Source: E-mail dt. 7 June 2012
Emerging paragigms in Venture Capital regulatory reforms
Dr. R. Karuppasamy M.Com., MBA, M.Phil., Ph.D., PLME
Director, Management Studies, SNS College of Technology, Coimbatore, Tamilnadu, India
Mr. C. Arul Venkadesh MBA, PGDPM (IRLL), (PhD)
Assistant Professor – Department of Management Sciences, CIET College. Coimbatore, Tamilnadu, India
"There is a tide in the affairs of men, which taken at the flood, leads on to fortune. And we must take the current when it serves, or lose our ventures."
~ William Shakespeare
Growth is the process that only happens when the un tread is tried and the undone is materialized. For any new venture we undertake there is always apprehension of misses than hitting the bull’s eye and this apprehension for years has curbed the entrepreneurs from innovating and growing. Venture Capital is the conduit for giving the entrepreneurs wings to fly when they are willing to jump of the cliff. Simply put, Venture Capital is a term coined for the capital required by an entrepreneur to ‘venture’ into something new, promising and unconventional. Investing in a budding company has always been a risky proportion for any financier. The risk of the business failure and the apprehensions of an all together new project clicking weighed down the small entrepreneurs to get the start-up fund. The Venture Capitalists or the angel investors then came to the forefront with an appetite for risk and willingness to fund the ventures.
The development of the organized venture capital industry in India, as is in existence today was slow and belabored, circumscribed by resource constraints resulting from the overall framework of the socialistic economic paradigms. Although funding for new businesses was available from banks and government owned development financial institutions, it was provided as collateral-based money on project-financing basis, which made it difficult for most new entrepreneurs, especially those who were technology and services based, to raise money for their ideas and businesses. Most entrepreneurs had to rely on their own financial resources, and those of their families and well wishers or private financiers to realize their entrepreneurial dreams.
The regulations in India have been carefully drafted but then have left ambiguity in understanding to many. Though the laws relating are not complex but then they do not lay down clear cut laws; susceptible to interpretations and discussions. Section 2(m) defines a VCF is a corpus of funds created by raising funds in a specific manner to be invested in a manner as specified in the regulations. This means any activity beyond the periphery of what is laid in the charter is prohibited. A VCF can be created in a form of a 1) trust, 2) company including 3) a body corporate. This means that no matter what the form of a VCF is the core substance shall remain the same. The VCF is segregated into “schemes” in which the funds are invested. The scheme relates to investing the money into venture capital undertakings as defined under sec 2 (n) of the regulations. A VCF raises money from the investors in the form of “units” (discussed below) to be invested in these schemes.
Venture Capital financing is a process whereby funds are pooled in for a period of around 10 years and investing it in venture capital undertakings for a period of 3 to 5 years with an expectation of high returns. To protect the funds of the investors against the risk of losses, venture capital fund provides its expertise, undertake advisory function and invest in the ‘patient capital’ of the undertaking – equities. Venture Capital financing had been a popular source of funding in many countries and served as a lucrative bait to create a similar industry in India as well.
Venture Capital is a form of "risk capital". In other words, capital that is invested in a project (in this case - a business) where there is a substantial element of risk relating to the future creation of profits and cash flows. Risk capital is invested as shares (equity) rather than as a loan and the investor requires a higher "rate of return" to compensate him for his risk.
The main sources of venture capital in the UK are venture capital firms and "business angels" - private investors. Separate Tutor2u revision notes cover the operation of business angels. In these notes, we principally focus on venture capital firms. However, it should be pointed out the attributes that both venture capital firms and business angels look for in potential investments are often very similar.
Venture capital provides long-term, committed share capital, to help unquoted companies grow and succeed. If an entrepreneur is looking to start-up, expand, buy-into a business, buy-out a business in which he works, turnaround or revitalise a company, venture capital could help do this. Obtaining venture capital is substantially different from raising debt or a loan from a lender.
Lenders have a legal right to interest on a loan and repayment of the capital, irrespective of the success or failure of a business. Venture capital is invested in exchange for an equity stake in the business. As a shareholder, the venture capitalist's return is dependent on the growth and profitability of the business. This return is generally earned when the venture capitalist "exits" by selling its shareholding when the business is sold to another owner.
Venture capital in the UK originated in the late 18th century, when entrepreneurs found wealthy individuals to back their projects on an ad hoc basis. This informal method of financing became an industry in the late 1970s and early 1980s when a number of venture capital firms were founded. There are now over 100 active venture capital firms in the UK, which provide several billion pounds each year to unquoted companies mostly located in the UK.
Venture Capital Early Beginnings
The development of the organized venture capital industry in India, as is in existence today, was slow and belabored, circumscribed by resource constraints resulting from the overall framework of the socialistic economic paradigms. Although funding for new businesses was available from banks and government owned development financial institutions, it was provided as collateral-based money on project-financing basis, which made it difficult for most new entrepreneurs, especially those who were technology and services based, to raise money for their ideas and businesses. Most entrepreneurs had to rely on their own financial resources, and those of their families and well wishers or private
financiers to realize their entrepreneurial dreams.
In 1972, a committee on Development of Small and Medium Enterprises highlighted the need to foster venture capital as a source of funding new entrepreneurs and technology. This resulted in a few incremental steps being taken over the next decade-and-a-half to facilitate venture capital funds into needy technology oriented Small and medium Enterprises (SMEs), namely:
These schemes provided some succour to a limited number of SMEs but the activity of venture capital industry did not gather momentum as the funding was based on investment evaluation processes that remained largely collateral based, rather than being holistic, and the policy framework remained unaltered, without the instruments to inject dynamism in the VC industry. Also, there was no policy in place to encourage and involve the private sector in the venture capital activity.
The Funding Process
Step 1: Business Plan Submission
The first step in approaching a VC is to submit a business plan. At minimum, your plan should include:
- A description of the opportunity and market size;
- resumes of your management team;
- A review of the competitive landscape and solutions;
- Detailed financial projections; and
- A capitalization table.
You should also include an executive summary of your business proposal along with the business plan. Once the VC has received your plan, it will discuss your opportunity internally and decide whether or not to proceed. This part of the process can take up to three weeks, depending on the number of business plans under review at any given time.
Don’t be passive about your submission. Follow up with the VC to check the status of your proposal and to find out if there’s additional information you could be providing that might help the VC with its decision. If you are asked for further information, respond
Quickly and effectively. If possible, always try to get a face-to-face meeting with the VC. Keep in mind that most VCs receive an average of 200 business plans each month. Of those, less than five percent will be invited to meet with the VC’s partners. Just two percent will reach the due diligence phase, and less than one percent will be offered a term sheet. Some 0.3 percent of those submitting a business plan will ultimately obtain VC funding. The overwhelming majority of successful proposals come from a trusted referral of the VC, such as a limited partner, another VC, a known attorney or accountant, or other professional. If you can get your business plan referred by such a contact, you dramatically increase your odds of succeeding in getting VC funding.
Step 2: Introductory Conversation/Meeting
If your firm has the potential to fit with the VC’s investment preferences; you will be contacted in order to discuss your business in more depth. If, after this phone Conversation, a mutual fit is still seen, you’ll be asked to visit with the VC for a one- to two hour meeting to discuss the opportunity in more detail. After this meeting, the VC will determine whether or not to move forward to the due diligence stage of the process. Step 3: Due Diligence The due diligence phase will vary depending upon the nature of your business proposal. The process may last from three weeks to three months, and you should expect multiple phone calls, emails, management interviews, customer references, product and business strategy evaluations and other such exchanges of information during this time period.
Step 3: Term Sheets and Funding
If the due diligence phase is satisfactory, the VC will offer you a term sheet. This is a non-binding document that spells out the basic terms and conditions of the investment agreement. The term sheet is generally negotiable and must be agreed upon by all parties, after which you should expect a wait of roughly three to four weeks for completion of legal documents and legal due diligence before funds are made available.
Regulations of Venture Capital:
VCF are regulated by the SEBI (Venture Capital Fund) Regulations, 1996. The regulation clearly states that any company or trust proposing to carry on activity of a VCF shall get a grant of certificate from SEBI. Section 12 (1B) of the SEBI Act also makes it Mandatory for every domestic VCF to obtain certificate of registration from SEBI in accordance with the regulations. Hence there is no way that an Indian Venture Capital Fund can exist outside SEBI Regulations. However registration of Foreign Venture Capital Investors (FVCI) is not mandatory under the FVCI regulations.
A VCF and registered FVCI enjoy several benefits:
• No prior approval required from the Foreign Investment Promotion Board (FIPB) for making investments into Indian Venture Capital Undertakings (VCUs).
• As per the Reserve Bank of India Notification No. FEMA 32 /2000-RB dated December 26, 2000, an FVCI can purchase/ sell securities/ investments at a price that is mutually acceptable to the parties and there is no ceiling or floor restriction applicable to them.
• A registered FVCI has been granted the status of Qualified Institutional Buyer (QIB), so they can subscribe to the share capital of a VCU at the time of intial public offer. A lock-in of one year is applicable to the shares subscribed in an IPO.
• The lock-in period applicable for the pre-issue share capital from the date of allotment, under the SEBI (Disclosure and Investor Protection) Guidelines, 2000 is not applicable in case of a registered FVCI and VCF.
• Under the SEBI (Substantial Acquisition of Shares and Takeover) Regulations, 1997 if the promoters want to buy back the shares from FVCIs, it would not come under the public offer requirements.
1999 - The Companies (Amendment) Act, 1999 - Prior approval of Central Govt. dispensed with. investment by a company exceeding 60% [paid-up share capital + free reserves] or 100% free reserve, whichever is more, can be made by way of Special Resolution in General Meeting
2000 - SAST not to apply to the shares transferred from VCF or FVCI to the promoters or to the company itself, if effected as per pre-existing agreement between VCF or FVCI & promoters of the company. If promoters buy back the shares from FVCI then no requirement of public offering.
2000 - As per FEMA, FVCI can acquire or sell any investment held by it at a mutually acceptable price
2001 - The Companies (Amendment) Act, 2001 reduced the period of issue of fresh shares from 24 months to 6 months from when the company completes the buy back of its shares
2001 - The Companies (Issue of share capital with differential voting rights) Rules 2001, allowed every company limited by shares to issue shares with differential rights (voting or dividend)
2003 - Qualified Institutional Buyer “QIB” status granted to VCF / FVCI as per SEBI(DIP) guidelines. Can subscribe securities at IPO of a VCU through book-building process.
2004 - Lock-in period of one year after listing removed.
- Investible fund limit decreased to 66.67% from 75% in unlisted companies
- Removal of Real Estate from negative list of Schedule III
2004 - Permitted to invest in NBFC engaged in equipment leasing or Hire Purchase.
FVCI allowed to invest 100% in one VCU, as compared to 25% earlier.
2005 - Press Note 1 of 2005, exemption from prior Govt. approval under press note 18 of 1998
Flexible Structure - LLP / LLC
Flexibility in investment
· At present VCF cannot invest more than 25% of the funds in one VCU.
§ Though SEBI has relaxed VC guidelines, but since VC is a high risk capital, it needs more flexibility in investment
Relaxation in lock-in period
· At present investment of VCF in preferential allotment of equity shares of a listed company is subject to lock in period of one year
· At present there is a lock in period of one year on pre IPO shares, held by VCFs or FVCIs (exceptions)
Venture capital is a unique form of finance capital with special implications for high-technology economic development. Conventional wisdom suggests that venture capital will stimulate high-technology development. Venture Capital is a term coined for the capital required by an entrepreneur to ‘venture’ into something new, promising and unconventional. Investing in a budding company has always been a risky proportion for any financier. The risk of the business failure and the apprehensions of an all together new project clicking weighed down the small entrepreneurs to get the start-up fund. The Venture Capitalists or the angel investors then came to the forefront with an appetite for risk and willingness to fund the ventures. The development of the organized venture capital industry in India, as is in existence today, was slow and belaboured, circumscribed by resource constraints resulting from the overall framework of the socialistic economic paradigms. Although funding for new businesses was available from banks and government owned development financial institutions, it was provided as collateral-based money on project-financing basis, which made it difficult for most new entrepreneurs, especially those who were technology and services based, to raise money for their ideas and businesses. Most Indian entrepreneurs had to rely on their own financial resources, and those of their families and well wishers or private financiers to realise their entrepreneurial dreams.