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The Venture Capital Process in India

Vishnu Varshney, GVFL


Reprint Permission from Aspatore Inc., All Rights Reserved

Bullet points

  • India has emerged as a preferred destination for cross-border investment by large global venture funds.
  • Having overcome the learning curve, the Indian venture capital and private equity industry is poised for growth into its next phase.
  • Strong determinants for VC investment decisions in years to come include the makeup of the management team, the product and its market potential.
  • Under ideal circumstances, discerning entrepreneurs will approach venture capital firms known for value-added company building and fairness in deal structuring.
  • In the future, buyout and trade sales will become more common exit routes for startups that have seen venture funding in India.

Venture Capital in India - Background, Context and the Early Days

The venture capital industry in India is less than two decades old. Three All-India Financial Institutions, viz. IDBI, ICICI & IFCI, started venture investing in technology start-up companies on a modest scale in the mid-eighties. IDBI, ICICI, and IFCI are financial institutions which provide financial assistance primarily as term leaders for very large industrial projects based anywhere in the country. That is why these institutions are referred to as "All-India Financial Institutions." Subsequently, the World Bank took a major initiative for fostering the venture capital industry in India and in a 1988 seminar, brought together the issues and implications of undertaking such an endeavor. Responding to the need for a policy initiative to encourage venture activity, the government set forth the first venture capital guidelines in November of that same year. Concurrently, the World Bank created a special fund to invest in Venture Capital Funds to be set up by select Public and Private Institutions in India.

Then, in 1990, four venture capital funds were set up by four public financial institutions during the World Bank initiative. Later, the World Bank added two more to this list. At the same time, five to six venture capital companies were also set up by the private sector. These funds were required to follow the government guidelines of 1988, which offered a narrow definition of venture capital as a risky investment in innovative, technology-oriented companies started by first generation entrepreneurs. This, coupled with a ceiling on the size of eligible companies, led to the financing of small companies with seed funding at the startup stage.

The Early Days of Venture Capital

  1. The preliminary initiatives were taken largely by government backed financial institutions and banks. Funds were largely provided by multilateral institutions and government agencies and a very small percentage of funds came from corporate parties and private individuals. The Indian venture capital industry initially lacked professional expertise as it was dominated by former credit managers and investment bankers who lacked operational skills in building companies. Over time, through World Bank sponsored initiatives and training development, many of these professionals evolved into highly successful venture capitalists.
  2. At this time, many Asian countries lacked favorable regulatory environments for the success of VC and private equity. In India, regulations defined VC narrowly and created all kinds of restrictions, while multiple government agencies regulated investments from a foreign VCF and time-consuming permission authorization was required from different agencies.

    Lately, this has begun to change. Governmental authorities have streamlined many of these necessary procedures and a level playing field has been created by removing tax anomaly. Multiple regulators have been replaced by single regulators, i.e. SEBI. Looking forward, limited partnership to structure VC funds is likely to be enacted. From a globalization perspective, as the global economy becomes more integrated, venture capital will naturally follow.

Economic Reforms & Venture Capital

Several changes in the last decade have had a significant impact on venture capital in India. Perhaps most importantly, the economic liberalization and financial sector reforms introduced in 1991 changed the competitive scenario for the venture capital industry substantially. In 1991, when the reforms were announced, Controller of Capital Issues (CCI), the government regulatory authority for the capital markets, Venture Capital Funds, etc, was abolished. Venture capital guidelines, announced by the Government of India in 1988, were referred to as CCI Guidelines and were narrowly focused on seed and start-up stage, small technology companies. All of the funds, including the funds sponsored by the World Bank, had based their investment strategy on these guidelines. However, after the abolition of CCI, these above guidelines were not applicable. As seed and start-up stage technology companies carry much higher risk and require substantial nurturing and hand-holding efforts, most of the VCs, in absence of any incentive, questioned the wisdom of continuing to invest in such companies. Therefore, many VCs changed their investment strategy from start-up to growth capital, buyout and pre IPO. Capital market was bullish up until 1992 to 1993 when a major scam was unearthed. Between 1991 and 1995 there were no regulations and hence many private sector funds mushroomed along with a large number of foreign funds. Foreign private equity funds decided to enter in the Indian market. However, most of the VCs did not follow the fixed-focused investment, strategy barring the funds sponsored by the World Bank, such as GVFL, APIDCVCL, CanBank Venture, and ICICI. This brought into focus major tax anomaly, which created uneven playing fields amongst funds settled by the Unit Trust of India. Funds managed by ICICI and RCTC were totally tax exempt under the UTI Act, where other domestic funds were required to pay a maximum marginal tax which went as high as 54 percent at one point in time.

In absence of any guidelines or regulations, a large number of foreign investors directed their attention towards India. However, a major scam in the capital markets in 1992 and 1993 set back the Indian economy and created a crisis of confidence. A large number of small investors were badly hurt. This also affected the newly started OTCEI, which was primarily started by the Government of India with the help of the World Bank and NASDAQ for listing small capital companies. Most of the domestic VCs had pinned their hopes on OTCEI for their exits through the listing of their Investee Companies on OTCEI. In order to take advantage of a bullish capital market, OTCEI was instead used by many Indian private sector companies with their surplus funds for speculative investments called "Bought out Deals." While some of the companies were genuine small start-up companies, a large number of them were fraudulent non-existent companies. The major scam in 1992 and 1993 had already dried out the IPO market completely and Indian Capital Market suffered a bearish trend for next several years. OTCEI also suffered substantially. It is still struggling to remain alive. The scam also affected entry of new VCs into the market for some time.

In 1994, GVFL, at the behest of the World Bank, organized a workshop of the then existing VC Funds and invited some foreign investors from Bangalore. The workshop was attended by top government officials from the ministry of economic affairs and officials from OTCEI and SEBI. All the VCs shared their experiences in this workshop. The government of India, impressed by the enthusiasm of the existing VC companies and the contribution they had made so far, invited the VCs for formulations of new VC regulations and guidelines.

In 1991, the existing twelve VC players had organized themselves into an association. As secretary of the association, I played a key role in organizing the workshop and formulating regulations by the Indian Government. These regulations were announced for the first time in the 1995 budget.

Likewise, industrial policy changed drastically with the removal of licensing and other restrictive provisions in the MRTP Act regarding the size and nature of large businesses. This led to a spurt in industrial activity, with companies redefining their strategic plans and expanding, modernizing and diversifying on a scale not seen before. At the same time, the demand for funds from the industry was quite high, leading to a quantum increase in capital market activity. A natural increase in the scope of activity in the industrial sector represented an increased spectrum of funding opportunities for all players in the financial markets, including venture capitalists.

Under the 1988 guidelines, the thrust had been on risky new technology indigenously developed. Many of the portfolio companies were into the manufacture of import substitutes, which was an attractive business in the pre-liberalization period. Then gradually there were new sorts of businesses that became attractive and many such ventures had no entry barriers. The scope for VC deals increased beyond the traditional technology based technocrat-entrepreneur. Concurrently, there was also a heightening of international interest in Indian businesses.

Liberalization also brought down the external trade barriers, with an across-the-board reduction in import duties for many products along with the abolition of restrictions on the import of many others. The competitive scenario for Indian venture capital altered significantly under the liberalized trade regime as Indian technology and products had to now compete in the world markets.

Additionally, the boom in the primary markets encouraged new companies to raise funds through public issue. The pricing, of course, was on par, except in the case of companies promoted by existing profitable companies. To the venture capital industry, this represented a new facet of competition. Promoters were more inclined to make a public offering and raise money from retail investors rather than issue equity to venture capitalists and be subject to extensive monitoring and controls. These changes in the economic landscape also brought about redefinition of the venture capital industry. It became much wider than it ever had been.

Entry of Foreign Players

The aforementioned liberalized industry policy provided a wide set of opportunities in many industries, which had hitherto been closed to foreign investors. There was a surge in foreign direct investments, joint ventures and collaborations, apart from existing foreign investors increasing their equity stakes in their companies.

The financial sector was opened to foreign investments in 1992, which led to an increased access to international markets for Indian companies. More importantly, foreign institutional investors were permitted to invest in Indian markets.

The signing of tax treaties with Mauritius in 1992, facilitating tax-favored investment in India through Mauritius, led to a spurt of offshore investment activities in India. Many foreign investors began investing in Indian companies in the form of direct equity investment, direct portfolio investment through mutual funds, and venture capital funds.

In 1995, foreign investment in venture capital funds became permissible and in the following year, foreign institutional investors were permitted to invest in unlisted equities of Indian companies. With the entry of large foreign investors investing in classic venture capital projects as well as making private equity investments in Indian companies, the venture capital industry has witnessed significant changes in the competitive scenario, as these funds primarily invested in buyouts, restructuring, expansions and mezzanine stage.

In 1995, a large number of foreign funds also entered the country. While the domestic funds were required to follow VC guidelines announced in the Government of India's budget of 1995, foreign offshore funds, which came through the Mauritius route, were not required to follow any such cumbersome guidelines. Such funds were free to decide their own investment strategy and hence these funds made investments on the basis of opportunity. These funds were of very large size. Usually they made very large investments as private equity in well-established listed as well as unlisted companies. Domestic funds could not invest in a large number of sectors due to government guidelines; they were also required to invest only in unlisted companies, through equity and quasi equity instruments. At this time many of the domestic funds started changing their investment strategy from start-up to growth, which was allowed by the regulations. There was an overall growth of venture capital industry due to the entry of a large number of foreign private equity funds such as Barings, CDC, HSBC, Citibank Corp, American Express, Jardine Flaming, Indocean, etc. These funds made much larger investments in the range of 2 to 3 million dollars in both established listed and unlisted companies. At the same time, the number of domestic funds also grew. But their growth was slower than expected, as they were required to follow the government guidelines, which were not very encouraging.

The Rise of Information Technology

By 1997, India started emerging as a major center for Information Technology. A substantial number of entrepreneurs of Indian origin had become highly successful in Silicon Valley. Their linkages with India provided impetus to the growth of the IT industry in the country. Demand for venture capital and its supply in India reached spectacular heights. Even though the VC industry faced a number of regulatory issues and bottlenecks, foreign investment continued flowing in with unprecedented speed. Foreign Institutional Investors replaced domestic supplies as main sources of Indian venture capital. In fact, the venture capital industry had turned faddish. Many industry specific private and public domestic funds were also started to satiate the growing appetite for venture capital by mushrooming small software and internet companies. Bangalore, Mumbai, Hyderabad, Chennai and Delhi emerged as hubs for venture capital in India. From 2000 to 2001 recession and the dotcom burst caused major shakeout and a large number of newly established funds - in India, but also worldwide - folded their operations. But in retrospect, IT euphoria did many good things to the industry. The government, having paid little attention to the industry thus far, made many positive changes in regulation, including leveling the playing field for domestic and foreign funds, replacing a system of multiple regulators with one in which the Securities and Exchange Board of India (SEBI) serves as a single regulator and practical guidelines were formulated in consultation with the industry. Additionally, SEBI registered domestic VCs were granted pass through status and complete income tax exemptions. Procedures for foreign funds were also drastically simplified.

Speedy implementation of economic reforms, along with the privatization of the public sector, has brought in economic recovery faster than anticipated. At present, the venture capital industry, which had become dormant like its counterpart in the US and elsewhere, is slowly getting back into action. Large foreign private equity funds have again started investing and valuations have become much more realistic. Capital Markets are booming and almost all sectors have been opened up by the government for foreign investment. These signs of the resurgence of venture capital are all very clear.

Major Players in Indian VC

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Vishnu Varshney, President & CEO

Mr Vishnu Varshney is considered to be the pioneer of VC funding in India. An articulate spokesperson and effective lobbyist for the VC industry, he is one of the co-founders of the Indian Venture Capital Association [IVCA] and has served as its Secretary from 1995 to 1997 and then as its Chairman from 1997 to 2000. During this period, he was instrumental in framing guidelines that enabled the government to draft the required legislation for the effective growth of the industry. He is considered one of the most proactive Chairman of the IVCA to date.

Mr Varshney has an impressive academic background. He holds a B.Tech in Electrical Engineering from IIT, Kanpur, a MS in Electrical Engineering, Louisiana State University, USA, and an MBA from Louisiana State University, USA. After completing his education, he worked for two years as Circuit and System Design Engineer with Tano Corporation, New Orleans, USA. He then returned to India and joined GIIC in 1979 as Project Manager. In 1990, he was selected by the World Bank and GIIC to start Gujarat Venture Finance Ltd (now known as GVFL Ltd) at Ahmedabad, Gujarat, India.

Mr Varshney has undergone exhaustive training to understand the working of the VC industry. He was the first executive from India to be selected by the World Bank to participate in an 18-week venture capital training course in the US with Hambro International Equity Partners, Boston in 1991. Moreover, he also successfully underwent a 17th Venture Capital course organized by the NASBIC and NVCA in the USA in September 1991. He has travelled throughout North America, Europe, Japan, Mexico, Algeria and Asia for negotiating transfer of technology, purchase of equipment, raising finance, etc. He has 29 years experience in equity investments, project planning and implementation and turnaround including 14 years in venture capital.

Under Mr Varshney's dynamic leadership, GVFL has evolved into one of the most eminent venture capital companies in India. At present, GVFL manages four funds: GVCF-1990, GVCF-1995, GVCF-1997 and Gujarat Information Technology Fund, with a total corpus of Rs 125 crore, invested in 56 companies across India.

Mr Varshney has been actively involved with various organizations in various capacities. He was a Member of the National Panel on Economic Affairs Committee, CII, and also Member of the SEBI Committee on Venture Capital. He has also been Chairman of the Gujarat Chapter of the Indo-American Chamber of Commerce. He is on the advisory board of incubations at IIT, Kanpur, IIM, Ahmedabad, and National Institute of Design, Ahmedabad and Nirma University. He has been a judge of various business plans and competitions. He has been invited to USA, Hong Kong, Singapore, Mauritius, etc. as a guest speaker by various institutions.

Mr. Varshney is a recipient of Who's Who in American College and Universities in 1972-73. He is also a member of Phi Kappa Phi and Eta Kappa Nu. Recently, he was felicitated by the CII at the annual Communication and Information Technology (CIT), 2002, Conference-cum-Exhibition, held in December, for his contribution to the development of the Indian IT Industry through venture capital. He has also received the first "Outstanding and Innovative Finance Man of the Year - 2002 Award" from Gujarat Finance Companies Association, Ahmedabad.

Mr Varshney has also been instrumental in setting up the Indo-American Education Society (IAES), a non-profit organization, which functions as a satellite centre of the US Educational Foundation in India (USEFI) and provides comprehensive counseling services to students interested in studying in the US.

Mr. Varshney has made more than 300 presentations on Venture Capital at various seminars, conferences and has written many articles. He was instrumental in setting up a comprehensive training program on venture capital prepared by the UTI Institute of Capital Markets by a World Bank Grant. Mr. Varshney is the only Venture Capitalist in India who has witnessed a complete cycle of fund raising, investing, divesting and distribution. Mr. Varshney was invited to write on Venture Capital in a book on SME finance published by Tata Mcgraw Hill on behalf of SIDBI and the Swedish Development Corporation. Recently Cornell University has undertaken two investee companies of GVFL as case studies.

About GVFL

GVFL Ltd (formerly known as Gujarat Venture Finance Limited) is widely regarded as the pioneer of venture capital in India. Started by GIIC at the initiative of the World Bank in July 1990, GVFL is a board-managed, autonomous venture finance company based in Ahmedabad, Gujarat, India. The World Bank and GIIC selected Mr Vishnu Varshney as GVFL's first President and CEO.

GVFL has been promoted by a leading state public institution, multilateral agencies like World Bank, CDC-UK and some leading private sector companies like HDFC, ICICI Bank, Zydus Cadila, Asian Paints etc. The Board of Directors includes eminent professionals from the industry.

So far, GVFL has raised four funds, aggregating a total corpus of Rs 1240 million, and has invested in 56 technology companies at seed, start up and early stage all over India. GVFL is reputed for its value addition and nurturing of its investee companies. It is the only Classical Venture Capital Company which has tried out Entrepreneur in-residence for IT Company.

The details of the funds managed by GVFL are as under:

GVCF-1990 Was started in November 1990 with a target corpus of Rs 240 million. It is a close-ended fund of 15 years duration. The investor base includes public and private sector companies. Besides the World Bank, GIIC and CDC, investors include 30 private sector companies such as Arvind Mills, Asian Paints, Hero Cycles, HDFC etc. The Fund has invested in 26 start-up companies all over India. GVCF 1990 is the first fund in India to be registered with SEBI.
GVCF-1995 GVFL launched its second fund, GVCF-1995, a 12-year close ended fund, with a corpus of Rs 550 million. The investors of this fund include public institutions like GIIC, IDBI and SIDBI, multilateral agencies like the World Bank and CDC (UK), private sector companies like Gujarat Gas (British Gas Co.), ICICI, Torrent, Cadila, Ahmedabad Electricity Company, HDFC, Essar, Aptech, Lloyds Finance etc.
GVCF-1997 GVCF-1997 is a close-ended fund of 12 years duration. The corpus of the fund is Rs 200 million. The fund has invested in six IT start-up ventures. The investors of this fund include the World Bank and SIDBI.
Gujarat IT Fund This Fund has been targeted at funding new and existing small/medium sized ventures in the IT sector. The fund is specifically marked for companies that are coming up in Gujarat. It is also a close-ended fund of 10 years duration, with a corpus of Rs 200 million. Major contributors to this fund are SIDBI and Gujarat Informatics Limited.

GVFL has so far successfully divested from 30 out of 56 investee companies. The Cornell University has recently selected two investee companies of GVFL for case study. PriceWaterhouse Coopers have recently undertaken a study on review of GVFL's performance vis-Ç -vis other venture finance companies in India and has rated it as one of the few outstanding performers in the country.