Venture Capital

What is Venture Capital/Private
Equity?
• Venture capital is a subset of private equity and
refers to equity investments made for the launch,
early development, or expansion of a business
• Among different countries, there are variations in
what is meant by venture capital and private
equity
• In Europe, these terms are generally used
interchangeably and venture capital thus includes
management buy-outs and buy-ins (MBO/MBIs).
• This is in contrast to the US, where MBO/MBIs
are not classified as venture capital.

• Private equity provides equity capital to
enterprises not quoted on a stock market.

Why companies need financing?
• For start-ups or growing companies, as well as those
facing a major change, financing is one of the key
business issues.
• New capital is needed e.g. for
• 1. Financing of product development
• 2. Financing of market penetration
• 3. Financing of investments
• 4. Working capital financing to secure operative
continuity
• 5. Maintaining liquidity to be able to cover daily
payments

• During their start-up, growth and expansion
stages, the companies are often faced with
the fact that the incoming cash flow is not
sufficient for the operations.
• The company's cumulative cash flow is
negative.
• The time needed for turning the company‘s
cash flow positive varies considerably

• A long product development stage and slow
market penetration prolong the negative cash
flow period.
• The company can have a negative cash flow
for years, a situation that is typical in high-
tech branches.

Operative financing
• To bridge the deficit in operative financing, the
company has the following choice of available
measures:
• 1. to ensure that the liquidity planning has been
appropriate
• 2. to make the clients pay their invoices on time by
offering, for example, discounts for rapid payments
• 3. to intensify the collection of sales receivables
• 4. to delay the payments to suppliers within their
terms of payment
• 5. to maximize the sales margins to cut indirect costs

External financing
• Should these measures not be sufficient, the
• company has the following alternatives:
• to acquire equity capital (e.g. venture capital
investors)
• to borrow capital

The Process of acquiring Venture
Capital financing
• The actual venture capital investment made in a
company is preceded by a thorough and selective
assessment of potential investment targets made
by the venture capital investor.
• At the first stage, the assessment of the
investment request is based on a business plan
made by the company.
• This is the stage where most of the projects
(about 90 %) of all proposed projects are
rejected.

• The initial assessment is made relatively
rapidly and therefore the company should pay
attention to two aspects:
• the business plan should be carefully prepared
and the contact targeted to the correct
investors.
• A well-prepared business plan summary is the
best means of attracting and convincing the
investor.

Capital financing
• The central issues considered by the venture
capital investor at this stage are:
– Is the company able to conduct profitable and
growing business operations?
– Do the company executives have the necessary
qualities to manage the business in the various
development stages?
– Will the investor be able to obtain the desired
return through an increase in the company's net
worth?

Capital financing
• Besides the company's business plan, the
venture capital investor will assess the
compatibility of the investment request
against its own investment strategy.

• The decisive investment strategy criteria may
be company size, development stage, branch
or geographical location.
• Contacts directed to the correct investors at
an early stage of the process will save time
and diminish the probability of negative
answers.

• Should the investor decide that the
investment request meets his criteria, the
following step is a meeting arranged with the
company management.
• Experience has shown that about half of the
remaining companies are discarded at the
negotiation stage

• The third stage, or the due diligence stage,
involves a thorough study of the target
company by the venture capital investor who
assesses the company on the basis of his own,
weighted investment criteria.
• The preparedness of the company
management to launch and developed the
business in question is generally seen as the
most important criterion.

• Other vital issues include the size and
development of the company's target market,
• the competitiveness of the company‘s product
and technology
• as well as the capital required by the business
at the actual investment stage and the
eventual additional investment needs.

• During the second and third stage of the
assessment process, the investor determines
the value of the company.
• Once the entrepreneur and the investor have
agreed on the value, the investor's future
share of the company is determined.

• The entry valuation of investor will depend on
factors such as investors return expectations,
and the view of the opportunity for new
concept, product or service

• The intention is to liquidate the shareholding in
early phase companies after 4-8 years and in
companies with follow-on funding after 1-3
years.
• In the end, the investment is made in about 3 to
4 % cases of all received investment requests.
• The parties finally make a shareholder agreement
to establish practical operating rules.

Stages of Investments
• Early stage companies may have proprietary
technology or intellectual property that has
the potential to be exploited on a global scale.
• The technology or lead product is usually
beyond proof of principle stage

• Mid-stage companies may have strong
pipeline of technologies and products, which
has been developed by research and
management teams with scientific and
commercial credibility

• Later stage companies have operational and
corporate finance skills ideally positioned and
company may need investments to precipitate
consolidations.
• Companies at this stage are within 12 to 18
months of an IPO.

VC’s contribution to entrepreneur
• In addition to money, professional VC as a
shareholder bring strong industry,
operational, financial and investment banking
skills to the partnership with the target
company

• Through the VC’s expertise and network the
portfolio companies could gain access to:
• a) follow-on capital through venture capital ties
• b) knowledge of partnership opportunities in
multiple markets
• c) in-depth operational and management
experience’
• d) access to high-quality management teams
• e) ties to the investment banking community

VC’s contribution to entrepreneur
• VC adds the most value by assisting in the
creation of the best possible team to manage
and supervise the target company
• Management assessment is one of the major
tasks to be carried out by the venture capital
before deciding to invest

Seed stage financing
• The venture is still in the idea formation stage
and its product or service is not fully
developed.
• The usually lone founder/inventor is given a
small amount of capital to come up with a
working prototype.
• Monies may also be spent on marketing
research, patent application, incorporation,
and legal structuring for investors.

• It's rare for a venture capital firm to fund this
stage.
• In most cases, the money must come from the
founder's own pocket, from the "3 Fs" (Family,
Friends, and Fools), and occasionally from
angel investors.

Start up financing
• The venture at this point has at least one
principal working full time.
• The search is on for the other key
management team members and work is
being done on testing and finalizing the
prototype for production

First -stage financing
• The venture has finally launched and achieved
initial traction.
• Sales are trending upwards.
• A management team is in place along with
employees

• The funding from this stage is used to fuel
sales, reach the breakeven point., increase
productivity, cut unit costs, as well as build
the corporate infrastructure and distribution
system.
• At this point the company is two to three
years old

Second -stage financing
• Sales at this point are starting to snowball.
• The company is also rapidly accumulating accounts
receivable and inventory.
• Capital from this stage is used for funding expansion
in all its forms from meeting increasing marketing
expenses to entering new markets to financing
rapidly increasing accounts receivable
• Venture capital firms specializing in later stage
funding enter the picture at this point

Mezzanine or Bridge financing
• At this point the company is a proven winner and
investment bankers have agreed to take it public
within 6 months.
• Mezzanine or bridge financing is a short term
form of financing used to prepare a company for
its IPO.
• This includes cleaning up the balance sheet to
remove debt that may have accumulated, buy
out early investors and founders deemed not
strong enough to run a public company, and pay
for various other costs stemming from going
public.

• The funding may come from a venture capital
firm or bridge financing specialist.
• They are usually paid back from the proceeds
of the IPO.

Initial Public Offering (IPO)
• The company finally achieves liquidity by
being allowed to have its stock bought and
sold by the public.
• Founders sell off stock and often go back to
square one with another startup.

Types of VCs:
• – Angel investors
• – Financial VCs
• – Strategic VCs

Angel Investors
• Typically a wealthy individual
• • Often with a tech industry background, in position to
judge high-risk investments
• • Usually a small investment (< $1M) in a very early
stage company.
• • Motivation:
• – Dramatic return on investment via exit or liquidity
event:
• • Initial Public Offering (IPO) of company
• • Subsequent financing rounds
• – Interest in technology and industry

Financial VCs
• Most common type of VC
• • An investment firm, capital raised from
• institutions and individuals
• • Often organized as formal VC funds,
• • Sometimes organized as a holding company
• • Fund compensation: carried interest
• • Holding company compensation: IPO
• • Fund sizes: ~$25M to 10’s of billions
• • Motivation:
• – Purely financial: maximize return on investment
• – IPOs, Mergers and Acquisitions (M&A)

Strategic VCs
• Typically a (small) division of a large technology
company
• • Examples: Intel, Cisco, Siemens, AT&T
• • Corporate funding for strategic investment
• • Help companies whose success may spur revenue
growth of VC corporation
• • Not exclusively or primarily concerned with return on
investment
• • May provide investees with valuable connections
and partnerships
• • Typically take a “back seat” role in funding

The Funding Process: Single Round
• Company and interested VCs find each other
• • Company makes it pitch to multiple VCs:
• – Business plan, executive summary, financial projections with
assumptions, competitive analysis
• • Interested VCs engage in due diligence:
• – Technological, market, competitive, business development
• – Legal and accounting
• • A lead investor is identified, rest are follow-on
• • The following are negotiated:
• – Company valuation
• – Size of round
• – Lead investor share of round
• – Terms of investment
• • Process repeats several times, builds on previous rounds

Terms of Investment
• Initially laid out in a term sheet (not binding!)
• • Valuation + investment à VC equity (share)
• • Other important elements:
• – Board seats and reserved matters
• – Liquidation and dividend preferences
• These days, VCs extract a huge amount of
control over their portfolio companies.

Basics of Valuation
• Pre-money valuation V: agreed value of company prior to this
round’s investment (I)
• • Post-money valuation V’ = V + I
• • VC equity in company: I/V’ = I/(V+I), not I/V
• • Example: $5M invested on $10M pre-money gives VC 1/3 of the
shares,
• • I and V are items of negotiation
• • Generally company wants large V, VC small V, but there are many
subtleties…
• • This round’s V will have an impact on future rounds
• • Possible elements of valuation:
• – Multiple of revenue or earnings
• – Projected percentage of market share

Board Seats and Reserved Matters
• Corporate boards:
• – Not involved in day-to-day operations
• – Hold extreme control in major corporate events (sale, mergers,
acquisitions, IPOs, bankruptcy)
• • Lead VC in each round takes seat(s)
• • Reserved matters (veto or approval):
• – Any sale, acquisition, merger, liquidation
• – Budget approval
• – Executive removal/appointment
• – Strategic or business plan changes
• • During difficult times, companies are often controlled by their VCs

So What Do VCs Look For?
• Committed, experienced management
• • Defensible technology
• • Growth market
• • Significant revenues
• • Realistic sales and marketing plan

Exits
• Depending on the investment focus and strategy of the
venture firm, it will seek to exit the investment in the
portfolio company within three to five years of the initial
investment.
• While the initial public offering may be the most glamourous
and heralded type of exit for the venture capitalist and
owners of the company,
• most successful exits of venture investments occur through a
merger or acquisition of the company by either the original
founders or another company.

IPO
• The initial public offering is the most glamorous and
visible type of exit for a venture investment.
• In recent years technology IPOs have been in the
limelight during the IPO boom of the last six years.
• At public offering, the venture firm is considered an
insider and will receive stock in the company,
• but the firm is regulated and restricted in how that
stock can be sold or liquidated for several years.

• Once this stock is freely tradable, usually after about
two years, the venture fund will distribute this stock
or cash to its limited partner investor
• who may then manage the public stock as a regular
stock holding or may liquidate it upon receipt.
• Over the last twenty-five years, almost 3000
companies financed by venture funds have gone
public.

Mergers and Acquisitions
• Mergers and acquisitions represent the most
common type of successful exit for venture
investments.
• In the case of a merger or acquisition, the
venture firm will receive stock or cash from
the acquiring company and the
• venture investor will distribute the proceeds
from the sale to its limited partners.

48
• Where Does Venture Capital Money Come From?
• How are Venture Capital Funds Organized?
• How do Venture Capitalists make money Personally?

49
• Where Does Venture Capital Money Come From?
• Professional Venture Capital Firms raise money from Insurance
Companies, Educational Endowments, Pension Funds and Wealthy
Individuals.
• These organizations have an investment portfolio which they allocate to
various asset classes such as stocks (equities), bonds, real estate etc.
• One of the assets classes is called “Alternative Investments”- venture
capital is such an investment. Perhaps 5% to 10% of the portfolio might be
allocated to Alternative Investments.
• The portfolio owners seek to obtain high returns from these more risky
Alternative Investments.

50
• Most Venture Capital Funds are Limited Partnerships:
Venture Capital Fund
Limited Partners
Pension Funds, Educational Endowments,
Foundations, Insurance Companies, Wealthy
Individuals
General Partners The General Partners use an Offering Memorandum
to raise a fund of a given size from the Limited
Partners by convincing them that the GPs have a
unique strategy or expertise in a particular sector or
sectors of the market. Fund raising can take a year
or more.
If the GPs are successful they will convince
enough Limited Partners to invest enough
money to achieve the size fund offered. When
this happens there is a first “close” of the fund.

51
• What Do Venture Capitalists Do?
• Source Deals
• The GPs have to “source” deals- I.e. find investment opportunities. This is done in a
variety of ways- referrals from trusted sources (other funds, entrepreneurs they have
invested in before, lawyers, accountants etc.)
• Make Investment Decisions
• From the opportunities identified the GPs pick the ones they think will be the
“winners”. They might look at 50 or 100 opportunities for each one they invest in.

52
• What Do Venture Capitalists Do?
• Manage The Investment
• The GP/VCs have a fiduciary duty to the LPs to “manage” the investment. This
means they usually sit on the Board of Directors. Given this time commitment a
VC might only be able to handle 6 to 10 portfolio investment companies at a time.
• Harvest The Investment
• The GP/VCs win only if they can get their money out of the investment (“harvest
the investment”). This usually takes the form of an acquisition of the portfolio
company or taking the portfolio company public in an Initial Public Offering (IPO).
Note: even the most successful funds rarely have even 1/3 of their portfolio
investments become successful – i.e even with careful vetting 2 out of 3
investments are not “wins”.

53
• Economics of the Venture Capital Fund - CAPITAL
• Capital Commitments
• The Limited Partners do not actually invest money in the Fund at the closing. They
legally commit to provide a certain amount of capital when they are called upon.
This is called a Limited Partner’s Capital Commitment.
• Capital Calls
• When the General Partners find what they think is a good investment opportunity
they make a “Capital Call” on the Limited Partners. Example: a Fund has $500M of
capital and the GP/VCs want to make an investment of $10M. A Limited Partner
with a Capital Commitment of $50M will be required to send $1M to the General
Partners: 50M/500M = 10% times 10M = $1M

54
• Economics of the Venture Capital Fund – VC Compensation
• Management Fees
• The General Partners receive an annual Management Fee, which is usually a
percentage of the Capital Commitments to the Fund.
• A typical fee is 2.5%. On a $400M fund this $10M per year.
• The Management Fee is used by the General Partners to run the Fund business –
e.g. it pays the salaries of the General Partners, the Associates, the Support Staff
and the office rent.

55
• Splitting the Returns
• The GP/VCs make investments and they hopefully harvest some of those.
• The returns from the investment are split between the Limited Partners and the
General Partners. A typical arrangement is as follows:
• The Limited Partners receive 99% of all the returns and the GP/VCs receive 1%
of all returns until the Limited Partners receive back 100% of their Capital (plus
in some cases “interest” on that Capital).
• Thereafter the splits go 80% to the Limited Partners and 20% to the GP/VCs.
This 20% part is called the GP’s “Carried Interest”
• Venture Capitalists with a great track record will receive a higher Carried Interest-
e.g. 30%

©2000, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 14
Organizational Structure of
Venture Capital Investment
Portfolio
Companies
–Value
creation
– Generate deal flow
– Screen opportunities
– Harvest investments
– Negotiate deals
– Monitor and advise
General Partners
Venture Capital Fund
– Pension plan
– Endowments
– Life insurance companies
– Corporations
– Individuals
Limited Partners
Effort and
1% of
capital
Annual
Management
Fee 2-3%
Carried
Interest 20-
30% of
Gain
99% of Investment
Capital
Capital Appreciation
70-80% of Gain
Investment
Capital and
Effort
Financial
Claims

57
• Compensation Drives Behavior
• The Split Formula provides a heavy incentive for the GP/VCs to invest in situations
that can be Big Hits. Reason: They don’t make money unless they return Big
Returns to the Limited Partners.
• Examples
• Assume the Fund has invested $400M in 20 companies ($20M per company on
average).
• Assume that each of the Fund’s investment provides it with a 50% ownership
interest in a portfolio company.
• Assume that 25% of the companies are successful and the Fund can harvest those
investments – i.e. 5 of the 20 companies are successful.

58
• Example (continued)
• Assume the average “win” returns to the Fund 5 times the amount invested. In our
example, the $20M becomes $100M.
• Note: If the Fund owns 50% of a company then the value of the company at harvest has
to be $200M in order for the Fund to receive 5 times its investment.
Venture Partners Fund 1
Capital Commitments: 400
Winning Investments:
Company
Amount
Invested % Ownership
Return
Multiple
Investment
Value at
Harvest
Value of
Company
1 20 50% 5 100 200
2 20 50% 5 100 200
3 20 50% 5 100 200
4 20 50% 5 100 200
5 20 50% 5 100 200
100 500

59
• Example (continued)
• This is how the Return Splits would work:
• Recall: 99% of the returns go to the Limited Partners until they receive back their invested Capital then
the upside is split with the General Partners
• In this case the LPs are probably somewhat happy - they get a 19% return - and the GPs
make $23M. (note: this example ignores the time value of money).
Company
Amount
Return
Multiple
Investment
Value at
Harvest
1 20 50% 5 100
2 20 50% 5 100
3 20 50% 5 100
4 20 50% 5 100
5 20 50% 5 100
100 500
Return Splits
Returns $ % $ %
Return of Capital: 404 400 99% 4 1%
Upside, if any: 96 77 80% 19 20%
500 477 23
LP % Return: 19%
Limited Partners General Partners

60
• Sensitivity of Returns
• Notice what happens if the 5 winning investments pay out at lower multiples:
• The reward system makes the VCs “swing for the fences” – they need to find companies
that can be really big.
Company
Amount
Return
Multiple
Investment
Value at
Harvest
Value of
Company
1 20 50% 5 100 200
2 20 50% 4 80 160
3 20 50% 4 80 160
4 20 50% 3 60 120
5 20 50% 3 60 120
100 380
Return Splits
Returns $ % $ %
Return of Capital: 380 376.2 99% 4 1%
Upside, if any: 0 0 80% 0 20%
380 376 4
LP % Return: -6%
Company
Amount
Return
Multiple
Investment
Value at
Harvest
Value of
Company
1 20 50% 4 80 160
2 20 50% 4 80 160
3 20 50% 3 60 120
4 20 50% 3 60 120
5 20 50% 3 60 120
100 340
Return Splits
Returns $ % $ %
Return of Capital: 340 336.6 99% 3 1%
Upside, if any: 0 0 80% 0 20%
340 337 3
LP % Return: -16%

61
• Fund Investment Cycle
• Fund Life
• Most Funds have a 10 year life. At the end of 10 years they are liquidated.
• Funds plan to harvest winners in 5 to 7 years or less.
• Initial Portfolio Investments
• For Early Stage Funds it is typical for the Fund to reserve $2-$3 for every $1
invested. For example if the Fund invests $2m in Round 1 they will reserve another
$4m -$6m for follow-on rounds. So a $400M Fund might invest $100M in the first
rounds of portfolio companies and $300M in follow on rounds.
• Timing of Initial Investments
• A Fund usually makes its initial investments in the first 3 years of the Fund life cycle.
During the remaining life of the Fund follow-on investments are made and the
portfolio companies are positioned for “harvest”

62
• Follow-On Funds
• Once the initial investments have been made in Fund 1, the VCs are motivated to
raise Fund 2 so they can make investments in new opportunities and get additional
Management Fees.
• Hopefully there are some early successes in Fund 1 so they can go to their LPs and
get them to invest in Fund 2.
• Through this layering of Funds the GPs build up their total Capital Under
Management.
Year Year Year Year Year Year Year Year Year Year
1 2 3 4 5 6 7 8 9 10 Totals
Fund 1 Initial Investments 30 30 30 90
Fund 1 Follow On 50 110 150 310
Fund 2 Follow On 50 110 150 310
Fund 3 Follow On 50 110 150 310

63
• Things For the Entrepreneur To Think About
• Does Your Plan Fit the Needs of the Venture Capital Fund?
• As you can see they need to see Big Returns. If your Plan can justify this and
you need lots of capital to achieve your Plan then VC may be the way to go.
• You may be able to grow a successful company and make a lot of money without
having to scale to the size that will interest Venture Capital.
• Are You Ready For Venture Capital?
• As you can see VCs have a relatively short time fuse to success- a 10 year Fund
and the need to show some “Winners” early in order to raise the Next Fund.
• Result: You have to be ready to move quickly, there will not be much time to
recover from errors in the plan or execution.

64
• Things For the Entrepreneur To Think About
• Are You Prepared to Become a Minority Stockholder?
• As the examples show, in order to generate returns for their Limited Partners the
GP/VCs have to invest a large amount and this usually means they will obtain a
significant percentage of the company over time.
• Having a small piece of a Big Pie can make you rich but you have to be mentally
prepared to become a Minority Stockholder.
• Make Sure the VC You Work With Can Add Value
• Experienced Venture Capitalists can provide valuable advice and guidance,
saving you time and preventing mistakes. They also have contacts with potential
customers, Wall Street and acquirers.

VENTURE CAPITAL
Myths about Venture Capital
Financing
$ VCs want no less than 50% OwnershipVCs want no less than 50% Ownership
Fact:Fact: VC Funds customarily hold 47% to 53% Voting
Interest
$ VCs have the Right to Fire the Founder/CEOVCs have the Right to Fire the Founder/CEO
Fact:Fact: Customary Condition is Employment ContractCustomary Condition is Employment Contract
authorizing Majority of Directors toauthorizing Majority of Directors to firefire Founder/CEOFounder/CEO
““with or without causewith or without cause.”.” Performance Issues vs.Performance Issues vs.
Company Needs:Company Needs: Administrator or InspirationalAdministrator or Inspirational
LeaderLeader

VENTURE CAPITAL
Myths about Venture Capital FinancingMyths about Venture Capital Financing
$ VCs dominate the Private Equity MarketVCs dominate the Private Equity Market
Fact:Fact: VCs account for less than 1% of the PrivateVCs account for less than 1% of the Private
Equity MarketEquity Market
$ VCs finance a Broad Range of Industry Types on aVCs finance a Broad Range of Industry Types on a
Nationwide BasisNationwide Basis
Fact:Fact: Most VC investments are in High-Technology orMost VC investments are in High-Technology or
Bio-science Industries in California’s SiliconBio-science Industries in California’s Silicon Valley orValley or
Boston areaBoston area

VENTURE CAPITAL
Myths about Venture CapitalMyths about Venture Capital
FinancingFinancing
$ VCs expect to Earn a 700% Rate of Return within Two toVCs expect to Earn a 700% Rate of Return within Two to
Three YearsThree Years
Fact:Fact: VCs aim to “harvest” their Investments within 7VCs aim to “harvest” their Investments within 7
to 10 Years (and try to earn no less than 700%)to 10 Years (and try to earn no less than 700%)
$ Governments invest in VC Funds because they are aGovernments invest in VC Funds because they are a
“Win-Win” Situation: Eye-Popping Rates of Return and“Win-Win” Situation: Eye-Popping Rates of Return and
High-Paying JobsHigh-Paying Jobs
Fact:Fact: Probable Returns will be around 25% with less thanProbable Returns will be around 25% with less than
half of Firms surviving more than 3 yearshalf of Firms surviving more than 3 years

The Venture Capital Process
• Find Deals
• Research Deals – A 3-6 Month Process
• Structure and Close Deals
• Manage The Investment
• Exit The Investment

Some Statistics
• 99%+ of All Startups Do Not Require
Institutional Venture Capital
• VCs average initial investment is $3M+
• Average Dilution from Initial VC Investment is
40%+
• VCs look at over 100 business plans for every
one they finance

When Is VC Good
• Heavy R&D Component of the business
– Seminconductors
– Biotech
– Datacomm Equipment
• Very Large Opportunity Requiring A Lot of
Working Capital
– Federal Express
– Amazon.com

The Cost of Venture Capital
• Dilution
– Average founder who uses VC owns less than 10%
of the business upon exit
• Liquidation Preference
– The VCs will want to take their money out first

• Some of the unique features of a VC firm are

Investment in high-risk, high-returns
ventures
• As VCs invest in untested, innovative ideas the
investments entail high risks.
• In return, they expect a much higher return
than usual. (Internal Rate of return expected
is generally in the range of 25 per cent to 40
per cent).

Participation in management
• Besides providing finance, venture capitalists
may also provide technical, marketing and
strategic support.
• To safeguard their investment, they may also
at times expect participation in management.

Expertise in managing funds
• VCs generally invest in particular type of
industries or some of them invest in particular
type of businesses and hence have a prior
experience and contacts in the specific
industry which gives them an expertise in
better management of the funds deployed.

Raises funds from several sources
• A misconception among people is that
venture capitalists are rich individuals who
come together in a partnership. In fact, VCs
are not necessarily rich and almost always
deal with funds raised mainly from others. The
various sources of funds are rich individuals,
other investment funds, pension funds,
endowment funds, et cetera, in addition to
their own funds, if any.

Diversification of the portfolio
• VCs reduce the risk of venture investing by
developing a portfolio of companies and the
norm followed by them is same as the
portfolio managers, that is, not to put all the
eggs in the same basket.

Exit after specified time
• VCs are generally interested in exiting from a
business after a pre-specified period. This
period may usually range from 3 to 7 years.

What specific areas in India interest
VCs?
• Non-data, non-voice mobile phone applications.
• Internet-based technologies.
• Growth-stage businesses in real estate, and especially
entertainment and media, which will see many
emerging technologies. Late-stage businesses that
interest investors are in the retailing sector.
• Language-based Internet applications, like text-to-
voice conversion into vernacular.
• Pharma sector, which is attracting many private equity
funds.
• Sports and wellness/healthcare.

Setting the stage - Venture Capital in
India
• Phase I - Formation of TDICI in the 80’s and
regional funds as GVFL & APIDC in the early 90s.
• Phase II - Entry of Foreign Venture Capital funds
(VCF) between 1995-1999
• Phase III - (2000 onwards). Emergence of
successful India-centric VC firms
• Phase IV – (current) Global VCs and PE firms
actively investing in India
• 150 Funds active in the last 3 years (Government,
Overseas, Corporate, Domestic)

TDICI
• In 1988, the first organization to actually identify
itself as a venture capital operation,
• Technology Development & Information
Company of India Ltd. (TDICI),
• was established in Bangalore as a subsidiary of
the Industrial Credit & Investment Corporation of
India, Ltd.(ICICI),
• India’s second-largest development financial
institution (at the time, it was state owned and
managed).

GVFL
• In 1990, Gujarat Venture Finance Limited
(GVFL) began operations with a 240 million
rupee fund with investments from the World
Bank, the U.K. Commonwealth Development
Fund, the Gujarat Industrial Investment
Corporation, Industrial Development Bank of
India, various banks, state corporations, and
private firms

APDIC
• The Andhra Pradesh state government formed
a venture fund subsidiary in its AP Industrial
Development Corporation (APDIC).

The Second Stage, 1995–1999
• This stage saw the entrance of foreign
institutional investors.
• This included investment arms of foreign banks,
but particularly important were venture capital
funds raised abroad.
• Very often, NRIs were important investors in
these funds.
• The overseas private sector
• investors became a dominant force in the Indian
venture capital industry.

• The formalization of the Indian venture capital
community began in 1993 with the formation
of the Indian Venture Capital Association
(IVCA) headquartered in Bangalore.

• Phase III - (2000 onwards). Emergence of
successful India-centric VC firms
• Phase IV – (current) Global VCs and PE firms
actively investing in India

Number Of Investments
Investor 2005 2006 2007 2008 2009 Total
Sequoia Capital India 7 12 13 18 3 53
Ventureast 5 11 4 9 3 32
Intel Capital 3 7 4 8 1 23
Helion Venture Partners 0 4 8 8 2 22
DFJ India 0 3 3 9 2 17
Nexus India Capital 0 1 4 9 2 16
NEA IndoUS Ventures 0 0 5 9 0 14
IDG India Ventures 0 0 6 5 0 11
Kleiner Perkins 1 3 0 6 0 10
Norwest Venture
Partners
1 3 1 2 3 10
Canaan Partners 0 1 4 4 1 10
Inventus Capital Partners - - - - 3 3

Value Of Investments ($ mn)
Investor 2005 2006 2007 2008 2009 Total
Sequoia Capital India 42 184 114 138 26 504
Intel Capital 19 37 15 53 7 131
Norwest Venture
Partners
13.9 8.1 24.1 17.7 92.8 156.6
Helion Venture
Partners
- 30 30 30 10 100
Nexus India Capital - 7.5 16 45 7 75.5
DFJ India - 13.75 4 33 10 61
Ventureast 7 19 2 17 9 54
NEA IndoUS
Ventures
- - 24 26 - 50
Canaan Partners - 4 10 12 4 30
Kleiner Perkins 2 8 - 19 - 29
IDG India Ventures - - 14 8 - 22
Inventus Capital
Partners
- - - - - -

Foreign Venture Capital Investor
• An FVCI (or Foreign Venture Capital Investor) is
an investor incorporated or established outside
India
• which proposes to make investments either in
domestic Venture Capital Funds (‘VCFs’) or
Venture Capital Undertakings10
(‘VCUs’) in India
(defined to mean a domestic unlisted Indian
Company)
• and which is registered under the Foreign
Venture Capital Investor Regulations, 2000 (‘FVCI
Regulations’).

• Although foreign private equity players and
offshore VCFs can invest in India directly
under the Foreign Direct Investment Scheme
(the ‘FDI Scheme’),
• the SEBI grants certain benefits to those
investors who register themselves under the
FVCI Regulations

• The shares acquired by a FVCI in an unlisted company are
not subject to the one year lock-up period upon the Initial
Public Offering (‘IPO’) of the shares of the company. Thus,
the FVCI would be able to exit its investment in such a
company after the listing of the shares without having to
wait for the completion of the lock-up period.
• FVCIs registered with the SEBI are ‘Qualified Institutional
Buyers’ in the SEBI (Disclosure and Investor Protection)
Guidelines, 2000 (‘DIP Guidelines’).
• As a result, they are eligible to participate in the primary
issuance process, meaning that they would be able to
subscribe for the securities in an IPO under the typical
book-building process.

Lock-up requirements
• The SEBI, through the DIP Guidelines, has stipulated lock-
up requirements on shares of promoters to ensure that the
promoters or persons who are controlling the company
continue to hold some minimum percentage in the
company after the public offering.
• A promoter is defined as being a person (or persons) who is
in over-all control of the company or who is instrumental in
the formulation of a plan or program pursuant to which the
securities are offered to the public, and those named in the
prospectus as promoters(s).
• This definition, however, is an inclusive one and it would
really depend upon the manner in which the SEBI would
interpret the actions of a company and the key individuals/
entities associated with it.

• While considering an FVCI application, the
SEBI does review the applicant’s track record,
professional competence, financial soundness,
experience, general reputation, whether the
applicant is regulated by an appropriate
foreign regulatory authority or is an income
tax payer, amongst other factors.
• The SEBI then forwards its approval to the RBI,
which then grants its approval.

• While registration under the FVCI Regulations
is not compulsory, the Indian Government has
sought to make this registration attractive by
conferring certain benefits upon those
institutions that have registered.
• An FVCI is entitled to various benefits under
securities and taxation laws in India.

• Mauritius has traditionally been the most favored
jurisdiction for incorporation to invest in India.
• A company incorporated in Mauritius becomes a tax
resident of Mauritius, and thus is subject to the DTAA
between India and Mauritius.
• Under the India-Mauritius DTAA, any capital gains earned
by a resident of Mauritius are exempt from tax in India.
• Further, the business profits of a Mauritius offshore
company are taxable at an effective tax rate of only 3%25
.
• Most investors who come into India via Mauritius do not
have any substantive business in Mauritius and are
incorporated there only to take advantage of the DTAA

SEBI Venture Capital Funds (VCFs)
Regulations, 1996
• According to these regulations, a VCF means a
fund established in the form of a trust /
company and registered with SEBI which has
– A dedicated pool of capital raised in a manner
specified in the regulations and
– Invests in Venture Capital Undertakings (VCUs) in
accordance with these regulations.

VCU
• A VCU means a domestic company
• Whose shares are not on a recognized stock
exchange in India.
• Which is engaged in the business of providing
services/production/manufacture of
articles/things excluding a negative list.

• All VCFs must be registered with SEBI and pay
Rs 25,000 as application fee and Rs 5,00,000
as registration fee for grant of certificate.
• They cannot invest more than 25% corpus of
the fund in one VCU.

Questions for Revision
• What is Venture Capital ? What is Private
Equity?
• What is the process of acquiring Venture
Capital Financing?
• Explain the different stages of Venture Capital
Investment?
• Write a short note on the different types of
Venture Capitalists?

• Write a short note on exit for Venture Capital
Funds?
• Where Does Venture Capital Money Come
From?
• How do Venture Capitalists make money?

• Write a short Note on Venture Capital in
India?
• Write a short note on the regulatory
framework for Venture Capital in India?

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