Venture Capital - DOC by Nirmalpandya

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1. Introduction to Venture Capital. 2. Critical factors for success of venture capital industry. 3. Business Plans for startups. 4. Comparison with other source of investments. 5. The Venture Investment process. 6. History and evolution of venture capital. 7. Indian Scenario - A Statistical Snapshot. 8. Valuing. 9. Start From the future.


Introduction to Venture Capital.

Venture capital is money provided by professionals who invest alongside management in young, rapidly growing companies that have the potential to develop into significant economic contributors. Venture capital is an important source of equity for start-up companies. Professionally managed venture capital firms generally are private partnerships or closely held corporations funded by private and public pension funds, endowment funds, foundations, corporations, wealthy individuals, foreign investors, and the venture capitalists themselves. In India where the industry is still nascent, the Securities and exchange board of India has laid down those activities that would constitute eligible business activities qualifying for the concession available to a recognized venture capital fund. Initially, SEBI defined venture capital as an equity supported for the project launched by 1st generation entrepreneurs using commercially untested but sophisticated technologies. However, this definition has been subsequently relaxed and the restrictive feature concerning “technology financing “ were dispensed with. Venture capital is now seen as encompassing all kinds of funding of a high technology intensive undertaking at any stage of its life. It would appear from the foregoing that venture capital investment would have one or more of its follow characteristics. 1. Equity or equity featured instrument of investment.

2. Young companies that do have access to public sources of equity or other forms of capital.

3. Industry, products or services that hold potential of better than normal or average revenue growth rates.

4. Companies with better than normal or average profitability.

5. Product / Services in the early stages of there life cycle.


6. Higher than average risk levels that do not lend themselves to systematic quantification through convention technique or tools.

7. Turnaround companies.

8. Long term (more than 3 years) and active involvement with investee.

When considering an investment, venture capitalists carefully screen the technical and business merits of the proposed company. Venture capitalists only invest in a small percentage of the businesses they review and have a long-term perspective. They also actively work with the company's management, especially with contacts and strategy formulation.

Venture capitalists mitigate the risk of investing by developing a portfolio of young companies in a single venture fund. Many times they co-invest with other professional venture capital firms. In addition, many venture partnerships manage multiple funds simultaneously. For decades, venture capitalists have nurtured the growth of America's high technology and entrepreneurial communities resulting in significant job creation, economic growth and international competitiveness. Companies such as Digital Equipment Corporation, Apple, Federal Express, Compaq, Sun Microsystems, Intel, Microsoft and Genentech are famous examples of companies that received venture capital early in their development. (Source: National Venture Capital Association 1999 Yearbook).

In India, these funds are governed by the Securities and Exchange Board of India (SEBI) guidelines. According to this, 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. (Source: SEBI (Venture Capital Funds) Regulations, 1996).


Critical factors for success of venture capital industry:

The following factors are critical for the success of the VC industry in India:

(A) The regulatory, tax and legal environment should play an enabling role. Internationally, venture funds have evolved in an atmosphere of structural flexibility, fiscal neutrality and operational adaptability. (B) Resource raising, investment, management and exit should be as simple and flexible as needed and driven by global trends (C) Venture capital should become an institutionalized industry that protects investors and investee firms, operating in an environment suitable for raising the large amounts of risk capital needed and for spurring innovation through startup firms in a wide range of high growth areas. (D) In view of increasing global integration and mobility of capital it is important that Indian venture capital funds as well as venture finance enterprises are able to have global exposure and investment opportunities. (E) Infrastructure in the form of incubators and R&D need to be promoted using Government support and private management as has successfully been done by countries such as the US, Israel and Taiwan. This is necessary for faster conversion of R & D and technological innovation into commercial products.


Recommendations: Multiplicity of regulations – need for harmonization and nodal

Regulator: Presently there are three set of Regulations dealing with venture capital activity i.e. SEBI (Venture Capital Regulations) 1996, Guidelines for Overseas Venture Capital Investments issued by Department of Economic Affairs in the MOF in the year 1995 and CBDT Guidelines for Venture Capital Companies in 1995 which was modified in 1999. The need is to consolidate and substitute all these with one single regulation of SEBI to provide for uniformity, hassle free single window clearance. There is already a pattern available in this regard; the mutual funds have only one set of regulations and once a mutual fund is registered with SEBI, the tax exemption by CBDT and inflow of funds from abroad is available automatically. Similarly, in the case of FIIs, tax benefits and foreign inflows/outflows are automatically available once these entities are registered with SEBI. Therefore, SEBI should be the nodal regulator for VCFs to provide uniform, hassle free, single window regulatory framework. On the pattern of FIIs, Foreign Venture Capital Investors (FVCIs) also need to be registered with SEBI.

Tax pass through for Venture Capital Funds:

VCFs are a dedicated pool of capital and therefore operate in fiscal neutrality and are treated as pass through vehicles. In any case, the investors of VCFs are subjected to tax. Similarly, the investee companies pay taxes on their earnings. There is a well-established successful precedent in the case of Mutual Funds, which once registered with SEBI are automatically entitled to tax exemption at pool level. It is an established principle that taxation should be only at one level and therefore taxation at the level of VCFs as well as 6

investors amount to double taxation. Since like mutual funds VCF is also a pool of capital of investors, it needs to be treated as a tax pass through. Once registered with SEBI, it should be entitled to automatic tax pass through at the pool level while maintaining taxation at the investor level without any other requirement under Income Tax Act.


Mobilisation of Global and Domestic resources:


Foreign Venture Capital Investors (FVCIs):

Presently, FIIs registered with SEBI can freely invest and disinvest without taking FIPB/RBI approvals. This has brought positive investments of more than US $10 billion. At present, foreign venture capital investors can make direct investment in venture capital undertakings or through a domestic venture capital fund by taking FIPB / RBI approvals. This investment being long term and in the nature of risk finance for start-up enterprises, needs to be encouraged. Therefore, atleast on par with FIIs, FVCIs should be registered with SEBI and having once registered, they should have the same facility of hassle free investments and disinvestments without any requirement for approval from FIPB / RBI. This is in line with the present policy of automatic approvals followed by the Government. Further, generally foreign investors invest through the Mauritius-route and do not pay tax in India under a tax treaty. FVCIs therefore should be provided tax exemption. This provision will put all FVCIs, whether investing through the Mauritius route or not, on the same footing. This will help the development of a vibrant India-based venture capital industry with the advantage of best international practices, thus enabling a jump-starting of the process of innovation.

The hassle free entry of such FVCIs on the pattern of FIIs is even more necessary because of the following factors:


Venture capital is a high-risk area. In out of 10 projects, 8 either fail or yield negligible returns. It is therefore in the interest of the country that FVCIs bear such a risk. For venture capital activity, high capitalization of venture capital companies is essential to withstand the losses in 80% of the projects. In India, we do not have such strong companies. The FVCIs are also more experienced in providing the needed managerial expertise and other supports.

Augmenting the Domestic Pool of Resources:

The present pool of funds available for venture capital is very limited and is predominantly contributed by foreign funds to the extent of 80 percent. The pool of domestic venture capital needs to be augmented by increasing the list of sophisticated institutional investors permitted to invest in venture capital funds. This should include banks, mutual funds and insurance companies upto prudential limits. Later, as expertise grows and the venture capital industry matures, other institutional investors, such as pension funds, should also be permitted. The venture capital funding is high-risk investment and should be restricted to sophisticated investors. However, investing in venture capital funds can be a valuable return-enhancing tool for such investors while the increase in risk at the portfolio level would be minimal. Internationally, over 50% of venture capital comes from pension funds, banks, mutual funds, insurance funds and charitable institutions.

Flexibility in Investment and Exit:

Allowing multiple flexible structures: Eligibility for registration as venture capital funds should be neutral to firm structure. The government should consider creating new structures, such as limited partnerships, limited liability partnerships and limited liability corporations. At present, venture capital funds can be structured as trusts or companies in order to be eligible for registration with SEBI. Internationally, limited partnerships, Limited


Liability Partnership and limited liability corporations have provided the necessary flexibility in risk-sharing, compensation arrangements amongst investors and tax pass through. Therefore, these structures are commonly used and widely accepted globally specially in USA. Hence, it is necessary to provide for alternative eligible structures.

Flexibility in the matter of investment ceiling and sectoral restrictions: 70% of a venture capital fund‟s investible funds must be invested in unlisted equity or equity-linked instruments, while the rest may be invested in other instruments. Though sectoral restrictions for investment by VCFs are not consistent with the very concept of venture funding, certain restrictions could be put by specifying a negative list which could include areas such as finance companies, real estate, gold-finance, activities not legally permitted and any other sectors which could be notified by SEBI in consultation with the Government. Investments by VCFs in associated companies should also not be permitted. Further, not more than 25% of a fund‟s corpus may be invested in a single firm. The investment ceiling has been recommended in order to increase focus on equity or equity-linked instruments of unlisted startup companies. As the venture capital industry matures, investors in venture capital funds will set their own prudential restrictions.

Changes in buy back requirements for unlisted securities: A venture capital fund incorporated as a company/ venture capital undertaking should be allowed to buyback upto 100% of its paid up capital out of the sale proceeds of investments and assets and not necessarily out of its free reserves and share premium account or proceeds of fresh issue. Such purchases will be exempt from the SEBI takeover code. A venture-financed undertaking will be allowed to make an issue of capital within 6 months of buying back its own shares instead of 24 months as at present. Further, negotiated deals may be permitted in unlisted securities where one of the parties to the transaction is VCF.

Relaxation in IPO norms: The IPO norms of 3-year track record or the project being funded by the banks or financial institutions should be relaxed to 9

include the companies funded by the registered VCFs also. The issuer company may float IPO without having three years track record if the project cost to the extent of 10% is funded by the registered VCF. Venture capital holding however shall be subject to lock in period of one year. Further, when shares are acquired by VCF in a preferential allotment after listing or as part of firm allotment in an IPO, the same shall be subject to lock in for a period of one year. Those companies, which are funded, by Venture capitalists and their securities are listed on the stock exchanges outside the country, these companies should be permitted to list their shares on the Indian stock exchanges.

Relaxation in Takeover Code: The venture capital fund while exercising its call or put option as per the terms of agreement should be exempt from applicability of takeover code and 1969 circular under section 16 of SC(R)A issued by the Government of India.

Issue of Shares with Differential Right with regard to voting and dividend: In order to facilitate investment by VCF in new enterprises, the Companies Act may be amended so as to permit issue of shares by unlisted public companies with a differential right in regard to voting and dividend. Such a flexibility already exists under the Indian Companies Act in the case of private companies which are not subsidiaries of public limited companies.

QIB Market for unlisted securities: A market for trading in unlisted securities by QIBs be developed.

NOC Requirement : In the case of transfer of securities by FVCI to any other person, the RBI requirement of obtaining NOC from joint venture partner or other shareholders should be dispensed with.

RBI Pricing Norms: At present, investment/disinvestment by FVCI is subject to approval of pricing by RBI which curtails operational flexibility and needs to be dispensed with. 10

Global integration and opportunities:

(A) Incentives for Employees: The limits for overseas investment by Indian Resident Employees under the Employee Stock Option Scheme in a foreign company should be raised from present ceilings of US$10,000 over 5 years, and US$50,000 over 5 years for employees of software companies in their ADRs/GDRs, to a common ceiling of US$100,000 over 5 years. Foreign employees of an Indian company may invest in the Indian company to a ceiling of US$100,000 over 5 years.

(B) Incentives for Shareholders: The shareholders of an Indian company that has venture capital funding and is desirous of swapping its shares with that of a foreign company should be permitted to do so. Similarly, if an Indian company having venture funding and is desirous of issuing an ADR/GDR, venture capital shareholders (holding saleable stock) of the domestic company and desirous of disinvesting their shares through the ADR/GDR should be permitted to do so. Internationally, 70% of successful startups are acquired through a stock-swap transaction rather than being purchased for cash or going public through an IPO. Such flexibility should be available for Indian startups as well. Similarly, shareholders can take advantage of the higher valuations in overseas markets while divesting their holdings.

(C) Global investment opportunity for Domestic Venture Capital Funds (DVCF): DVCFs should be permitted to invest higher of 25% of the fund‟s corpus or US $10 million or to the extent of foreign contribution in the fund‟s corpus in unlisted equity or equity-linked investments of a foreign company. Such investments will fall within the overall ceiling of 70% of the fund‟s corpus. This will allow DVCFs to invest in synergistic startups offshore and also provide them with global management exposure.


Infrastructure and R&D : Infrastructure development needs to be prioritized using government support and private management of capital through programmes similar to the Small Business Investment Companies in the United States, promoting incubators and increasing university and research laboratory linkages with venture-financed startup firms. This would spur technological innovation and faster conversion of research into commercial products.

Self Regulatory Organisation (SRO): A strong SRO should be encouraged for evolution of standard practices, code of conduct, creating awareness by dissemination of information about the industry.

Implementation of these recommendations would lead to creation of an enabling regulatory and institutional environment to facilitate faster growth of venture capital industry in the country. Apart from increasing the domestic pool of venture capital, around US$ 10 billion are expected to be brought in by offshore investors over 3/5 years on conservative estimates. This would in turn lead to increase in the value of products and services adding upto US$100 billion to GDP by 2005. Venture supported enterprises would convert into quality IPOs providing over all benefit and protection to the investors. Additionally, judging from the global experience, this will result into substantial and sustainable employment generation of around 3 million jobs in skilled sector alone over next five years. Spin off effect of such activity would create other support services and further employment. This can put India on a path of rapid economic growth and a position of strength in global economy.


Business Plans for Startups

Who reads business plans? Very few people read them thoroughly, including most investors. And even if you submit a well-written plan to the right parties, you'll be lucky to hold a potential investor's attention for even 60 seconds unless you have one very strategic piece in place -- a referral or personal introduction. Marc Friend of U.S. Venture Partners says: "If someone I know refers a business plan to me, it gets much more thorough attention. I reason that if the idea is as good and unique as the entrepreneurs say it is, that they should have a network in place that can verify the validity and uniqueness of that value proposition by providing a personal introduction." John L. Walecka of Brentwood Venture Capital agrees: "We entertain a lot of plans, but the ones that are best qualified come through referrals." Assuming you clear this hurdle and your business plan actually lands on someone's desk, you'll want your plan to be succinct and compelling. A concise and well-written business plan can do much more than give you something to show potential investors. It can also be an important tool for attracting strategic partners, identifying strengths and weaknesses, and "evangelizing" potential supporters. If the idea behind your business is solid, and you have a personal introduction from someone with credibility, you will still need the right "calling card" to get the millions you're looking for. Even after establishing a business relationship that begins with a simple handshake, you'll need something neatly typed on plain paper and presented in an attractive binder, with numbers that make sense.

Keep It Simple, Direct, and Affirmative

Most business plans are written because investors require them. But they can also help you to clarify your thinking, measure your market, analyze the competition, and think ahead. In short, the business plan is your roadmap to success. Marc Friend approaches it like a mathematician: For a business plan to be compelling, he says, "there should be a logical progression to each of the steps. You want to get a nod of approval at every step of the way so that by the end of the plan, the investor says 'Let's invest!'" And although you may


occasionally need to make minor adjustments to the plan en route, a well thought out business plan will keep you focused on your ultimate destination. Many business plans are boring and nearly unreadable. Yours shouldn't be. In business plans, as in so many other things, less is often more. It can be an artfully expanded version of your elevator pitch. You can create an exciting vision of your new company's future in less time than it takes to read the sports page in your local newspaper.

Craft a Stellar Executive Summary

The executive summary of your plan is crucially important -- it must capture and hold the attention of potential investors, because if you lose readers at the outset, you'll never get them back . The executive summary to your plan should be highly telegraphic -- two to three pages at the most. And you should assume no one will read any further than your executive summary, so everything that makes your plan a winner should be here -- the details can come later. If you can't write up your ideas in clear, compelling prose, hire someone who can. The executive summary to the business plan you write can provide a solid foundation for all future marketing, planning, and promotional documents.

Set Yourself Apart

No matter how artfully executed, a business plan is only as good as the opportunity it presents and the people behind it. It's the entrepreneurs with vision, originality, and technical acumen who are leading the way. For starters, you'll need more than a good idea. You'll need an idea that's big, bold, and innovative if you want to capture the attention of investors. As the Internet grows in quantum leaps, investors are looking for ideas that alter the game. John Walecka explains: "We look for incredibly bright, experienced engineers and entrepreneurs who have a unique insight on how to change the way people do business today in some important, fundamental way. We're always on the lookout for that sea change that creates opportunity."


And a bold, innovative idea is only as good as its execution. If the team behind the project lacks credibility and experience in establishing their ideas in the marketplace early on to declare success for the long term, they won't get far with investors. Marc Friend comments: "I'll take a brief look at the executive summary to see what they're proposing, and then I'll flip to the resumes to see who's talking. What special expertise does this team have that convinces me they can accomplish the goal they set out to accomplish?"

Play the Numbers

Let's be brutally honest -- numbers seem solid, but they are the most suspect piece of a business plan. You must include them, but they don't mean much -- and investors will challenge them every time. Although you can and should make the numbers look promising, be prepared to defend your startup's strategy for generating revenue. Most plans include projections based on overly optimistic speculation, and venture capitalists take this information with several grains of salt. In your plan, be honest but mildly optimistic -- it may add to your credibility in the long run. And always support your numbers and assumptions. Pitch a Long-Term Dream, Not a Fast-Buck Scheme

Most importantly, make sure you present your business as poised on the threshold of a long -- or at least reasonably long -- future. The world of high tech and Internet startups is already overpopulated with companies created by biz school grad students or dropouts looking for a fast buck. Going public with a profitless shell that will never be economically viable was last year's idea. Even if you do plan to sell the business at some future point, the most attractive businesses to buyers will be the ones that have a decent shot at eventual long-term profitability.


Comparison with other source of investments.

One of the important characteristics of venture capital from conventional loan is the participation of VCC / VCF in the management of VCU. The VCC / VCF intends to increase the value of the VCU by helping the companies in its marketing and financial aspects, thereby increasing the profitability of the company. VCF / VCC provides highly professionalised and competent advises on the technical aspect of the functioning of the company. The following are the activities of the VCF / VCC concerning the VCU: Assist in financing , marketing and strategic planning of the VCU.

Recruiting of key personnel in the initial stages.

Obtaining bank and other financing avenues for the VCU.

Introducing to strategic partners and vendours.

Comparison can be done on the investment patterns in bought out deals and conventional financing with essentially high risk technology intensive funding for first generation entrepreneurs.


Venture capital

Bought out deal

Convential loan financing

Participation In

High. As the VCF/VCC has a

Low. Though the equity in the company is held by the sponsor, there would not any direct interference in the management except in exceptional cases.

Nil. The lender does not have the expertise or interest in promoting the company as Long as the payment schedule is Followed.

Management. Equity stake in the VCU, it is generally Bound to follow the Advice. Also considering the expertise of VCC/VCF, Participation is high In strategic planning. Returns to Investor Extremely high in most of the cases Considering thr high Risk in such Investment.

High. Though the company is not into technologically intensive. Exit from The investment in Resonabaly certain.

Moderate. As the payment schedule is finalized before the investment, There is no Uncertainty.


Time period

Very long. Exit from Investment takes 7-10 yrs on an

Not very long. Exit from investment is normally done

May be set as per choice of the

investor/ average. Immediately after lender.

the expiry of lock-in . Regulations Not high as the Venture capital is Considered Reasonably nacent For regulation to be In place. Also, with period High. Bought out deals are reasonably well regulated as it concerns listing of security in the stock exchange where Moderate. Regulations cover the safety of such investment/ lending.


High risk being Inherent in the Investment process, Regulations only Oversee the process Of such investment Not the safety.

small investors interests have to be protected.

The Venture Investment process.

Generating a Dealflow

Due Diligence


Investment Valuation

Pricing and structuring the deal

Value addition and Monitoring; and


The venture capital process has variances / features that are context specific to countries / regions. However, activities in a venture capital fund follow a typical sequence with a number of commonalties. Generating a Dealflow In generating a dealflow, the venture capital investor creates a pipeline of deals or investment opportunities that he would consider for investing in. This is achieved primary through plugging into an appropriate network. The most popular network obviously is the 20

network of venture capital funds / investors. It is also common for venture capital funds / investors to develop working relationship with R & D institution, 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 fund / 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. Successful venture capital investors in the U.S.A examine hundreds of business plans in order to make three or four investment in a year. It is important to note the difference between the profile of investment opportunities that a venture capital would examine and pursued by a conventional credit oriented agency or an investment institution. By definition, as mentioned earlier, the venture capital investor focuses on the opportunities with a high degree of innovativeness. The dealflow composition and the technique of generating a dealflow can vary from country to country. In India, different venture capital funds / companies have their own methods varying from promotional seminar with R and D institution and industry associations to direct advertising campaigns targeted at various segments. A clear pattern between the investment focus of a fund and the constitution of the deal generation network is discernible even in the India context.


Due diligence is the industry jargon for all the activities that are associated with evaluation an investment proposal. It includes carrying out reference checks on the proposal. It includes carrying out reference checks on the proposal related aspects such as management team, products, technology and market. The important feature to note


is that venture capital due diligence focuses on the qualitative aspects of the investment opportunity.

It is also not unusual for venture capital funds / companies to set up an investment screen. The screen is a set of qualitative ( sometimes quantitative criteria such as revenues are also used ) criteria that help venture capital funds / companies to quickly decide on whether an investment opportunity warrants further diligence. Screen can be sometime elaborate and rigorous and sometime specific and brief. The nature of the screen criteria is also a function of the investment focus of the firm at that point. Venture capital investors rely extensively on the reference checks with leading lights in the specific area of concern being addressed in the due diligence.


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 evaluation process goes through the following sequence: Evaluate future revenue and profitability. 22

Forecast likely future value of the firm based on expected market capitalization or expected acquisition proceeds depending upon the anticipation exit from the investment. Target on ownership position 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. Symbolically the valuation exercise may be represented as follows: NPV = ( cash / post ) x ( patx ( pat ) x k; Where NPV = Net present value of the cash flows relationg to the investment comprising outflow by way of investment and inflows by way of interest / dividends and realization on exit. The rate of return used for discounting is the hurdle rate of return set by venture capital investor. Post = pre + cash Cash represent the amount of cash being brought into the particular round of financing by the venture capital investor. Pre is the pre- money valuation of the firm estimated by the investor. While technically it is measured by the intrinsic value of the firm at the time of raising capital, it is more often a matter of negotiation driven by the ownership of the company that the venture capital investor desires and the ownership that the founders / management team is prepared to give away for the required amount of capital. ( PAT ) is the forecast of profit after tax in a year and often agreed upon by the founders and the investors. ( PER ) is the price earning multiply that could be expected of a comparable firm in the industry. It is not always possible to fund such a comparable fit in venture capital situations. That necessitates, therefore, a significant degree of judgement on the part of the venture capital to arrive at alternate PER scenarios. ( k ) is the present value interest factor ( corresponding to a discount rate r ) for the investment horizon.



Venture capital investment require and permit innovativeness in finance engineering. While venture capital investment follow no set formula, they attempt to address the needs and concerns of the investors and the investee.


The investor tries to ensure the following:

Reasonable reward for the given level of risk; Sufficient influence on the management of the company through board representation; Minimization of taxes; Ease in achieving future liquidity on the investment.

The entrepreneur at the same tome seeks to enable:

The creation of the business that he has conceptualized Financial rewards for creating the business; Adequate resources needed to achieve their goal; Voting control;

Common consideration for both sides includes;

Flexibility of structure that will allow room to enable additional investment later, incentives for future management and retention of stock if management leaves. Balance sheet attractiveness to suppliers and debt financiers. Retention of key employees through adequate equity participation.

In the Indian context, one of the primary considerations is retention of majority shareholdings often, the promoters do not even wish to encourage external equity participation. These cultural issues have a significant influence on the structuring of a deal.



We have seen in our earlier defination of venture capital that sustained, active involvement over an extended period of time is one of the distinguishing characteristics of venture capital. This process of the venture capital investors involvement in the portfolio company is often referred to broadly as ”value addition“. The value “that the venture capital brings to the portfolio company can vary from one venture capital profession to another depending upon the individuals background and approach to venture capital. There are


venture capital professional, especially those who invest in vary early stage situations, whose involvement can go up to providing operating management support. There are also other whose involvement may not extent beyond leading and avid ear to the proceedings of quaterly or monthly board meetings. The extent of involvement could also depend upon the venture capital investors stake in the company and his role in the consortium, when the investment has been syndicated among number of investors. In a consortium, it is not an uncommon practice for one of the investors to play the role of the lead investor taking upon himself significant responsibilities with respect to the portofolio company, on behalf of himself as well as the co-investor in syndicate. Investment exposure and / or specific ability to add value and / or geographic presence are some of the usual criteria for a venture capital investor being designated lead investor.


The process of exit from a venture capital is as important as in any other process in the investment cycle. The two exit option are: 1. Sale of the venture capital position either along with or subsequent to a public offering; 2. Acquisition of a company.


History and evolution of venture capital

Since its humble beginnings in 1946 through the American research and development corporation of general doriot “ the institutionalization of the venture investment process ” has made significant strides. Observers of the industry trace the American industry as having progressed through distinct phases of evolution in the seventies and eighties. Soon however the concept of professional venture capital attained popularity in Canada and a number of European countries with the British industry in a pioneering role. Presently, Venture capital in one form or the other come to stay in over thirty five countries. It must be highlighted that Venture capital as obtains in some of this 28

countries is predominantly engaged in providing term finance for small business in addition to equity and may therefore not confirm to the defination of Venture capital spelt out elsewhere in paper. The Second World War produced an abundance of technological innovation, primarily with military applications. They include, for example, some of the earliest work on micro circuitry. Indeed, J.H. Whitney‟s investment in Minute Maid was intended to commercialize an orange juice concentrate that had been developed to provide nourishment for troops in the field. In the mid-1950s, the U.S. federal government wanted to speed the development of advanced technologies. In 1957, the Federal Reserve System conducted a study that concluded that a shortage of entrepreneurial financing was a chief obstacle to the development of what it called "entrepreneurial businesses." As a response this a number of Small Business Investment Companies (SBIC) were established to "leverage" their private capital by borrowing from the federal government at below-market interest rates. Soon commercial banks were allowed to form SBICs and within four years, nearly 600 SBICs were in operation. At the same time a number of venture capital firms were forming private partnerships outside the SBIC format. These partnerships added to the venture capitalist‟s toolkit, by offering a degree of flexibility that SBICs lack. Within a decade, private venture capital partnerships passed SBICs in total capital under management. The 1960s saw a tremendous bull IPO market that allowed venture capital firms to demonstrate their ability to create companies and produce huge investment returns. For example, when Digital Equipment went public in 1968 it provided ARD with 101% annualized Return on Investment (ROI). The US$70,000 Digital invested to start the company in 1959 had a market value of US$37mn. As a result, venture capital became a hot market, particularly for wealthy individuals and families. However, it was still considered too risky for institutional investors. In the 1970s, though, venture capital suffered a double-whammy. First, a red-hot IPO market brought over 1,000 venture-backed companies to market in 1968, the public markets went into a sevenyear slump. There were a lot of disappointed stock market investors and a lot of disappointed venture capital investors too. Then in 1974, after Congress legislation against the abuse of pension fund money, all high-risk investment of these funds was halted. As a result of poor


public market and the pension fund legislation, venture capital fund raising hit rock bottom in 1975. Well, things could only get better from there. Beginning in 1978, a series of legislative and regulatory changes gradually improved the climate for venture investing. First Congress slashed the capital gains tax rate to 28% from 49.5%. Then the Labor Department issued a clarification that eliminated the pension funds act as an obstacle to venture investing. At around the same time, there were a number of high-profile IPOs by venture-backed companies. These included Federal Express in 1978, and Apple Computer and Genetech Inc in 1981. This rekindled interest in venture capital on the part of wealthy families and institutional investors. Indeed, in the 1980s, the venture capital industry began its greatest period of growth. In 1980, venture firms raised and invested less than US$600 million. That number soared to nearly US$4bn by 1987. The decade also marked the explosion in the buy-out business. The late 1980s marked the transition of the primary source of venture capital funds from wealthy individuals and families to endowment, pension and other institutional funds. The surge in capital in the 1980s had predictable results. Returns on venture capital investments plunged. Many investors went into the funds anticipating returns of 30% or higher. That was probably an unrealistic expectation to begin with. The consensus today is that private equity investments generally should give the investor an internal rate of return something to the order of 15% to 25%, depending upon the degree of risk the firm is taking. However, by 1990, the average long-term return on venture capital funds fell below 8%, leading to yet another downturn in venture funding. Disappointed families and institutions withdrew from venture investing in droves in the 1989-91 period. The economic recovery and the IPO boom of 1991-94 have gone a long way towards reversing the trend in both private equity investment performance and partnership commitments. In 1998, the venture capital industry in the United States continued its seventh straight year of growth. It raised US$25bn in committed capital for investments by venture firms, who invested over US$16bn into domestic growth companies in all sectors, but primarily focused on information technology. In India Venture capital Industry had its formal introduction in the bugget speech of the finance minister in1988. Though extremely focused in its technology development objective, the introduction 30

recognized the need for a source of patient capital with ability to participate in high risk projects in return for high rewards. Coincidentally around the same time, the Industrial credit and Investment corporation or India Limited ( ICICI ) came forthwith initiatives for addressing technology intensive projects. One such initiative, the Venture capital division, was spun off into Technology development and information company of India Limited ( TDICI ) which has since emerged as a significant player and a pioneer in the industry. Most of the success stories of the popular Indian entrepreneurs like the Ambanis and Tatas had little to do with a professionally backed up investment at an early stage. In fact, till very recently, for an entrepreneur starting off on his own personal savings or loans raised through personal contacts/financial institutions. Traditionally, the role of venture capital was an extension of the developmental financial institutions like IDBI, ICICI, SIDBI and State Finance Corporations (SFCs). The first origins of modern Venture Capital in India can be traced to the setting up of a Technology Development Fund (TDF) in the year 1987-88, through the levy of a cess on all technology import payments. TDF was meant to provide financial assistance– to innovative and high-risk technological programs through the Industrial Development Bank of India. This measure was followed up in November 1988, by the issue of guidelines by the (then) Controller of Capital Issues (CCI). These stipulated the framework for the establishment and operation of funds/companies that could avail of the fiscal benefits extended to them. However, another form of (ad?)venture capital which was unique to Indian conditions also existed. That was funding of green-field projects by the small investor by subscribing to the Initial Public Offering (IPO) of the companies. Companies like Jindal Vijaynagar Steel, which raised money even before they started constructing their plants, were established through this route. The industry‟s growth in India can be considered in two phases. The first phase was spurred on soon after the liberalization process began in 1991. According to former finance minister and harbinger of economic reform in the country, Manmohan Singh, the government had recognized the need for venture capital as early as 1988. That was the year in which the Technical Development and Information Corporation of India (TDICI, now ICICI ventures) was set up, soon followed by Gujarat Venture Finance Limited (GVFL). Both these organizations were promoted by financial institutions. Sources of these


funds were the financial institutions, foreign institutional investors or pension funds and high net-worth individuals. Though an attempt was also made to raise funds from the public and fund new ventures, the venture capitalists had hardly any impact on the economic scenario for the next eight years. However, it was realized that the concept of venture capital funding needed to be institutionalized and regulated. This funding requires different skills in assessing the proposal and monitoring the progress of the fledging enterprise. In 1996, the Securities and Exchange Board of India (SEBI) came out with guidelines for venture capital funds has to adhere to, in order to carry out activities in India. This was the beginning of the second phase in the growth of venture capital in India. The move liberated the industry from a number of bureaucratic hassles and paved the path for the entry of a number of foreign funds into India. Increased competition brought with it greater access to capital and professional business practices from the most mature markets. There are a number of funds, which are currently operational in India and involved in funding start-up ventures. Most of them are not true venture funds, as they do not fund start-ups. What they do is provide mezzanine or bridge funding and are better known as private equity players. However, there is a strong optimistic undertone in the air. With the Indian knowledge industry finally showing signs of readiness towards competing globally and awareness of venture capitalists among entrepreneurs higher than ever before, the stage seems all set for an overdrive. The Indian Venture Capital Association (IVCA), is the nodal center for all venture activity in the country. The association was set up in 1992 and over the last few years, has built up an impressive database. According to the IVCA, the pool of funds available for investment to its 20 members in 1997 was Rs25.6bn. Out of this, Rs10 bn had been invested in 691 projects. Certain venture capital funds are Industry specific(ie they fund enterprises only in certain industries such as pharmaceuticals, infotech or food processing) whereas others may have a much wider spectrum. Again, certain funds may have a geographic focus – like Uttar Pradesh, Maharashtra, Kerala, etc whereas others may fund across different territories. The funds may be either close-endedschemes (with a fixed period of maturity) or open-ended. Classification


Venture funds in India can be classified on the basis of Genesis Financial Institutions Led By ICICI Ventures, RCTC, ILFS, etc. Private venture funds like Indus, etc. Regional funds like Warburg Pincus, JF Electra (mostly operating out of Hong Kong). Regional funds dedicated to India like Draper, Walden, etc. Offshore funds like Barings, TCW, HSBC, etc. Corporate ventures like Intel. To this list we can add Angels like Sivan Securities, Atul Choksey (ex Asian Paints) and others. Merchant bankers and NBFCs who specialized in "bought out" deals also fund companies. Most merchant bankers led by Enam Securities now invest in IT companies. Investment Philosophy Early stage funding is avoided by most funds apart from ICICI ventures, Draper, SIDBI and Angels. Funding growth or mezzanine funding till pre IPO is the segment where most players operate. In this context, most funds in India are private equity investors.

Size Of Investment The size of investment is generally less than US$1mn, US$1-5mn, US$5-10mn, and greater than US$10mn. As most funds are of a private equity kind, size of investments has been increasing. IT companies generally require funds of about Rs30-40mn in an early stage which fall outside funding limits of most funds and that is why the government is promoting schemes to fund start ups in general, and in IT in particular. Value Addition The venture funds can have a totally "hands on" approach towards their investment like Draper or "hands off" like Chase. ICICI Ventures


falls in the limited exposure category. In general, venture funds who fund seed or start ups have a closer interaction with the companies and advice on strategy, etc while the private equity funds treat their exposure like any other listed investment. This is partially justified, as they tend to invest in more mature stories. A list of the members registered with the IVCA as of June 1999, has been provided in the Annexure. However, in addition to the organized sector, there are a number of players operating in India whose activity is not monitored by the association. Add together the infusion of funds by overseas funds, private individuals, „angel‟ investors and a host of financial intermediaries and the total pool of Indian Venture Capital today, stands at Rs50bn, according to industry estimates! The primary markets in the country have remained depressed for quite some time now. In the last two years, there have been just 74 initial public offerings (IPOs) at the stock exchanges, leading to an investment of just Rs14.24bn. That‟s less than 12% of the money raised in the previous two years. That makes the conservative estimate of Rs36bn invested in companies through the Venture Capital/Private Equity route all the more significant. Some of the companies that have received funding through this route include: Mastek, one of the oldest software houses in India Geometric Software, a producer of software solutions for the CAD/CAM market Ruksun Software, Pune-based software consultancy SQL Star, Hyderabad based training and software development company Microland, networking hardware and services company based in Bangalore Satyam Infoway, the first private ISP in India Hinditron, makers of embedded software PowerTel Boca, distributor of telecomputing products for the Indian market Rediff on the Net, Indian website featuring electronic shopping, news, chat, etc


Entevo, security and enterprise resource management software products, Microland‟s subsidiary, one of India‟s leading portals Torrent Networking, pioneer of Gigabit-scaled IP routers for inter/intra nets Selectica, provider of interactive software selection Yantra, ITLInfosys‟ US subsidiary, solutions for supply chain management Though the infotech companies are among the most favored by venture capitalists, companies from other sectors also feature equally in their portfolios. The healthcare sector with pharmaceutical, medical appliances and biotechnology industries also get much attention in India. With the deregulation of the telecom sector, telecommunications industries like Zip Telecom and media companies like UTV and Television Eighteen have joined the list of favorites. So far, these trends have been in keeping with the global course. However, recent developments have shown that India is maturing into a more developed marketplace, unconventional investments in a gamut of industries have sprung up all over the country. This includes: Indus League Clothing, a company set up by eight former employees of readymade garments giant Madura, who set up shop on their own to develop a unique virtual organization that will license global apparel brands and sell them, without owning any manufacturing units. They dream to build a network of 2,500 outlets in three years and to be among the top three readymade brands. Shoppers Stop, Mumbai‟s premier departmental store innovates with retailing and decides to go global. This deal is facing some problems in getting regulatory approvals. Airfreight, the courier-company which has been growing at a rapid pace and needed funds for heavy investments in technology, networking and aircrafts. Pizza Corner, a Chennai based pizza delivery company that is set to take on global giants like Pizza Hut and Dominos Pizza with its innovative servicing strategy.


Car designer Dilip Chhabria, who plans to turn his studio, where he remodels and overhauls cars into fancy designer pieces of automation, into a company with a turnover of Rs1.5bn (up from Rs40mn today).

Indian Scenario - A Statistical Snapshot

Contributors Of Funds Contributors Rs mn Per cent

Foreign Institutional Investors




All India Financial Institutions



Multilateral Development Agencies



Other Banks



Foreign Investors



Private Sector



Public Sector



Nationalized Banks



Non Resident Indians



State Financial Institutions



Other Public



Insurance Companies



Mutual Funds







Methods Of Financing


Rs million

Per cent

Equity Shares




Redeemable Preference Shares



Non Convertible Debt



Convertible Instruments



Other Instruments






Financing By Investment Stage Investment Stages Rs million Number





Later stage



Other early stage



Seed stage



Turnaround financing






Financing By Industry


Rs million


Industrial products, machinery




Computer Software



Consumer Related






Food, food processing



Other electronics



Tel & Data Communications






Energy related



Computer Hardware










Financing By States


Rs million






Tamil Nadu Andhra Pradesh Gujarat Karnataka West Bengal Haryana Delhi Uttar Pradesh Madhya Pradesh Kerala Goa Rajasthan Punjab Orissa Dadra & Nagar Haveli Himachal Pradesh Pondicherry Bihar Overseas Total

1531 1372 1102 1046 312 300 294 283 231 135 105 87 84 35 32 28 22 16 413 9994

119 89 49 93 22 22 21 29 2 15 16 11 6 5 1 3 2 3 12 691


Source IVCA

Problems With VCs In The Indian Context One can ask why venture funding is so successful in USA and faced a number of problems in India. The biggest problem was a mindset change from "collateral funding" to high risk high return funding. Most of the pioneers in the industry were people with credit background and exposure to manufacturing industries. Exposure to fast growing intellectual property business and services sector was almost zero. All


these combined to a slow start to the industry. The other issues that led to such a situation include:

Valuing Valuation of any business has always been complicated. With the growing prominence of service businesses, valuing businesses has become all the trickier. Consider the straightforward issue of valuation of any manufacturing concern. The basic material required for such an exercise is readily available. For example, the financial records of the company, its product line the industry in which it operates its competitive position, etc.


But even here, there are a number of thorny issues. For one, what should be the discounting rate? Even experts find it difficult to come to a conclusion on the most appropriate rate of discounting to be applied. Or for that matter, the method of valuation. To twist the tale a little further, what if a steel maker gets into the business of reselling computer hardware? On the other hand, service businesses are a different ball game all together. The investment required to set up a service business is generally far lesser than that required for a manufacturing business. Moreover, predominant assets deployed by service business are intangible. Human capital usually forms a very vital part of such intangible assets. And how do you value human capital? That is the question most accounting bodies the world over are grappling with. The fact is that most traditional parameters used to value companies simply cannot be applied to these new age companies! Most often, these companies operate in unknown markets and with brand new technologies. There are no precedents to follow. There are no established norms. There are only ideas and more ideas. Only a very small percentage of the entrepreneurs diligently implement their ideas and give birth to path breaking businesses. How do you value companies that have had no past and only hold the promise of the future? It is in this context that valuation of software companies; Internet companies and Dotcoms have come to pose formidable challenges to both regulatory bodies and valuers. Regulators the world over have tried to set some guidelines, which will help in the valuation of such concerns. But don't traditional valuation methods focus on these anyway? Don't the existing statutory requirements necessitate the furnishing of such information through annual reports and statement of results and other declarations to various authorities? The point is this: you cannot differentiate a Dotcom from any another company. Ultimately, every business entity has to create and enhance stakeholder value. Any business that does not do this does not deserve to exist. Hence, all normal disclosure norms and valuation methods should be applied to Dotcom and Internet companies. In fact, only the strict application of investment prudence and normal business principles can safeguard the interests of all involved.


For example, the management team factor is said to be the most important ingredient for the success of an Internet company or a Dotcom. Or for that matter, for any business concern. Any business venture will be on a sticky wicket if its management team is not up to the mark. But, how will statutory norms ensure this? Therefore, regulators need to ensure that all pertinent information that is necessary for all companies disclose informed decision-making. Policy framework, accounting policies to be followed and stringent action plan against defaulters (that are implemented!) the other areas regulatory bodies need to put in place. As far as investors are concerned, one cardinal principle must never be forgotten: caveat emptor! After all, aren't valuation exercises a game of betting on the future? In early 2000, Internet entrepreneurs had succeeded in quickly transforming their business ideas into billion dollar valuations that seemed to defy common wisdom about profits, multiples, and the short tem focus on capital markets. Below mentioned is an attempt to understand how Dotcoms are valued. The most common critique one hears about the valuation of Internet companies is that their values balloon as their loss balloon. This relationship is driven by 2 factors: supernormal growth; and investments running through the income statement. Many Internet related start-ups experience annual growth rates exceeding 100 percent. This hyper-growth when fuelled by investments that have been expensed rather than capitalized will create ever-increasing losses until growth rates slow. Internet companies typically do not require heavy investments of the type that get capitalized, such as factories, plant and equipment, etc. their investment is in customer acquisition, which has to be expensed through the income statement. For e.g., if the acquisition cost per customer, through advertisements and direct mails of CD- ROMs is $40 per customer and a company successfully builds its customer base from 1 million in 1 year to 3 million in the second year, to 6 million in the third year, its acquisition costs will rise from $40 million in the first year to 120 million in the third year. In a „bricks and mortar‟ retailer case, much of the customer acquisition costs will comprise of costs consist of securing a store location, furniture fixtures etc. these expenses are largely capitalized and expensed over their useful life. Hence the physical retailer will break even years earlier than the virtual retailer with the same investment. Provided that the virtual retailer will earn a positive net present value


on its customer acquisition investments, increasing losses because of accelerating customer acquisition will raise the value of the company. These conditions of super normal growth and investment through the income statement render short hand valuation approaches including price to earnings and revenue multiplies, meaningless. The best way of valuing Internet companies is the DCF (Discounted Cash Flow) approach, which makes the distinction between expensed and capitalized investments unimportant because Accounting treatments don‟t affect cash flows. The absence of meaningful historical data and positive earnings also don‟t matter, because the DCF approach relies solely on forecasts of performances and can easily capture the worth of value creating businesses that have had several years of initial losses. A three-stage approach is used to make DCF more useful for valuing Internet companies – starting from a fixed point in the future and working back to the present using probability- weighted scenarios to address high uncertainty in an explicit way, and exploiting classic analytical techniques to understand the underlying economics of these companies and to forecast their future performance. The above approach is illustrated with a valuation of AMAZON.COM, the archetypal Internet company, as of November 1999. From its launch in 1995 it built a customer base of 10 million and expanded its offerings from books to toys, CD‟s, videos etc. it also invested in branded Internet players like and This company is a symbol of the new economy. It has a very high market capitalization of 25 US$ as at November 1999 and yet the company has never made profits and has lost $390 million in 1999. The company has become a focus of debate whether Internet stocks were greatly overvalued. Start From The Future Instead from starting from the present – the usual practice in DCF valuations is to start from the future – what the company and the industry could look like when they evolve from today‟s very high growth, unstable condition to a sustainable moderate growth state in the future and extrapolate it back to current performance. The future growth rate should be defined by metrics such as penetration rate, average revenue per customer, and sustainable growth margins. For the purpose of understanding this concept, let us create an optimistic scenario. Let be the next Wal-Mart. Say by


2010, continues to be; and has established itself as the leading on line retailer; in both online and off line markets. Assume the company has a 13% share of the total U.S books and music market; it would have revenues of appx. $60 billion (based on today‟s market share) by 2010. Let us assume that earns an average operating margin of 11% since due to its size will have a better purchasing power and also incur fewer associated costs. Also in the optimistic scenario will require less working capital and fewer fixed assets than traditional retailers do. We also assume that‟s capital turnover will be 3.4. Hence based on the above we get the following financials forecasts for for the year 2010. 1. 2. 3. Revenues - $60 billion. Operating profit - $7 billion. Total capital – $ 18 billion.

To estimate‟s current value we discount the projected free cash flows back to the present. Its present value is $37 billion.

What went wrong? What happened to the multi million-dollar valuations? Where did all the money go? Let us try and first understand what the Internet stands for, what the Internet was intended for. The Internet is intended to increase efficiencies and effectiveness that would aid in business transactions. It is a tool to build efficiencies. How can one build a business model around it? It is like building a business model around a fax machine or a telephone. Some may argue that Direct Marketing is a business model built around the telephone. But Direct Marketing is a channel, a means for marketing and not the end and be all of the business functions. Direct Marketing is used to enhance current business. But what happened with the Internet? An entire business model was built around the Internet. The Internet was intended to take over all the functions in the supply chain and do away the human aspect of business. We must understand the Internet is intended to AID human beings, reduce human interference and hence the inefficiencies associated with it, NOT do away completely with them. No communication medium can become the root foundation of a business model besides that for a service provider of that communication 49

medium. What was the main foundation of the Dotcoms? If you have an idea that can be converted into a web application that caters to most of the business functions the business will succeed. It was assumed that the people would prefer to buy online rather than off line. But what they forgot is that people don‟t buy a product because of good technology or that what the need is available just one click away. People need other people. They need the human aspect. These days, whenever I think of Dotcom, I think of a ticket to an overpriced experience race. More than 90 per cent of the Dotcom startups announced in the last 1-2 years, only a handful has even made it to the starting post - leave alone run the final race. Eventual failure is nothing new for sunrise industries in any sector. Old Economy or New. Most industries grow by kindling a hundred entrepreneurial dreams; only handfuls survive in the end. Nature's law will thus take care of the Dotcoms in the usual way. Most Indian Dotcoms have tried to mimic the assumed early success in US and elsewhere instead of asking series of fundamental questions:  What is it that I am offering that is not already being offered by others?  What will be my revenue sources?  If there are many players in the field what will be the differentiating factor? The answer, currently, is very little. Whether it is groceries, or textiles, or anything I would require regularly, I don't see the net as a great place to buy. Given cheap Indian labor, almost all such things can be done more easily over the phone. I can order dinner - sometimes even a small order like a plate of idlis - from any nearby restaurant at no extra cost in most Indian cities. I can order groceries from shops in the vicinity of my home with a mere phone call. I would not order a shirt or jewellery over the net for fear of not getting what I want (who will I chase in case of wrong delivery as the word customer service is alien to most Indian companies). Would I buy a TV or PC on the net? Maybe. But only if the price advantage over the conventional showroom is very clear supported with a good customer service agreement. Not otherwise. Net business models, especially in the B2C area, will work best in areas where there are no physical products to be moved. Meaning, they should work well in areas like broking, banking and financial trading-and not so well in grocery or garments. Reason: there is no physical product that I need to cart from factory to consumer, from Mumbai to Delhi. On the other hand, whether I am in Mumbai or Delhi,


in areas like share trading the net clearly facilitates transactions and brings down costs. I can buy or sell a share more easily and at lower cost on the net. I can also do most of my banking from home or the office, or even through my cellphone. A business will work on the net if its products are sufficiently standardized. The reason why Dell sells a lot of PCs through the net is because the things going into PCs are no more than glorified commodities - the same Intel chips, the same Microsoft software, and the same add-on hardware. You can also sell high quality branded products through the net, but risk commoditisation in the process. The reason: the net allows the consumer to see all similar products on the same shelf. Thus it would put a Titan watch and a Piaget on the same pedestal. Good for Titan. But for Piaget? The once robust Dotcom sector has seen a stunning reversal of fortunes in the past several months. And no one knows how many more are quietly cutting expenses. Where has IndiaInfo gone now? What is SatyamOnline doing? Whether a company shuts down completely or simply cuts back, its advertising budget invariably suffers. Marketing is the first thing to go. Dotcoms can't live by ads alone. Dot-com closures are accelerating, with Internet startups now closing at the rate of about one a day, according to a new report. The figures bring clarity to the endless announcements of young companies shutting down -- some of which launched amid great fanfare only earlier this year. In the next five years, out of all the companies existing in the Indian Internet space (estimated to be around 500), 90 per cent will die and the rest 10 per cent will survive through consolidation. The consolidation will be done primarily through mergers and acquisitions activity between companies that are technology driven and those having strong business models. Only 12 per cent of all the Indian Internet companies have received a venture capital funding and these are primarily the ones that will experience consolidation activity. The reason why incubation of start-up companies has not taken off in India is that most of the incubator companies and venture capital funds themselves are less than one-year old. Primarily financial compulsions, rather than being driven by complimentary synergies between various companies drive the merger and acquisition activity in India. This is because the Indian start-up ecosystem is not yet mature, and the venture capitalists are themselves learning.


The valuations of Dotcom companies have dropped by 50 per cent as compared to those six months back. In fact, the valuations have become more realistic today. There is no parameter to measure valuations, but the stock market. But this is also not real, as the stock market is not applicable to a Dotcom company (because the presence of a Dotcom company in the stock market is very far away, only when it goes public Valuations of the Internet companies are more of a perception and are driven by sentiment. Then why was there a mad rush to invest in Dotcoms? Why were million of dollars pumped into these ventures? Didn’t people realize that this might not work? Over 80 percent of the 350 companies that have gone public under the guise of the Internet are not showing profits. Because they don't have profits, it‟s hard to know how to value them. has been valued like Microsoft on steroids. The reason that Microsoft has a high valuation is that it has 37 percent to 40 percent operating profit margins, whereas a company like Amazon, which is just a distribution company, can never expect those kinds of margins. Microsoft is an intellectual property company. An Amazon is just a distributor -distribution companies typically generate 2 percent profit margins. But since they weren't generating any profits, people didn't know what to expect, so they thought -- oh, maybe they're going to be the next Microsoft. Now, people are starting to understand who are the real companies and what are the real business models. Clearly, the bubble has burst. Things will never be the same. What's happened is a lot of people have lost a lot of money and is going to scar them for a long time, and they're going to realize that it's now back to fundamentals. It‟s back to rationality. The bottom line is that there was this game of musical chairs that was being played. I think that intuitively people knew that the market was artificially propped up, but everyone has been making so much money in the market in the last two or three years, so no one wanted the music to stop and it kind of took on a life of its own. E-tailing companies plus the Web media companies got caught recently. The e-tailing companies were caught with people realizing that they're never going to make the kind of profits that a Microsoft or a


technology company would. As for the Web media companies: When AOL merged with Time Warner, it was kind of like the smartest guy in the Web media business, As Steve Case, said that in order to move forward successfully I need old economy capability. So, a lot of these pure-play Internet media companies, such as and iVillage, got kind of left hanging out there. Bubble or boom, the dot still fascinates, and the rush to set up Dotcom portals continues unabated. Evidently, the pot of gold at the end of a venture capital rainbow is too strong a temptation to resist.


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