Professor Ravi Anshuman & PGP Office

CCSReport

Presented to

Professor Ravi Anshuman & PGP Office

Indian Institute of Management, Bangalore

August 29, 2006

Towards

Partial Fulfillment of the Requirement for the

Post Graduate Programme

Submitted by

Vengat Krishnaraj V ( 0511127)

Soudabi N (0511190)

Contents

Need for the study

Overview of venture capital
History
Definition
Snap shop of the global VC industry in 2006
The US venture capital industry
The European VC industry
The Israeli VC industry
The Chinese VC industry
An academic look and literature survey of the Venture capital cycle
Deal sourcing
Due-diligence
Valuation
Deal structuring
Post financing engagement
Exit
The Indian VC industry
Overview
History
Size, activity, investments,
trends
sources of funds
active players
Peculiarities of the Indian industry
Case studies
Suzlon energy
ICICI Ventures and Dr Reddys – innovative deal structuring
Yes Bank
Bharti Televentures
Patni Computers
Biocon
India Bulls
NDTV

Need for the study

Emerging markets are the 1st and 2nd most attractive FDI destinations for investors globally. Indiahas moved up the pecking order and has joined China to attain unprecedented levels of investor confidence as can be seen from the shift over the last three years in the AT Kearney FDI confidence survey[1].

While China has held the top spot since 2002, India’s entry into the top three is a recent phenomenon. What is more interesting to note also is the fact that India and China together hold the top spots in almost all major industries and sectors.

The report also concludes that India appears to be at the cusp of an FDI take off and expects the long term attractiveness of India to increase in the coming years.

Private Equity and Venture Capital inflows, although they are counted as FII inflow into the country, in terms of dynamics and purpose are in a sense more akin to FDI inflow in the country as these inflows are more long term in nature and are primarily for the purpose of long term investment in Indian enterprises.

Hence we believe that overseas VC and PE investment in India is set to take off into a higher level with significant inflows and investments in the coming years. In this context it would be an useful exercise to gain a greater understanding of the dynamics and intricacies of this industry and appreciate its importance to one of the world’s leading emerging economies – India.

Organization of the report

We commence our study by taking a brief look at the history of the Private equity and Venture capital industry world wide in Part 1. We also provide a definition for the purpose of this study. In the subsequent section, we look at the global Venture Capital industry and provide a glimpse of the key countries and geographies where a lot of the action is concentrated. In Part 3, we study a typical investment cycle and the stages through which Private Equity transactions are consummated.

In Part 4 of the study we take a close look at the Indian Venture capital industry and provide an understanding of the direction and growth in investments in the last few years. In the final section we take a closer look at a select few transactions in the Indian context and relate them to the theoretical background of Part 3.

PART 1

History of Venture Capital and Private Equity

The concept of risk financing is as old as Columbus’ journey to America. Mark Anson[2] notes that the investment decision of Queen Isabella who sold her jewelry to finance Columbus’s fleet of ships in return for what ever spoils he could find in the New World is probably one of history’s most profitable venture capital investments[3]. This in short summarizes the private equity industry – a large risk of failure coupled with the potential for outstanding gains.

Although the term "Venture capital" was first used as a term in a public forum by Jean Witter in his presidential address to the 1939 Investment Bankers Association of America convention, [4]the usage of the word in its current context took shape in the post – World War II years.

The first modern venture capital firm was American Research and Development, formed in 1846 with the mandate to invest in growth industries – aerospace, broadcasting and pharma.

In the mid-1950s, the U.S. federal government with the objective of speeding up the development of advanced technologies facilitated the setting up of Small Business Investment Companies (SBIC). Soon commercial banks were allowed to form SBICs and within four years, nearly 600 SBICs were in operation[5]. SBICs have provided capital to several of the industrial giants and household names of today including Apple, Fedex and Intel.

The first venture capital limited partnership was formed in 1958 by Draper, Gaither and Anderson. The next significant thrust to the venture capital industry came with the change in the “prudent person” standard in the pension und industry in the 1970s. Essentially the net effect was that pension funds were allowed to invest in venture capital investments and this opened the floodgates of capital inflow into this industry.

Definition of Venture Capital2,3

The OECD (1996) defines venture capital “as capital provided by firms who invest alongside management in young companies that are not quoted on the stock market. The objective is high return from the investment. Value is created by the young company in partnership with the venture capitalist’s money and professional expertise”. More strict definitions of venturecapital exclude buyouts, mezzanine, and other financial transactions. Venture capitalists invest inequity in the form of common stock, or preferred stock, convertible debentures, or other financialinstruments convertible into common stock when the small company is sold either through amerger or a public equity offering. At this liquidity event venture capitalists realize their profitsin the form of capital gains.

Problems and confusion emerge when the terms “venture capital” and “private equity” are being used. In the USA “venture capital” refers to early stage investment, in Europe it also includes later stage investment. For the purpose of our analysis in this study, although we use the terms almost interchangeably, we refer to late stage investments, buyouts and growth investment as private equity and refer to early stage investment as venture capital.

Role of VCs

Venture capitalists are often active investors, monitoring the progress of firms, sitting onboards of directors, and meting out financing based on the attainment of milestones. Unlike bankswhich restrict their activities to monitoring the financial health of firms that they lend to, venture capitalists monitor strategy andinvestment decisions as well as take an active role in advising the firm. Venture capitalists oftenintervene in the company’s operations whennecessary. In addition, venture capitalists provide entrepreneurs with access to consultants,investment bankers, and lawyers[6]

There are four basic categories of institutional venture capital funds, as described in Pratt (1997).

Small Business Investment Companies (SBICs): federally chartered corporations established as a result of the Small Business Administration Act of 1958. SBICs have investedover $14 billion in approximately 80,000 small firms. Historically, these venture capitalists have relied ontheir unique ability to borrow money from the U.S. Treasury at very attractive rates and hence were the onlytypes of venture capitalist that preferred to structure their investments as debt rather than equity.
Subsidiaries of financial institutions, particularlycommercial banks. These are generally set up with the belief that portfolio companies will ultimately becomeprofitable customers of the corporate parent.
Corporate venture capital funds are subsidiaries or stand-alone firms established by non-financial corporations. Theseare generally established by industrial firms eager to gain access to emerging technologies by making earlystageinvestments in high-tech firms.
Finally, venture capital limited partnerships are funds established byprofessional venture capital firms, which act as the general partners organizing, investing, managing, andultimately liquidating the capital raised from the limited partners. While most venture capital limitedpartnerships have a single-industry focus, the firms themselves are not associated with any single corporationor group.

Part 2

Snap shop of the global VC industry today

The 2005 Ernst & Young annual Venture Capital Insight Report identified US, Europe and Israel as the mature hotbeds of venture capital investing and concluded that the interesting emerging market of India and China would drive venture capital fund raising in future.

Venture capital and private equity investments world wide reached a level of US $ 31.3 billion in 2005. The United States, Canada, Europe and Israel represented about 93% of the capital invested while India and China represent the rest.[7]

U. S Venture Capital Industry

State of the industry

A total of 108 funds closed in the U.S. in 2005, raising $22.16 billion, 19% more than was raised in 2004 and in fact the highest amount raised since 2001. Although fundraising is still much smaller than it was in 2000, when $83.18 billion was raised in a single year, it has rebounded over the last 5 years from the low point of $ 9.44 billion in 2003.[8] Almost 8% of the funds closed during 2005 were $ 500 to $1 billion which indicate the increasing preference for large sized funds.

Stage of investments

Investment activity by round class in 2005 showed the varyingfocus of investors. While later-stage deals represented themajority of deal flow, or 37% of all venture capital deals overthe course of the year, the interest in early-stage deals ran aclose second, representing 35% of the year’s financingrounds, up from 34% in 2004. Second-round financings which made up only20% of deals in 2005.

Size of funds

Almost 8% of the funds closed during 2005 were$500-$999 million in size. Investors are reportedly raising large funds becauseof the increasing globalization of the technology marketand the need to provide entrepreneurial companieswith larger rounds of financing so they can competeand create a presence internationally

Increased Investor Segmentation according to Industries

The investment preference of VC and PE investors in the United Statesis predominantly concentrated in Information Technology and products services followed by health care sector with investments in biopharmaceuticals and medical devices.

European Venture Capital Industry

The European venture capital environment in 2005showed the great contrasts in this market. On theone hand, European liquidity activity for venture backedcompanies rebounded significantly, particularly for initialpublic offerings (this was in part due to the availability of exchanges such as AIM which allow small investors a viable listing option). In addition, venture capital fundraisingin Europe reached its highest level in three years. But on theother hand, venture capital deal flow took a steep decline andthe capital invested shrank considerably.

In 2005, seed- and first-round deals accounted for just31% of all deals in Europe, down from 33% in 2004.In addition, the percentage of overallinvestment in early-stage rounds was just 22% in 2005, downfrom 28% in the preceding year. In contrast, later-stage dealsrepresented 40% of all financing rounds in 2005, up significantlyfrom the 33% in 2004.

The ability of venture-capital supported companies inEurope to achieve IPO exits in larger numbers was clearlyrelated to the new availability of exchanges such as AIM,which provides a marketplace for relatively young entrepreneurialcompanies.

Chinese Venture Capital Industry[9]

The venture capital industry in China is heating up eventhough it’s a relatively recent phenomenon. It has been emerging from decades of government-led technology policy.It is promoted by government not as a means to private gain but as a critical mechanism of linking S&T capabilities and outputs for economic and social development. The institutionalization of China’s VC system is as a result of preceding and on-going changes in China’s national innovation system and business system during the transition era.

By late 1970s some of the problem of centrally planned system came into effect. Inefficiencies and lower effectiveness of a centrally planned economy and R&D system in China attract special attention during this period. Later the government changed the system to focus more on

- Policy of decentralization

- Provide legitimacy to VC as well as private entrepreneurship

- Create institutional environment conducive to investment in new ventures

Local Governments are to have much more direct role in development of new ventures and supporting infrastructure, including in basic activities of the VC system.

There is more uncertainty and higher risk in China, while with great opportunities Some of the risks are higher information asymmetry, potentially higher moral hazard of entrepreneur, shortage of experienced entrepreneurs and investors, lack of experience of managing growing enterprise, quickly changing environment, technology application, market, deregulation, broad infrastructure, legal framework, the lack of liquid financial markets, et al.

In China, in 2005, there was a decline in investment activities due to the enforcement of regulatory initiative that had halted the establishment of the offshore corporate structures allowing foreign venture capitalists to exit a Chinese company through an IPO on a foreign exchange. In a development applauded by Chinese Venture Capital Association and legal observers, China’s State Administration of Foreign Exchange recently issued a new initiative, that laid out the process for establishing offshore structures, restoring the exit path for foreign investors. As a result the Chinese venture-capital investment is expected to rebound. Some of the major challenges in Chinese market include6

Lack of NASDAQ-like exchange to provide exits for high growth venture capital companies
Weak intellectual property regulation and protection, making it difficult to capitalize the innovation.
Lack of a comprehensive venture capital law in terms of structures and taxations
Shortage of management talent
Underdeveloped system for technology transfer
Large degree of freedom exercised by the central government in the venture eco system.
Lack of stability in regulations

Part 3

Venture Capital Cycle

Section summary: This section presentsan academic review and literature survey of the entire Venture capital cycle and the various considerations in each stage including

Deal sourcing
Due-diligence
Valuation
Deal structuring
Post financing engagement
Exit

Deal sourcing[10]

In generating a deal flow, the venture capital investor creates a pipeline of ‘deals’ or investment opportunities that he would consider for investing in.

This is achieved primarily through plugging into an appropriate network such as the network of venture capital funds/investors. It is also common for venture capitals to develop working relationships with R&D institutions, academia, etc, which could potentially lead to business opportunities.

Some of the potential sources of deals are

Referrals: Friends, business or personal acquaintances, or people with whom an investor has co-invested in the past are good sources for new deals.
Angel organizations: There are many angel organizations that bring start-ups and seed capital together.
Technology centers: Universities or technology transfer institutes are seeding grounds for early stage companies.
Entrepreneur clubs and events: Events and organizations that attract entrepreneurs are a forum to source deals.
Broker dealers: These are individuals or firms retained by startup companies to raise money. Broker dealers bring deals to VCs or angel investors, and in return, they are compensated based on the amount of money raised for the company.
Investment bankers: Investment bankers are interested in establishing relationships with promising startups, which will give them an edge over other investment banks when the startup becomes large enough to go public, or to make acquisitions, or to be acquired.
Service providers: A small group of professionals such as accountants, and lawyers have broad exposure to early stage companies due to the nature of their business. This is especially true in a country like India where auditors also double as investment advisors in promoter driven companies.

Due Diligence[11]:

Due diligence can be broken down to include an initial screening of the deal and a detailed evaluation in determining the suitability of a deal before moving to the next stage in which the valuation and deal structure is conducted. This note will outline the general practices involved in screening due diligence and business due diligence.

Screening Due Diligence. The intent of screening due diligence is to quickly flag the deals that either do not fit with the investment criteria of the firm or the criteria that are deemed necessary for success. Venture firms are often inundated with investment opportunities. The approach to screening is to determine what is critical to its each fund and what types of deals will fit. Fit is often characterized by the stage of the business, geographic region, size of the deal, and industry sector. In screening for a high quality deal there are a few additional areas of focus. Therefore most firms screen based on investment fit and investment potential.

Investment Fit

–Determines if the investment proposal is consistent with the investment philosophy of the firm - Venture capitalists may be generalist or specialist depending on their investment strategy. As a generalist, a firm may invest in various industry sectors, or various geographic locations, or various stages of a company’s life. As a specialist, a firm may invest in one or two industry sectors, or may seek to invest in only a localized geographic area. Another criterion is the stage of the business lifecycle.

Investment potential

–Once the investment proposal is deemed to “fit” with the philosophy of the firm, a screening is conducted to test the viability of the deal. Although screening is unique to a particular firm’s needs, there are some common threads that a firm evaluates.

–These include

Management
Market
Product/ service
Business model
Origin of the deal

Valuation

Valuation in Private Equity[12]

Valuation in Private Equity settings which involves dealing with companies in various stages of their life cycle and difficult to predict cash flows is often a subjective process.

Some of the common methods used are

Comparables method
NPV method
Adjusted price value method
Venture capital method and
Options valuation method

Comparables method: Often used to obtain a quick ballpark valuation