds are sometimes relaxed while financing the projects of the existing entrepreneurs having a good track record. Notwithstanding, such dissimilarity in the valuation technique as compared to the developed and efficient markets as that of US, the Indian industry will have to come up with a scientific valuation approach in order to improve the prospects of the industry.

Conclusion:

It is relevant to add here that the Indian industry is yet to adopt the US approach towards the administration of the VC funds. The major VC funds in
India are the ones promoted by IDBI, TDICI, IFCI, ANZ Grindlays Bank and National Equity fund. The liberalization of capital markets across the globe
and the real Bull Run in the Indian stock markets is drawing venture funds towards further investment in this sector. Recently Small Industries Development
Bank of India (SIDBI) has also planned to increase the size of its venture capital fund, named Growth Fund, to Rs 500 crore from the current level of
Rs 100 crore. This is an immature discussion but it is intended to give both investors and entrepreneurs some idea of the process involved.