WealthLockhead: November 2021

Meaning of Venture Capital

The term venture capital comprises of two words, namely, ‘venture’ and ‘capital’. The term ‘venture’ literally means a ‘course’ or ‘proceeding’, the outcome of which is uncertain (i.e., involving risk). The term capital refers to the resources to start the enterprise. Thus venture capital refers to capital investment in a new and risky business enterprise. Money is invested in such enterprises because these have high growth potential.

A young hi-tech company that is in the early stage of financing and is not yet ready to make a public issue may seek venture capital. Such high-risk capital is provided by venture capital funds in the form of long-term equity finance with the hope of earning a high rate of return primarily in the form of capital gain. In fact, the venture capitalist acts as a partner with the entrepreneur.

Venture capital is the money and resources made available to start-up firms and small businesses with exceptional growth potential (e.g., IT, infrastructure, real estate, etc.). It is fundamentally a long-term risk capital in the form of equity finance for the small new ventures which involve risk. But at the same time, it has a strong potential for growth. It thrives on the concept of high-riskhigh return. It is a means of equity financing for rapidly growing private companies.

Venture capital can be visualized as the ‘your ideas and our money’ concept of developing business. It is ‘patient’ capital that seeks a return through long-term capital gain rather than immediate and regular interest payments as in the case of debt financing.

When venture capitalists invest in a business, they typically require a seat on the company’s board of directors. But professional venture capitalists act as mentors and provide support and advice on a number of issues relating to management, sales, technology, etc. They assist the company to develop its full potential. They help the enterprise in the early stage until it reaches the stage of profitability. When the business starts making considerable profits and the market value of the shares go up to a considerable extent, venture capitalists sell their equity holdings at a high value and thereby make capital gains.

In short, venture capital means the financial investment in a high-risk project with the objective of earning a high rate of return

Characteristics of Venture Capital

1. It is basically equity finance.

2. It is a long-term investment in growth-oriented small or medium firms.

3. Investment is made only in high-risk projects with the objective of earning a high rate of return.

4. In addition to providing capital, venture capital funds take an active interest in the management of the assisted firm. It is rightly said that “venture capital combines the qualities of banker, stock market investor and entrepreneur in one”.

5. The venture capital funds have continuous involvement in business after making the investment.

6. Once the venture has reached its full potential, the venture capitalist sells his holdings at a high premium. Thus his main objective of the investment is not to earn profit but capital gain.

Types of Venture Capitalists

1. Venture capital funds set up by angel investors (angels): They are individuals who invest their personal capital in start-up companies. They are about 50 years old. They have high income and wealth. They are well educated. They have succeeded as entrepreneurs. They are interested in the start-up process.

2. Venture capital subsidiaries of Corporations: These are established by major corporations, commercial banks, holding companies, and other financial institutions.

3. Private capital firms/funds: The primary source of venture capital is a venture capital firm. It takes high risks by investing in an early-stage company with high growth potential.

Methods or Modes of Venture Financing (Funding Pattern)/Dimensions of Venture Capital Venture

capital is typically available in four forms in India: equity, conditional loan, income note, and conventional loan.

Equity:

All VCFs in India provide equity but generally, their contribution does not exceed 49 percent of the total equity capital. Thus, the effective control and majority ownership of the firm remain with the entrepreneur. They buy shares of an enterprise with an intention to ultimately sell them off to make capital gains.

Conditional loan:

It is repayable in the form of royalty after the venture is able to generate sales. No interest is paid on such loans. In India, VCFs charge royalty ranging between 2 and 15 percent; the actual rate depends on the other factors of the venture, such as gestation period, cost-flow patterns, and riskiness.

Income note:

It is a hybrid security that combines the features of both conventional loans and conditional loans. The entrepreneur has to pay both interest and royalty on sales but at substantially low rates.

Conventional loan:

Under this form of assistance, the enterprise is assisted by way of loans. On the loans, a lower fixed rate of interest is charged, till the unit becomes commercially operational. When the company starts earning profits, normal or higher rate of interest will be charged on the loan. The loan has to be repaid as per the terms of the loan agreement.

Other financing methods:

A few venture capitalists, particularly in the private sector, have started introducing innovative financial securities like participating debentures introduced by TCFC.

Stages of Venture Capital Financing

1. Early-stage financing: This stage has three levels of financing. These three levels are:

(a) Seed financing: This is the finance provided at the project development stage. A small amount of capital is provided to the entrepreneurs for concept testing or translating an idea into a business.

(b) Start-up finance/first stage financing: This is the stage of initiating commercial production and marketing. At this stage, the venture capitalist provides capital to manufacture a product.

(c) Second stage financing: This is the stage where the product has already been launched in the market but has not earned enough profits to attract new investors. Additional funds are needed at this stage to meet the growing needs of the business. Venture capital firms provide larger funds at this stage

2. Later-stage financing:

This stage of financing is required for the expansion of an enterprise that is already profitable but is in need of further financial support. This stage has the following levels:

(a) Third stage/development financing: This refers to the financing of an enterprise that has overcome the highly risky stage and has recorded profits but cannot go for public issues. Hence it requires financial support. Funds are required for further expansion.

(b) Turnarounds: This refers to finance to enable a company to resolve its financial difficulties. Venture capital is provided to a company at a time of severe financial problem for the purpose of turning the company around.

(c) Fourth stage financing/bridge financing: This stage is the last stage of the venture capital financing process. The main goal of this stage is to achieve an exit vehicle for the investors and for the venture to go public. At this stage the venture achieves a certain amount of market share.

(d) Buy-outs: This refers to the purchase of a company or the controlling interest of a company’s share. Buy-out financing involves investments that might assist management or an outside party to acquire control of a company. This results in the creation of a separate business by separating it from their existing owners.

Venture Capital in India In India

venture capital plays a vital role in the development and growth of innovative entrepreneurship. Venture capital activity in the past was possibly done by developmental financial institutions like IDBI, ICICI, and state financial corporations. These institutions promoted entities in the private sector with debt as an instrument of funding.

For a long time, funds raised from the public were used as a source of venture capital. And with the minimum paid-up capital requirements being raised for listing at the stock exchanges, it became difficult for smaller firms with viable projects to raise funds from the public.

In India, the need for venture capital was recognized in the 7 five-year plan and long-term fiscal policy of the Government of India. In 1973, a committee on the development of small and medium enterprises highlighted the need to foster VC as a source of funding for new entrepreneurs and technology. VC financing really started in India in 1988 with the formation of Technology Development and Information Company of India Ltd. (TDICI) – promoted by ICICI and UTI.

The first private VC fund was sponsored by Credit Capital Finance Corporation (CEF) and promoted by the Bank of India, Asian Development Bank, and the Commonwealth Development Corporation, namely, Credit Capital Venture Fund. At the same time, Gujarat Venture Finance Ltd. and AFIDC Venture Capital Ltd. were started by state-level financial institutions. Sources of these funds were the financial institutions, foreign institutional investors or pension funds, and high networth individuals. The venture capital funds in India are listed in the following table:

Guidelines for the Venture Capital Companies

The Government of India has issued the following guidelines for various venture capital funds operating in the country.

1. The financial institutions, State Bank of India, scheduled banks, and foreign banks are eligible to establish venture capital companies or funds subject to the approval as may be required from the Reserve Bank of India.

2. The venture capital funds have a minimum size of Rs. 10 crores and a debt-equity ratio of 1:1.5. If they desire to raise funds from the public, promoters will be required to contribute a minimum of 40% of the capital.

3. The guidelines also provide for NRI investment up to 74% on a non-repatriable basis.

4. The venture capital funds should be independent of the parent organization.

5. The venture capital funds will be managed by professionals and can be set up as joint ventures even with non-institutional promoters.

6. The venture capital funds will not be allowed to undertake activities such as trading, broking, and money market operations but they will be allowed to invest in leasing to the extent of 15% of the total funds deployed. The investment or revival of sick units will be treated as a part of venture capital activity.

7. A person holding a position of being a full-time chairman, chief executive, or managing director of a company will not be allowed to hold the same position simultaneously in the venture capital fund/company.

8. The venture capital assistance should be extended to the promoters who are now and are professionally or technically qualified with inadequate resources.

SEBI (Venture Capital Funds) (Amendment) Regulations, 2000 and SEBI (Foreign Venture Capital Investors) Regulations, 2000

A. Following are the salient features of the SEBI (Venture Capital Funds) (Amendment) Regulations, 2000:

1. 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:

(a) has a dedicated pool of capital;

(b) raised in the manner specified under the Regulations; and

2. Definition of venture capital undertaking: Venture capital undertaking means a domestic company:

(a) Whose shares are not listed on recognized stock exchanges in India

(b) Which is engaged in the 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.

3. Minimum contribution and fund size: The minimum investment in a Venture Capital Fund from any investor will not be less than Rs. 5 lakhs and the minimum corpus of the fund before the fund can start activities shall be at least Rs. 5 crores.

4. Investment criteria: The earlier investment criteria have been substituted by a new investment criterion which have the following requirements:

(a) Disclosure of investment strategy;

(b) Maximum investment in a single venture capital undertaking not to exceed 25% of the corpus of the fund;

(d) At least 75% of the investible funds to be invested in unlisted equity shares or equity linked instruments.

(e) Not more than 25% of the investible funds may be invested by way of;

(i) Subscription to initial public offer of a venture capital undertaking whose shares are proposed to be listed subject to a lock-in period of one year.

(ii) Debt or debt instrument of a venture capital undertaking in which the venture capital fund has already made an investment by way of equity.

It has also been provided that venture capital funds seeking to avail benefit under the relevant provisions of the Income Tax Act will be required to divest from the investment within a period of one year from the listing of the venture capital undertaking.

5. Disclosure and information to investors: In order to simplify and expedite the process of fundraising, the requirement of filing the placement memorandum with SEBI is dispensed with, and instead the fund will be required to submit a copy of the Placement Memorandum/copy of contribution agreement entered with the investors along with the details of the fundraised 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 requirements from the fund on their investment activity.

6. 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 SEBI (Venture Capital Fund) Regulations.

7. 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 the 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.

8. 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 their corpus in the case of open-ended schemes and up to 10% of their corpus in the case of close-ended schemes. Apart from raising the resources for venture capital funds, this would provide an opportunity for small investors to participate in venture capital activities through mutual funds.

9. 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.

10. The following will be the salient features of SEBI (Foreign Venture Capital Investors) Regulations, 2000.

a. Definition of foreign venture capital investor: outside India and proposes to make an investment in undertaking and registered with SEBI. Any entity incorporated and established venture capital fund or venture capital

b. 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 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 taxpayer, or submits a certificate from the banker of its or its promoters’ track record where the applicant is neither a regulated entity, not an income taxpayer.

C. Investment criteria:

(i) Disclosure of investment strategy;

(ii) Maximum investment in a single venture capital undertaking not to exceed 25% of the funds committed for investment to India. However, it can invest its total fund committed in one venture capital fund.

(iii) At least 75% of the investible funds to be invested in unlisted equity shares or equity-linked instruments.

(iv) Not more than 25% of the investible funds may be invested by way of;

1. Subscription to initial public offer of a venture capital undertaking whose shares are proposed to be listed subject to the lock-in period of one year;
2. Debt or debt instrument of a venture capital undertaking in which the venture capital fund has already made an investment by way of equity.

11. Hassle-free entry and exit: The foreign venture capital investors proposing to make venture capital investment under the Regulations would be granted registration by SEBI. SEBI registered foreign venture capital investors shall be permitted to make investments on an automatic route within the overall sectoral ceiling of foreign investment under Annexure III of Statement of Industrial Policy without any approval from FIPB. Further, SEBI registered FVCIs shall be granted general permission from the exchange control angle for inflow and outflow of funds and no prior approval of RBI would be required for pricing, however, there would be an ex-post reporting requirement for the amount transacted.

12. 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.