CCS Report
CCS Report
Presented to
Professor Ravi Anshuman & PGP Office
Indian Institute of Management, Bangalore
On
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
1. Overview of venture capital
a. History
b. Definition
2. Snap shop of the global VC industry in 2006
a. The US venture capital industry
b. The European VC industry
c. The Israeli VC industry
d. The Chinese VC industry
3. An academic look and literature survey of the Venture capital cycle
a. Deal sourcing
b. Due-diligence
c. Valuation
d. Deal structuring
e. Post financing engagement
f. Exit
4. The Indian VC industry
a. Overview
i. History
ii. Size, activity, investments,
iii. trends
iv. sources of funds
v. active players
vi. Peculiarities of the Indian industry
5. Case studies
a. Suzlon energy
b. ICICI Ventures and Dr Reddys – innovative deal structuring
c. Yes Bank
d. Bharti Televentures
e. Patni Computers
f. Biocon
g. India Bulls
h. NDTV
Need for the study
Emerging markets are the 1st and 2nd most attractive FDI destinations for investors
globally. India has 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 survey1.
Rank
1
2
3
4
5
6
7
8
9
10
2005
China
India
United States
United Kingdom
Poland
Russia
Brazil
Australia
Germany
Hong kong
2004
China
United States
India
United Kingdom
Germany
France
Australia
Hongkong
Italy
Japan
2003
China
United States
Mexico
Poland
Germany
India
United Kingdom
Russia
Brazil
Spain
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
1
AT Kearney FDI Confidence Survey 2005
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 investments3. 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, 4the 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 operation5. SBICs have provided capital to
several of the industrial giants and household names of today including Apple, Fedex and
Intel.
“Hand book of Alternate Assets”, Mark J.P Anson
“Towards a Global Venture Capital model”, William Megginson, University of Oklahoma, Dec 2001
4
Note on Venture Capital, Martin Kenney
5
www.indiainfoline.com/bisc/veca/ch04.html
2
3
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 Capital 2,3
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 venture capital exclude buyouts, mezzanine, and other financial
transactions. Venture capitalists invest in equity in the form of common stock, or
preferred stock, convertible debentures, or other financial instruments convertible into
common stock when the small company is sold either through a merger or a public equity
offering. At this liquidity event venture capitalists realize their profits in 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 on
boards of directors, and meting out financing based on the attainment of milestones.
Unlike banks which restrict their activities to monitoring the financial health of firms that
they lend to, venture capitalists monitor strategy and investment decisions as well as take
an active role in advising the firm. Venture capitalists often intervene in the company’s
operations when necessary. In addition, venture capitalists provide entrepreneurs with
access to consultants, investment bankers, and lawyers6
There are four basic categories of institutional venture capital funds, as described in Pratt
(1997).
I. Small Business Investment Companies (SBICs): federally chartered corporations
established as a result of the Small Business Administration Act of 1958. SBICs
have invested over $14 billion in approximately 80,000 small firms. Historically,
these venture capitalists have relied on their unique ability to borrow money from
the U.S. Treasury at very attractive rates and hence were the only types of venture
capitalist that preferred to structure their investments as debt rather than equity.
II. Subsidiaries of financial institutions, particularly commercial banks. These are
generally set up with the belief that portfolio companies will ultimately become
profitable customers of the corporate parent.
III. Corporate venture capital funds are subsidiaries or stand-alone firms established by
non-financial corporations. These are generally established by industrial firms eager
to gain access to emerging technologies by making earlystage investments in hightech firms.
IV. Finally, venture capital limited partnerships are funds established by professional
venture capital firms, which act as the general partners organizing, investing,
managing, and ultimately liquidating the capital raised from the limited partners.
While most venture capital limited partnerships have a single-industry focus, the
firms themselves are not associated with any single corporation or group.
6
‘ What drives Venture Capital Fundraising?’, Paul Gompers and Josh Lerner
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 varying focus of investors. While
later-stage deals represented the majority of deal flow, or 37% of all venture capital deals
over the course of the year, the interest in early-stage deals ran a close second,
7
8
Global venture Capital Insights Report 2006, Ernst & Young
Global venture Capital Insights Report 2006, Ernst & Young
representing 35% of the year’s financing rounds, up from 34% in 2004. Second-round
financings which made up only 20% 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 because of the increasing globalization of the technology
market and the need to provide entrepreneurial companies with larger rounds of financing
so they can compete and create a presence internationally
.
Increased Investor Segmentation according to Industries
The investment preference of VC and PE investors in the United States is 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 2005 showed the great contrasts in this
market. On the one hand, European liquidity activity for venture backed companies
rebounded significantly, particularly for initial public 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 fundraising in Europe reached its highest level in
three years. But on the other hand, venture capital deal flow took a steep decline and the
capital invested shrank considerably.
In 2005, seed- and first-round deals accounted for just 31% of all deals in Europe, down
from 33% in 2004. In addition, the percentage of overall investment in early-stage rounds
was just 22% in 2005, down from 28% in the preceding year. In contrast, later-stage deals
represented 40% of all financing rounds in 2005, up significantly from the 33% in 2004.
The ability of venture-capital supported companies in Europe to achieve IPO exits in
larger numbers was clearly related to the new availability of exchanges such as AIM,
which provides a marketplace for relatively young entrepreneurial companies.
Chinese Venture Capital Industry9
The venture capital industry in China is heating up even though 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
9
China's Venture Capital System and Investment Decision-making, Dr. Wei Zhang
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 include 6

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 presents an 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 sourcing10
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.
10
Website : http://www.indiainfoline.com/bisc/veca/ch13.html
Website :: http://www.venturechoice.com/vc_blog/

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 Diligence11:
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
“Note on Due Diligence in Venture capital”, Tuck School of Business, Dartmouth. Center for Private
Equity and Entrepreneurship
11
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
o Management
o Market
o Product/ service
o Business model
o Origin of the deal
Valuation
Valuation in Private Equity12
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
First firms that display similar ‘value characteristics’ are selected. These characteristics
include risk, growth rate, capital structure, and the size and timing of cash flows. Often,
these value characteristics are driven by other underlying attributes of the company which
can be incorporated in a multiple. This valuation method is most useful when all the
chosen comparable firms are publicly traded and their capital structure, revenue, profit
margins, net profit figures are known. Common measures used are:

P-E Ratio

Price to sales ratio

Market-to-book ratio(shareholder’s equity)

Market Value to EBITDA ratio
Some of the disadvantages of this method are

The need to make adjustments (smudge factors) to account for the illiquidity of a
private firm when using publicly traded comparables.
This note draws upon the work of Josh Lerner in “A Note on Valuation in Private Equity settings”,
published in the Venture Capital and Private Equity Case book. And a note on How to value startups and
emerging companies ? by Amit Bapat (http://cpd.ogi.edu/MST/capstone/StartUpValuation.pdf)
12

The difficulty of obtaining appropriate comparable companies
NPV Method
This method used the present value of cash flows discounted at the appropriate cost of
capital. The disadvantages associated with this method are that

WACC assumes a constant capital structure and a constant effective tax rate
neither of which may hold true in the case of venture backed companies with
multiple rounds of financing and probable Net operating losses in early years.

The valuation is also very sensitive to discount rate and terminal value
assumptions
Adjusted present value method is a variation of the NPV method.
When a firm’s capital structure is changing or it has net operating losses (NOL) that can
be used to offset taxable income, APV method is used. If a firm has NOLs then its
effective tax rate changes over time, as NOLs are carried forward for tax purposes and
netted against taxable income. APV accounts for the effect of the firm’s changing tax
status by valuing NOLs separately.
Thus under APV method,

First cash flows are valued ignoring the capital structure.

The discount rate used is different than in NPV method as it is assumed that the
company is financed totally by equity. This implies that the discount rate should
be calculated using unlevered beta.

The tax benefits associated with the capital structure are then estimated. The net
present value of the tax savings from tax-deductible interest payments is
quantified.

The interest payments will change over time as debt levels change. By convention
the discount rate for this calculation is pre-tax rate of return on debt which will be
lower than cost of equity.

Finally NOLs available to the company are quantified. The discount rate used to
value NOLs is often pre-tax rate on debt. If it is almost certain that NOLs will
result in tax benefits risk free rate can also be used as the discount rate.
Shortcomings of this method are similar to the NPV method. However the problems
related to WACC are eliminated.
Venture capital method
This method is the most commonly applied method in the private equity industry
especially when dealing with early stage companies. Most private equity investments are
characterized by negative cash flows and earnings in the early stages and highly uncertain
but potentially substantial future rewards. The VC method accounts for this profile by
valuing a company using a multiple, at a time in the future when it is projected to have
achieved positive cash flows and earnings. This terminal value is then discounted back to
the present value at a typically very high discount rate 40% to 75% depending on the
target IRR of the Private Equity firm to arrive at the equity stake demanded by the
investor.
Although this method is commonly used, it suffers from the excessive reliance on the PE
approach to calculating the exit valuation of the company.
Options valuation method
This is a relatively new method and is not yet extensively used even in developed
markets such as the US.
The underlying rationale for this method is as follows:
DCF methods like NPV and APV can be deficient in situations where a manager or
investor has flexibility in terms of changing rate of production, defer deployment or
abandon a project. These changes affect the value of the firm which can not be measured
accurately using discounted cash flow methods. Private equity-backed companies are
often characterized by multiple rounds of funding. Venture capitalists use this multi-stage
approach to motivate the entrepreneur to perform better and limit their exposure to a
particular company.
In this method firms are analyzed like a financial option. There are five variable
commonly used in a financial option:
X = exercise price
S = stock price
T = time to expiration
σ = standard deviation of returns on the stock
r = time value of money
In the firm option, they are interpreted as:
X = Present value of expenditures required to undertake a project
S = Present value of the expected cash flows generated by the project
T = The length of time that the investment decision can be deferred
σ = riskiness of the underlying assets
r = risk free rate of return
Once these variables are know the value of the option can be calculated using BlackScholes computer model.
Non Financial considerations
Along with the above valuation methods that mainly rely on financial data, investors also
consider several non financial considerations while valuing a company:

Quality of management team

Current state of technology

Current state of companies in similar market

Current market conditions

Size of the market and company’s potential to acquire market share

Track record of entrepreneur; repeat entrepreneurs get better valuation

Distribution of bargaining power between VC and entrepreneur
Cost of capital and required rates of return
When using P/E or similar benchmarks for valuation of venture capital investments the
fudge factor to accommodate liquidity discount is as much as 30% of overall valuation.13
Investor return expectations:
As a rough guideline for expected investor returns14,
Seed or startup investment
60% or more per annum
Early stage investments
50% or more per annum
Development capital investment
35-40% per annum
MBO/MBI
Over 30% per annum
Other literature on the expectations of investors also paints a similar picture:
Bygrave and Timmons15 (1992), note, that independent private venture capital firms
expected a minimum annualized rate of return on individual investments that ranged from
75% for seed-stage financing to about 35% per year for bridge financing.
Rich and Gumpert16 (1991) state, that companies with fully developed products and
proven management teams should yield between 35% and 40% on their investment,
13
The Venture Capital Handbook, William Bygrave, Micheal Hay and Jos B Peeters
Note on Deal structuring and pricing, The Venture Capital Handbook, William Bygrave, Micheal Hay
and Jos B Peeters
15
“Cost of capital for Venture Capitalists and Under diversified investors”, Frank Kerkins, Janet Kiholm
Smith and Richard Smith, 2002
16
“Cost of capital for Venture Capitalists and Under diversified investors”, Frank Kerkins, Janet Kiholm
Smith and Richard Smith, 2002
14
while those with incomplete products and management teams are expected to bring in
60% annual compounded returns. In these statements, the cited percentages properly are
interpreted as targets for analysis of a success scenario, and not as statistical expectations.
Deal Structuring
Typical deal structuring in the US17
The terms and structure of an offer to invest in a company is usually charted out in a term
sheet. There are brief preliminary, non binding documents designed to facilitate and
provide a framework for negotiations between investors and entrepreneurs. A term sheet
generally focuses on a given enterprise’s valuation and the conditions under which
investors agree to provide financing. The term sheet eventually forms the basis of several
formal agreements including the “Stock Purchase Agreement,” which is a legal document
that details who is buying what from whom, at what price, and when.
Typically, term sheets also contain additional control provisions, to mitigate various risks
that the investor perceives in an investment. The nature of securities used in these
investments also provides insights into the various risks perceived and the mitigating
mechanisms used
Commonly used securities in structuring VC deals:
Different investments have varying risk/reward characteristics which call for different
types of securities to accommodate investors goals.
The most common types used in venture capital transactions are described below.
Common stock is a type of security representing ownership rights in a company, usually
entitles the owner to one vote per share as well as any future dividend payments. Usually,
17
“Note on Private Equity Deal Structures” Tuck school of Business, Dartmouth
company founders, management and employees own common stock while investors own
preferred stock. Claims of secured and unsecured creditors, bondholders and preferred
stockholders take precedence over those of the common stockholders.
Convertible preferred stock provides its owner with the right to convert to common
shares of stock. Usually, preferred stock has certain rights that common stock does not
have, such as a specified dividend that normally accrues and senior priority in receiving
proceeds from a sale or liquidation of the company. Therefore, it provides downside
protection due to its negotiated rights and allows investors to profit from share
appreciation through conversion.
The face value of preferred stock is generally equal to the amount that the VC invested.
For valuation purposes, convertible stock is usually regarded as a common stock
equivalent. Typically, convertible preferred stock automatically converts to common
stock if the company makes an initial public offering (IPO). When an investment banking
underwriter is preparing a company to go public, it is critical that all preferred investors
agree to convert so the underwriter can show public investors that the company has a
clean balance sheet. Convertible preferred is the most common tool for private equity
funds to invest in companies.
Participating preferred stock is a unit of ownership that is essentially composed of two
elements -- preferred stock and common stock.

The preferred stock element entitles an owner to receive a predetermined sum of
cash (usually the original investment plus any accrued dividends) if the company
is sold or liquidated.

The common stock element represents additional continued ownership in the
company (i.e. a share in any remaining proceeds available to the common
shareholder class).
Like convertible preferred stock, participating preferred stock usually converts to
common stock (without triggering the participating feature) if the company makes an
initial public offering (IPO). Participation can be pari passu or based on seniority of
rounds.
Multiple Liquidation Preference is a provision that gives preferred stock holders of a
specific round of financing the right to receive a multiple (2x, 3x, or even 6x) of their
original investment if the company is sold or liquidated. A multiple liquidation
preference still allows the investor to convert to common stock if the company does well,
and it provides a higher return (assuming the selling price is sufficient to cover the
multiple) if an IPO is unlikely.
Redeemable preferred stock can be redeemed for face value at the choice of the
investor. Sometimes called straight preferred, it cannot be converted into common stock.
Usually, the terms of the issue specify when the stock must be redeemed, such as after an
IPO or a specific time period. Redeemable preferred gives the investor an exit vehicle
should an IPO or sale of the company not materialize.
Convertible debt is a loan vehicle that allows the lender to exchange the debt for
common shares in a company at a preset conversion ratio.
Mezzanine debt is a layer of financing that often has lower priority than senior debt but
usually has a higher interest rate and often includes warrants.
Senior debt is a loan that enjoys higher priority than other loans or equity stock in case
of a liquidation of the asset or company.
Subordinated debt is a loan that has a lower priority than a senior loan in case of a
liquidation of the asset or company.
Warrants are derivative securities that give the holder the right to purchase shares in a
company at a pre-determined price. Typically, warrants are issued concurrently with
preferred stock or bonds in order to increase the appeal of the stock or bonds to potential
investors. They may also be used to compensate early investors for increased risk.
Options are rights to purchase or sell shares of stock at a specific price within a specific
period of time. Stock purchase options are commonly used as long-term incentive
compensation for employees and management.
Anti-Dilution - Dilution occurs when an investor’s proportionate ownership is reduced
by the issue of new shares. Investors are primarily concerned with “down rounds,” or
financing rounds that value the company’s stock at a lower price per share than previous
rounds. Down rounds may occur due to a number of factors like economic conditions or
company performance. Since investors cannot determine with certainty whether a
company will undergo a down round, they negotiate certain rights, or anti-dilution
provisions referred to as “ratchets,” that may protect their investment.
The two most common mechanisms are full ratchets and weighted average ratchets.

Full Ratchets protect investors against future down rounds. A full ratchet
provision states that if a company issues stock to a lower price per share than
existing preferred stock, then the conversion price of the existing preferred stock
is adjusted (or “ratcheted”) downward to the new, lower price. This has the effect
of protecting the ratchet holder’s investment by automatically increasing his
number of shares at the expense of stockholders who do not enjoy full ratchet
protection.

Weighted average provisions are generally viewed as being less harsh than full
ratchets. In general, the weighted average method adjusts the investor’s
conversion price downward based on the number of shares in the new (dilutive)
issue. If relatively few new shares are issued, then the conversion price will not
drop too much and common stockholders will not be crammed down as severely
as with a full ratchet. If there are many new shares and the new issue is highly
dilutive to earlier investors, however, then the conversion price will drop more
o The weighted average protection may be broad-based, taking into
account all shares outstanding before the new dilutive issue
o Narrow based, which takes into account only preferred stock or omit
options outstanding.
Pay-to-play (aka Play or Pay) Provisions are usually used with price-based antidilution measures, these provisions require an investor to participate (proportionally to
their ownership share) in down rounds in order to receive the benefits of their antidilution provision. Failure to participate results in forced conversion from preferred to
common or loss or the anti-dilution protection. This encourages VCs to support
struggling portfolio companies through multiple rounds and increases the companies’
chances of survival.
Other Issues In addition to the key financial provisions described above, term sheets
usually include a number of other important items related to control, and a mix of
financial and non-financial terms is common. Many of the provisions described in this
paper, both financial and non-financial, tend to be used more often during difficult
economic times. It should be noted that overly burdensome, shortsighted terms may
misalign interests and invite the competition to provide a better deal. Some non-financial
terms are discussed below:
Voting Rights. Term sheets often address issues of control in order to allow investors in
a company to add value and also to exercise control if things go wrong. While investors
may not want majority board control if things are going well, they may negotiate
provisions that give them control if certain events occur.
Board Representation. Venture capitalists may negotiate control of part of the Board of
Directors, generally to influence decision-making and to protect their investments rather
than to run the company. Often, classes of stockholders are allowed to elect a percentage
of the board members separately. If venture capitalists invest as a syndicate and board
representation is not possible for all of the participating firms, then board observer
rights are an option. These rights allow investors to monitor their portfolio companies
and to influence decisions by being present at board meetings, but they are not allowed to
vote.
Covenants. Most preferred stock issues and debt issues have associated covenants, or
things that the portfolio company promises to do (positive covenants), and not to do
(negative covenants). They are negotiated on a case-by-case basis and often depend on
other aspects of the deal. Failure to comply with covenants can have serious
consequences to the company such as automatic default and payments due.
Vesting. This provision states that a manager or entrepreneur earns ownership of
common stock or options only after a predetermined period of time or after the company
achieves certain milestones. The most important effect of vesting is that it motivates
employees to stay with the company and may prevent them from leaving prematurely to
pursue other opportunities.
Bridge Loans. Bridge financing can be used to prepare a company for sale or as a preround financing. A bridge is, in essence, short term financing designed to be either repaid
or converted into ownership securities.

In the sale case, a bridge is useful when a company needs a relatively small
amount of capital to achieve its final targets and achieve maximum value in the
eyes of potential buyers.

A bridge is also useful to pump cash into a company quickly while investors are
found to complete a formal round of financing. Bridge investors often insist on
warrants or equity kickers to compensate them for the higher risk of lending
money to high growth ventures.
If the “bridge” becomes a “pier,” that is, no additional sources of funding step up to the
challenge, then the bridge lenders have senior rights to any equity holders for the
remaining assets of the company.
Phased financing. A venture capital firm may agree to phased financing, or incremental
financing in tranches. In this case, the entrepreneur and his or her team must reach certain
milestones in order for the venture capitalist to agree to invest more capital in the startup.
This has the additional benefit of allowing the startup and the venture firms to trumpet
the larger commitment amount, generating positive PR, while limiting the actual cash
disbursements until the startup has proven itself.
Results of some theoretical studies made:18

Unlike in the United States, where the use of convertible preferred securities is
ubiquitous in private equity, substantially different securities are employed in
developing nations. More than one-half of the transactions employ common stock,
and a subset of transactions employ instruments that are essentially debt.

Private equity investor rights that are standard in the United States, such as antidilution provisions, are encountered far less frequently.

In nations where the rule of law is less established, private equity groups are less
likely to employ preferred securities. They are likely, however, to have a majority
of the firm’s equity and to make the size of their equity stakes contingent on the
performance of the company.
Exits19
Exiting an investment is a key consideration that drives the structuring, valuation, post
financing role and even the prefinancing due-diligence of the investor.
There are 4 primary exit options for venture capital and private equity investments
1. IPOs or through sale in the secondary market(in the case of PIPEs)
2. Trade sale
“PE in the Developing world: Determinants of Transaction Structures”, Josh Lerner and Antoinette
Schoar
19
This note draws upon, among other references, the teaching notes and class lectures of Prof. Sabarinathan
of the Indian Institute of Management Bangalore.
18
3. Sale of the financial interest of the investor by the promoters of the company
4. Buy back of the investor’s financial through the company’s cashflows
A brief discussion on each of the methods follow
1. IPO – this is often the most preferred mode of exit by the PE/VC investors as it
usually leads to the realization of the highest returns. Typically the most
successful investments of a private equity fund reach the IPO stage. Apart from
capital appreciation, some of the other payoffs for investors is the visibility that it
creates for the VC fund. Given the levels of visibility and performance
demonstrated by IPO, it becomes easier for an investor to raise subsequent funds
and generate reputation capital based on the number of investments taken public.
Infact private equity investors have often been accused to dragging their investee
companies too soon into an IPO primarily for the purpose of creating a public
demonstration of success – a phenomenon that has been termed as
grandstanding20.
The IPO route of exit however is fraught with many difficulties and
imponderables. One important consideration is the dynamics of the market for
primary listings. Investors in the capital markets are receptive to certain industries
at certain times and luke warm to the same industries at other times. These
“windows of opportunity” are difficult to predict and time appropriately.
Further there is also the question of preparing the company to go public. A public
company under the scrutiny of the market is subject to several disclosure norms
that have direct and indirect costs on the management including the need to put in
place the necessary internal organization structure that is needed to generate
periodic filings and other indirect costs such as managerial distraction. Further the
“Grandstanding in the Venture Capital Industry” Journal of Financial Economics, 43 (September 1996)
pages 133-156. Josh Lerner
20
pressure to deliver quarter on quarter earnings can force companies to focus on
short term profit maximizing behavior. It is estimated that the process of
“preparing the company” for the IPO may be as long as a year.
2. The Trade Sale
The trade sale is one of the most common exit route for investors especially in
economies where the absence of a mature capital market for small company IPOs
preclude the IPO mode of exit. Often trade sale is also a viable opportunity for
companies that have not performed as great as expected and hence serves as a
residual alternative for companies that have not made the grade for an IPO.
Further, the investors are not subject to any risk of share price decline post as IPO
exit if the trade sale route is adopted. On the negative side, the returns that are
generated in a trade sale are usually deemed lesser that that derived in an IPO.
The reason is that valuations may be more stringent in a trade sale.
Trade sales have emerged as a frequent exit route as several large business look to
grow inorganically in order to cope with rapid changes in technology, business
development cycles, and innovative new product development. Further several
startups in developed nations are built around the strategy of “built to sell” i.e.
they identify gaps in the product technology gaps of existing offerings and build
products around such gaps with the intention of achieving a sell off to large
incumbent companies at attractive valuations.
Part 4
The Indian VC and Private Equity Industry
History21
The first formal venture capital organizations in India began in the public sector.
First Phase (pre 1995)
Indian policy toward venture capital has to be seen in the larger picture of the
government’s interest in encouraging economic growth. In 1988, the Indian government
issued its first guidelines to legalize venture capital operations and were aimed at
allowing state-controlled banks to establish venture capital subsidiaries.
In November 1988, the Indian government announced an institutional structure for
venture capital (Ministry of Finance 1988). The World Bank had earlier observed that the
focus on lending rather than equity investment had led to institutional finance that had
become “increasingly inadequate for small and new Indian companies focusing on
growth” (World Bank 1989: 6).
The most important feature of the 1988 rules was that venture capital funds received the
benefit of a relatively low capital gains tax rate. They were also allowed to exit at prices
not subject to the control of the Controller of Capital Issues (which otherwise did not
permit exit at a premium over par). The funds’ promoters could be banks, large financial
institutions, or private investors. The funds were restricted to investing in small amounts
per firm (less than 100 million rupees); the recipient firms had to be involved in
technology that was “new, relatively untried, very closely held or being taken from pilot
to commercial stage, or which incorporated some significant improvement over the
existing ones in India.” The government also specified that the recipient firm’s founders
should be “relatively new, professionally or technically qualified, and with inadequate
resources or backing to finance the project.”
This note is based on the study by the Asia Pacific Research Center, Stanford University titled “Creating
an environment: Developing Venture Capital in India”, Rafiq Dossani and Martin Kenney.
21
There were also other guidelines including a list of approved investment areas. Two
government-sponsored development banks, ICICI and IDBI, were required to
clear every application to a venture capital firm. Also, the Controller of Capital Issues
had to approve every line of business the VC firm wished to invest.
Four state-owned financial institutions established venture capital subsidiaries under
these restrictive guidelines and received a total of $45 million from the World Bank.
funds, two of which were established by state-level financial institutions (Andhra Pradesh
and Gujarat), one by Canara Bank and one by ICICI. The venture capital funds were
expected to be investing principally in equity or quasi-equity.
The venture capitalists agreed with the World Bank that they would operate under the
following operating guidelines:
(a) the primary target groups for investment would be private industrial firms in
sectors where India had a comparative advantage, and protected industries would
be avoided;
(b) the quality and experience of the management was key, along with the prospects
of the product;
(c) the portfolio return should be targeted to be at least a 20 percent annual return;
(d) no single firm should receive more than 10 percent of the funds, and the venture
capitalist would not own more than 49 percent of its voting stock.
ICICI had begun a small investing division at its Mumbai headquarters in 1985 focused
upon unlisted, early stage companies.
Nadkarni and ICICI Chairman Vaghul implemented a novel instrument for India, termed
the “conditional loan.” It carried no interest but entitled the lender to receive a royalty on
sales (ICICI charged between 2 percent and 10 percent as a royalty). They would
typically invest 3 million rupees in a firm, of which one-third was used to buy equity at
par for about 20–40 percent of the firm, while the rest was invested as a conditional loan,
which “was repayable in the form of a royalty (on sales) after the venture generated
sales.” There was no interest on the loan. However, the problem with this scheme is that
the loan did not provide capital gains.
In its first year, the division invested in seven such deals, of which three were in software
services, one in effluent engineering, and one in food products (a bubble gum
manufacturer). Being a novel institution in the Indian context, as Nadkarni (2000) noted,
“There was no obvious demand for this kind of funding and a lot of work went into
creating such deals...” . The company targeted deals that would earn 2–3 percent above
ICICI’s lending rate. “ … looking back, there was no sectoral focus so it is remarkable
that we invested so much in Information Technologies.” Infosys, then a fledgling startup
was rejected by ICICI, because the project was deemed too risky.
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 ICICI.
The ICICI division was merged into TDICI as an equal joint venture between ICICI and
the state-run mutual fund UTI. The major reason for creating the JV with UTI was to use
the tax pass-through, an advantage that was not available to any corporate firm at that
time other than UTI (which had received this advantage through a special act of
parliament).
Hence, the investment manager for the new funds was TDICI and the funds were
registered as UTI’s Venture Capital Unit Schemes (VECAUS). Vecaus I, established in
1988, had a paid-in capital of 300 million rupees. Founded in 1991, Vecaus II had a paidin capital of 1 billion rupees.
TDICI opened operations in Bangalore. Interest in technology had increased due to the
success of multinationals such as Texas Instruments and Hewlett Packard that were
operating in Bangalore. Bangalore was chosen because of the presence of Indian software
firms such as Wipro, PSI Data, and Infosys apart from the decision by the Indian
government to establish it as the national center for high technology. The research
activities of state-owned firms such as Indian Telephone Industries, Hindustan
Aeronautics Limited, the Indian Space Research Organization (ISRO), and the Defense
Research Development Organization, along with the Indian Institute of Science were
centralized there.
Vecaus I invested in several successful information technology firms in Bangalore
including Wipro for developing a “rugged zed” computer for army use. There were
several successes, including several firms which went public, such as VXL, Mastek
Software Systems, Microland, and Sun Pharmaceuticals. The fund had an inflationadjusted internal rate of return of 28 percent.
TDICI was the most successful of the early government-related venture capital
operations. Moreover, TDICI personnel played an important role in the formalization of
the Indian venture capital industry. Kiran Nadkarni established the Indian Venture
Capital Association, and was the Indian partner for the first U.S. firm, Draper
International to begin operations in India. In addition to Nadkarni, TDICI personnel also
left to join other firms. Vijay Angadi joined ICF Ventures. Also, a number of TDICI
alumni became managers in Indian technology firms. So, the legacy of TDICI includes
not only evidence that venture capital could be successful in India, despite all of the
constraints, but also a cadre of experienced personnel that would move into the private
sector.
Gujarat Venture Finance Limited (GVFL) began operations with a 240 million rupee
fund. GVFL was established with a handicap – It was meant to invest in the state of
Gujarat. However, though its returns were not high, it was sufficiently successful so that
in 1995, it was able to raise 600 million rupees for a second fund. In 1997 it raised
a third fund to target the information technology sector. It is estimated that GVFL made
annualized returns of the order of 15%. – a relatively weak performance.
The other two venture funds also had marginal returns. The AP Industrial Development
Corporation (APDIC) was mandated to invest in its state. Though located in a strong
high-technology region (Hyderabad), APDIC suffering from the difficulties of stateoperated funds and had a relatively low return. The final venture fund, the only bankoperated venture capital fund, CanBank Venture Capital Fund also performed poorly.
This first stage of the venture capital industry in India was plagued by inexperienced
investment professionals, mandates to invest in certain states and sectors, and general
regulatory problems. The firms’ overall performance was poor, and only TDICI could be
considered a success. And yet, from this disappointing first stage, there came a realization
that there actually were viable investment opportunities in India.
The second stage(1995-1999)
The success of Indian entrepreneurs in Silicon Valley became far more visible in the
1990s. This attracted attention and encouraged the notion in the United States that India
might have more possible entrepreneurs. The figure on total capital under management in
India increased after 1995.The greatest source of this increase was the entrance of foreign
institutional investors including investment arms of foreign banks, but particularly
important were venture capital funds raised abroad.
NRIs were important investors in these funds coupled with the comparative decrease in
the role of the multilateral development agencies and the Indian government’s financial
institutions. The overseas private sector investors became a dominant force in the Indian
venture capital industry.
Various stages of development of risk capital in India22
22
“Accessing Risk Capital in India”, Rafiq Dossani and Asawari Desai
Phase 1
Pre 1995
30
8
Phase 2
1995-1997
125
20
Diversified
Diversified
Total Funds( $ mn)
Number of funds(estimated)
Stages & Sectors
World Bank,
Government
30
1.00
Primary sources of funds
Total number of transactions
Average investment($ mn)
Phase 3
1998-2001
2847
50
Early stage & Growth,
Telecom & IT
Phase 4
2002-2005
5239
75
Growth/ Maturity,
Diversified
Government
Overseas Institutional
Overseas Institutional
65
1.92
548
5.20
446
11.75
VC and PE in India - Today
The importance of India as an investment opportunity in the VC and PE industry has
been growing tremendously over the last few years. A host of factors are responsible for
this including availability of restructuring opportunities at attractive valuations, newly
deregulated industries at attractive valuations, rich talent pool, a reasonably robust legal
framework and most importantly a liquid capital market
PE investment in India
2,500
2,000
USD mn
2,000
1,800
1,750
1,500
1,500
1,200
1,000
774
500
500
20
80
150
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
Chart1. PE Investment in India - History23
After a down turn in 2002 and 2003 following the dot-com bust, the investment is on a
rebound once again. When VC and PE investments are taken as a total, investment in
23
Business Today, August 2005
India in 2005 was USD 2.6 billion, a 36% growth over the USD 1.9 billion invested in
200424. In 2006, given the fact that over USD 2,5 billion has already been invested in the
first 4 months, total VC and PE investment is expected to be of the order of USD 6
billion according to various market sources25.
Several VC including Draper Fisher Jurvetson, Matrix, Nexus, Helion Ventures and
Inventus have raised India specific funds for early stage VC investing in the last one year.
In the PE space too investors such as Temasek, Actis, Warburg Pincus and Chrys Capital
have earmarked significant amounts from their Global/ Asia funds for India specific
investments or have raised funds purely for the purpose of investing into India.
Though foreign investors play an important role in Indian private equity market, they
behave differently when in Indian market.26 A US investor may specialize in a particular
stage, say growth or expansion capital investments or buyouts. Further, it may also
specialize out in a particular sector, say, manufacturing. But in India, for example
Warburg and CVC have invested in a wide variety of sectors in different types of deals.
These investors have been following the classical model of specializing in the developed
market. PE firms need to be opportunistic and flexible to achieve good returns in India.
Some of the major players who invests in private equity in India are27
Fund Of Funds - These are funds that invest in funds. For example, Adams Street is an
investor in ChrysCapital.
The Buyout Funds – This is relatively new in India. Texas Pacific Group, Carlyle, and
Blackstone are primarily buyout funds that invest large amounts in entire businesses.
Mid-market Private Equity Funds - This is the most popular variety in India because
most of the private equity demand comes from mid-sized companies that are expanding.
24
Venture Intelligence Report.
The European Venture Capital Journal, May 30, 2006 – “Indian Buyouts”; “The India opportunity”,
Business World, 14 Aug 2006
26
BW private equity survey 2006
27
Business Today, August 2006
25
Late-stage Private Equity Fund - Warburg, Temasek, General Atlantic Partners,
Newbridge, Carlyle, 3i and Apax are some of the funds that fall in this category. The
target companies are relatively large-cap stocks.
Real Estate Funds, Hybrid Hedge Funds and Venture Capital Funds
Private Equity fund universe:
As on 2006 there are an estimated 62 private equity players in India28.With several
foreign investment funds including Carlyle, Texas Pacific Group and the Blackstone
Group entering India in the last few years, the market is flush with funds.
S. No
Type
Description
Avg Deal
Size
Examples of funds in India
1
Fund of funds
Funds that invest in other funds
> 100 mn
Evolvence India Fund
2
Buyout funds
Funds that invest in entire businesses to gain
operational control, add value and sell at a
premium
~ 100 mn
NewBridge, Carlyle, Apax & Blackstone, ICICI
Venture
3
Late Stage PE
funds
Funds that target late stage/ large cap stocks
30 - 100 mn
Warburg, Temasak, GAP, 3i
4
Mid market PE
funds
Funds that invest in listed/unlisted mid sized
companies
10- 30 mn
CVC, Chrys capital, Actis, Baring, GW Capital,
Kotak, ILFS, IDC
5
VC Funds
Funds that invest in Early stage, seed stage
ventures
5-15 mn
West Bridge(Sequioa), ICICI Ventures,
Jumpstartup, UTI VF, Intel Capital
6
Real Estate Funds
Invest in Real Estate projects
IREO, OZ Capital, Trikona, Ascendas India
Property Fund
7
Hybrid Hedge
Funds
Opportunistic investment across board from
private equity to corporate bonds
Oaktree, New Vernon, Pequot Capital
Table: VC Fund Universe in India29
28
29
“Conducting Successful transactions in India” Ernst & Young
“Conducting Successful transactions in India”, Ernst & Young
Private Equity Investment by Industry
2004
Industry
USD mn
IT & ITES
976
Manufacturing
149
Healthcare and lifesciences
98
Textiles
15
BFSI
54
Media
61
Engineering and Construction
188
Others
TOTAL
112
1,653
%
59%
9%
6%
1%
3%
4%
11%
7%
100%
2005
USD mn
412
371
269
147
306
102
92
485
2,184
%
19%
22%
16%
9%
19%
6%
6%
29%
100%
Source: Venture Intelligence Roundup
Venture Capital Investment by Industry
2004
Industry
USD mn
%
IT & ITES
206
69%
Retail
16
5%
Healthcare and lifesciences
16
5%
BFSI
16
5%
Media
0%
Others
43
14%
TOTAL
297
100%
2005
USD mn
261
23
82
22
52
27
467
%
56%
5%
18%
5%
11%
6%
100%
Source: Venture Intelligence Roundup
Early stage vs. late stage
Private Equity Investment by Stage
Stage
Early Stage
Early stage - cros border
Growth stage
Late stage
2004
USD mn
55
48
192
298
PIPE
Buyout
TOTAL
Source: Venture Intelligence Roundup
547
514
1,654
%
3%
3%
12%
18%
33%
31%
100%
2005
USD mn
79
71
332
632
763
306
2,183
%
4%
3%
15%
29%
35%
14%
100%
Venture Capital Investment by Stage
2004
Industry
USD mn
Early India
55
Early Indo - US
48
Growth
192
TOTAL
295
%
19%
16%
65%
100%
2005
USD mn
79
71
332
482
%
0.16
0.15
0.69
1.00
Source: Venture Intelligence Roundup
As figures show, the market in India is mainly focused on post-venture private equity
deals. This is a feature of emerging markets. The table given below substantiates this
point. Most of the private equity funds investing in India are foreign funds and the early
stage comprises of the highest risk- highest return investments. Most foreign PE funds
feel that they are already taking on a higher level of risk as they are investing in an
emerging market. Therefore they prefer to back established companies with strong
financials, market presence and solid management that are perceived to be lower risk than
start-ups whose business model is untested.
% of total risk capital invested China
India
Israel
UK
US
6
32
39
29
in seed and early-stage firms
12.5
Sources: China: Zero2ipo-CVCAnnual Report 2005
Seed and Early Stage Investment – Selected Countries, 2004
The other reasons favoring late stage investments to early stage are the following:30

Transaction costs – the costs to an investor of appraising the risks and returns
from an investment tend to be fixed and high relative to the size of the investment.
30
Utz C, 2005, Early Stage Enterprises, Position Paper, Australian Venture Capital Association

Transaction size – venture capital investors typically require a minimum
transaction size, which is often higher than the average early stage company’s
requirement..

High risk - higher for early stage (and particularly pre-revenue) companies –
because the management team or company’s product and market may be
unproven.

Lack of exit options – there is no secondary market for trading in smaller firms’
shares.

Due to the current post 'tech-wreck' environment, many venture capitalists
have retreated from early stage investments in favor of later stage investments and
turnaround opportunities.
Other trends
The telecommunications and education infrastructure are advanced relative to India’s
stage of development. Relative to most other countries, skills are not in short supply.
Other positive features that make India an attractive investment destination include:

Human capital: sufficient rising number of graduates in various fields

Success of the software and services industry, leading to the creation of a cadre of
engineers and other domain experts with marketing and product development
skills

A cadre of returnees from western countries with advanced technical and business
development skills

Opportunities in newly competitive exporters, e.g., textiles, the auto components
industry and healthcare.

The
growth
of
domestic
markets
in
fast-growing
sectors
such
as
telecommunications, finance and retail.

Presence of risk capital providers in centers outside the main commercial center,
Mumbai, and, in consequence, closer to the locations of small and medium
enterprises

Expanding pool of multinational firms operating in the country which provide
access to the latest technologies in a range of sectors and create future
entrepreneurs.
Exit
According to Nainesh Jaisingh, head, India Pvt Equity, Standard Chartered Bank, “Exits
in India were predominantly happening through the capital markets. This was largely
because the capital markets are well developed in India as compared to some other
countries. Of late, however, we are seeing exits through buyouts and sale to strategic
investors.”31 The current private equity market boom is driven mainly due to the high rate
of return that the firms get at exit which in turn is a function of the state of the capital
markets. It could also be imputed that that private equity firms bring in new ideas,
professionalism and global expertise into the board room.
Among different types of exits the strategic buyer (as against a financial buyer) brings in
a lot of managerial inputs which helps in the company to achieve the targeted growth
besides offering a higher value in the market. In the case of buyouts, the premium paid
for acquiring the controlling stake is much higher than the market price. PE to PE sales is
another way of exit. In such a case where a private equity firms who wants to invest in a
growth stage buys the company from another PE firm who has already invested in the
early stage of financing. In such a case the valuation will be for future earnings and will
be higher than the traditional valuation.
As is the case globally, the most preferred route of exit in India is the IPO. A lot of
promoters especially of new age enterprises do not have a controlling stake in their
companies as they are forced to dilute their stake to raise start-up/growth capital. In such
cases, exit by private equity firms through IPOs allows the dispersion of ownership and
gives them a controlling edge despite not having the majority stake.
Some concerns
31
Profit through exits, Business India, Aug 2006

One concern is that of asset price inflation32. There is a good probability that a PE
firm pays more when most funds are looking at the same asset, especially in a bull
market. In such case the prices might not be in line with the valuation figures.

Another concern expressed in the business circle is that of the situation when
India loses its fancy or other markets with lower valuations catches the attention
of foreign PE firms. There is a need for more homegrown PE firms to come up to
balance the growth of foreign funds in India

Currently, PE investment is mostly in the form of equity. Private funds offering
mezzanine equity, senior debts and hybrid instruments have not thrived in India.
Pension funds and institutions need to participate more in PE funds.
A comparison of the Indian VC industry and the Chinese Industry
2500
India
China
USD mn
2000
1500
1000
500
0
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
Private Equity Investment, China vs. India33
While in terms of total volume of investment, China still lags behind India, China leads
in early stage financing. Further, the decline in investments in China in 2005 is due to a
regulatory initiative by China’s State Administration of Foreign Exchange (SAFE),
32
33
Business India, February 2006
TSJ Media Reports, Zero2Ipo-CVCA Annual Report 2005
(Circulars 11 and 29) that banned offshore corporate structures allowing foreign-venture
capitalists to exit through an IPO on a foreign exchange. However, SAFE recently issued
new regulations (Circular 75) that laid out a new process for establishing offshore
structures, restoring the exit path.
Which country is more attractive for the following attributes?34
Given the likely hood that India would compete with China for overall portfolio
allocation of global investors, a comparison of the investment attractiveness of India vs.
China could throw insights into the nature of fund flow.
34
A.T. Kearney FDI Confidence Index 2004
Market size
Market growth potential
Access to export markets
Government incentives
Production/ labour reforms
Infrastructure
Financial/ economic stability
Economic reform
Quallity of life
Political/ social stability
Tax Regime
Competitor presence
Customer Sophistication
Availablity of M&A targets
Regulatory Environment
Cultural barriers
Transparency
Rule of Law
Management Talent
Highly Educated workforce
0
20
China
40
60
80
100
120
India
As per the AT Kearney Confidence survey India scores favorably in the educated work
force and management talent while the lack of a sufficient local market is deemed as a
disadvantage while competing for foreign funds
Case studies
In this section we provide case studies of select private equity transactions:
1. Yes Bank
2. Suzlon energy
3. Dr. Reddys Labs
4. Patni Computers
5. Bharti
6. Biocon
7. India Bulls
8. NDTV
Suzlon energy
PE Investors: ChrysCapital, Citicorp
Instruments used: Redeemable convertible preference shares
In October 2005, the company was listed in the Indian stock markets. The closing price
on the IPO date was Rs 693. The cashflow and IRR to the investors is calculated below:
Amount
Date
Time
elapsed(years)
IRR
(500,000,080)
2,461,313,200
1,593,750,000
5,199,315,660
9-Apr-04
11-Jul-05
8-Sep-05
19-Oct-05
1.25
1.42
1.53
679%
(499,999,920)
14,288,662,080
10-Aug-04
19-Oct-05
1.19
1566%
Chryscapital
Initial investment
Partial Exit - GSIC
Partial Exit - TRP
Listing(proxy exit)
CitiCorp
Initial investment
Listing(proxy exit)
Terms of the Investment,

The Preference Shares held by the Private Equity Investors are required to be
compulsorily redeemed if the Company undertakes an initial public offer before
December 31, 2005
o The redemption will be made out of the proceeds of the initial public offer.

The Private Equity Investors have the option to convert the Preference Shares
after December 31, 2005 on the occurrence of the following events:
o Non-completion of an initial public offer;
o A change in control of the Company through a sale of Equity Shares of the
Company or otherwise;
o A sale of 51% or more of the assets of the Company;
o the assignment of any intellectual property owned or used by the
Company which is essential for the continued operation of the business of
the Company
o Default under the Shareholders Agreement (non-occurrence of IPO by
July 1, 2008).
Under the terms of the Shareholder Agreements,

The Board of the Company shall have a maximum of 12 Directors of which,
o One director each shall be a nominee of the Private Equity Investors.

Decisions on certain fundamental matters shall not be taken and/or implemented
without the written consent of the Private Equity Investors

Decisions of fundamental matters shall not be taken or implemented without the
affirmative vote of the Private Equity Investors
o These matters relate to mergers or winding up of the Company,
o the divestment or sale of assets of the Company in excess of Rs. 250
million,
o disposal of intellectual property developed by the Company,
o acquisitions, investments in subsidiaries and securities,
o capital expenditure in excess of Rs. 100 billion,
o indebtedness in excess of 10% above the amounts stated in the annual
budgets of the Company,
o increase in the issued share capital of the Company,
o buyback of shares,
o declaration of dividend in excess of Rs. 330 million or 30% of the net
profits after tax of the Company,
o giving or renewing guarantees in respect of subsidiaries and affiliates,
transactions with affiliates,
o amendments to the articles and memorandum of association and
commencement of a new line of business.

These rights fall away on the Private Equity Investors shareholding falling below
5% or if preference shares held by the investors are redeemed whichever is later.

After the completion of the Issue, upon the redemption of the preference shares
these rights shall not be available to ChrysCapital. Citicorp would continue to
exercise these rights under the above agreement.

Private Equity Investors are prohibited from transferring the Equity Shares held
by them

At any time prior to an initial public offer, if any of the parties desire to transfer a
portion of the Equity Shares held by them to any third party, they shall first offer
the same to the other parties to the Shareholder Agreements.

Further in the event that an initial public offer has not been undertaken by the
Company and the promoters propose to transfer the Equity Shares held by them
the Private Equity Investors shall have tag-along rights, exercisable at their sole
discretion to ensure that all the Shares held by the Private Equity Investors shall
be sold if the Equity Shares proposed to be transferred represent more than 25.1%
of the Shares of the Company and if such percentage is less than 25.1%, the
Private Equity Investors shall have the right to require a pro-rata transfer of the
Equity Shares held by them.

In the event that the Company seeks to create, issue or allot Equity Shares except
in the course of making an IPO, the Private Equity Investors shall have a right to
subscribe for a portion of such proposed issue of Equity Shares to ensure that the
shareholding of the Private Equity Investors remain same after such issue.

In the event the Company proposes to create, issue or allot Shares at a price lower
than the price at which the shares were subscribed to by the Private Equity
Investors, it shall offer to issue such Shares to the Private Equity Investors.

It is also proposed in the Shareholder Agreements, that the Company, undertake
an initial public offer prior to December 31, 2006

Under the terms of the Shareholder Agreements, non-occurrence of an initial
public offering or an offer for sale prior to July 1, 2008 constitutes an event of
default upon which, the Private Equity Investors may require the Company
o (i) to redeem the Preference Shares with the accrued dividends;
o (ii) to convert the Preference Shares and require the Company to follow a
high dividend policy of paying 50% of the profit after tax as dividend or
o (iii) to convert the Preference Shares and, sell their shareholding and
assign their rights under this Agreement.
ICICI Venture’s investment in DRL35
A "Private Investment for Royalties from a Public Enterprise's Future Revenues" deal36.
Dr Reddy’s Laboratories in 2005:
Hyderabad based, publicly listed pharmaceuticals firm Dr Reddy's Laboratories(DRL) a
leading Indian pharmaceutical company, has faced rough weather since mid-2004. Some
of its molecules haven't been doing as well as expected in the U.S. market, and the Indian
pharmaceutical market has been sluggish owing to the introduction of VAT(Value Added
Tax) from the existing sales tax system. However becoming a discovery led global
pharmaceutical company37 is one of DRL’s stated goals and the company did not want to
cut expenditures in R&D in order to shore up FY 05 profitablity.
“Anatomy of a Deal – Using Venture Capital to Fund Pharma R&D”, Nov 21, 2005,
Knowledge@Wharton
36
http://ventureintelligence.blogspot.com/2005/03/private-investment-for-royalties-from.html
37
Dr Reddys Laboratories, Annual Report 2005
35
The Indian Pharma Industry
The Indian pharma Industry has dozens of fast-growing companies, though they are all
relatively small by global standards. Ranbaxy, the largest player has revenues of a little
more than $1 billion. Most other companies, predominantly generics makers who
flourished under the then prevailing patent regime which did not recognize product
patents.
Some Indian companies had made good progress, both in plain generic sales and in
ANDA filings. (ANDA stands for "Abbreviated New Drug Application,". ANDAs are a
way to enter the lucrative U.S. generics market, since it involves less risk compared to
NCE(new chemical entities) research.
Some like Ranbaxy and DRL started taking R&D seriously in the late 1990s; many others
have put together R&D strategies in the last two or three years. While Dr Reddy’s
Laboratories’ R&D expenses amounted to 14.7% of its net sales in FY05, others like
Nicholas Piramal and Cipla spend less than 5% of their net sales on research 38. Lack of
resources is an issue for all these companies. Global companies have annual R&D
budgets running into billions of dollars. The Indian companies have traditionally
bootstrapped from revenues in the generics business to finance R&D. A bad year such as
2004-05, hence, can seriously strain cash flows available for R&D.
ICICI Venture Fund(IVF)
ICICI Venture (formerly TDICI Limited) was founded in 1988 as a joint venture with the
Unit Trust of India. Subsequently, ICICI bought out UTI's stake in 1998 and ICICI
Venture became a fully owned subsidiary of ICICI39. One of India’s largest home grown
venture funds, has realized several successful investments including Biocon, Shoppers
Stop, Naukri and Bazee.40
38
http://economictimes.indiatimes.com/articleshow/1237414.cms
Company website
40
“The India opportunity”, Business World, 14 August 2006
39
In a first of its kind investment in India in 2005, ICICI Venture Fund(IVF) agreed to
advance about $56 million to DRL to partly fund its R&D.
Deal structure
DRL entered into a partnership agreement with IVF such that IVF will fund the
development, legal and registration and legal costs related to the commercialization of
most of the ANDAs filed (or to be filed) in 2004-05 and 2005-06 on a pre-determined
basis.
On the commercialization of these generics, DRL will pay ICICI Venture a royalty on net
sales for a period of 5 years41.
The investment is structured over 2 tranches with USD 22.5 mn invested by IVF in the
first round in 2005. IVF also42 has the right to invest another USD 33.5 mn
Analysis of the deal:

DRL effectively de-risks the financials of its R&D operations with the VC
investor providing the risk capital funding for R&D.

The deal structure resembles debt structure in some ways?
o The bet is on R&D capability and the risk reward sharing is along the lines
of a VC investment

Given that new drug R&D is a high-investment, high-risk, but high-reward
business, the partnership between a private equity firm which has access to a lot
of capital and an established pharmaceuticals firm seems to be an ideal one43.

Risk diversification
o For a VC fund with a portfolio of investments in pharma R&D companies,
the investors risk will be much lower than an equity investor in just one
company
41
DRL Annual Report 2005.
Dr. Reddys Laboratories FY05 Earnings Call transcript. May 2005
43
http://ventureintelligence.blogspot.com/2005/03/private-investment-for-royalties-from.html
42
o The VC fund can further “pick and choose” from a number of
opportunities in various stages – a drug at a clinical trial stage has less risk
than a drug at a preclinical stage
o Further, the Venture fund need to stay invested till the product hits the
shelves – it may exit at an intermediate stage to another investor with a
different risk profile and investment window

Gestation periods – for drug discovery which involves investment over a long
gestation period which may be as high as 10 years, venture funding may be a
viable source of risk reward sharing in the Indian context
YES Bank
PE Investors: Citicorp, ChrysCapital, AIF Capital
Yes Bank was listed on 12th July 2005. The closing price as on the date of listing was Rs
60.85. The hypothetical cash flow and IRR to investors is given below
CitiCorp
Initial investment
Listing(proxy exit)
Chryscapital/AIF
Initial investment
Listing(proxy exit)
Amount
Date
Time
elapsed(years)
IRR
(280,000,000)
1,217,000,000
11-Dec-03
12-Jul-05
1.59
153%
(210,000,000)
912,750,000
11-Dec-03
12-Jul-05
1.59
153%
Terms of investment
Master Investment Agreement dated November 25, 2003 with the Private Equity
Investors, (the “MIA”)
In terms of the MIA,

Each of the Private Equity Investors shall be entitled to nominate one nonexecutive rotational director on the Board,

The directors nominated by the Private Equity Investors are also entitled to be
members of any committee or sub-committee of the Board.

The MIA lists out certain items that can be discussed only if the same are stated in
the agenda to the Board meeting, such as
o filing for bankruptcy or winding up,
o change in capital structure,
o merger, amalgamation or consolidation,
o modification of the any of our charter documents,
o and the appointment and removal of directors.

all parties subscribing to the Equity Shares prior to or simultaneously with the
Private Equity Investors are prohibited from transferring their Equity Shares for a
period of three years from the date of completion, i.e., March 10, 2004

MIA also prescribes the following exceptions to the aforesaid lock-in:
o loss of reputation;
o where the Private Equity Investors are required by law to liquidate their
shareholding
o where there is a reduction in either the period of lock-in or in the number
of Equity Shares, by RBI,
o where our Promoters are required to sell their Equity Shares for the
repayment of the loan facility availed by Mags and Morgan from
Rabobank International Holding;
o the sale of three million Equity Shares by Promoters through the random
order matching system of the stock exchanges after the listing
o The sale of 1,150,000 Equity Shares, 850,000 Equity Shares, 850,000
Equity Shares by Citicorp, ChrysCapital and AIF Capital, respectively,
through the random order matching system of the stock exchanges after
the listing of the Equity Shares.

Further, the Equity Shares held by the Private Equity Investors will be locked in
along with the entire pre-Issue equity share capital for a period of one year from
the date of allotment of Equity Shares in this Issue.

Upon listing of the Equity Shares, the Promoters are also prohibited from selling
their shareholding on the market without the prior consent of the Private Equity
Investors.

The MIA also prohibits for a period of five years, all inter-se transfers between
the parties to the MIA, without the consent of all the parties.

So long as the Promoters and the Promoter Group Companies hold 6.0% of our
equity share capital or for a period of six months from the date of cessation of
employment, the MIA prohibits them from associating themselves with any
similar business.

The MIA also mandates that the Bank is required to make an IPO of Equity
Shares within 18 months from the date of completion

However, the Bank is required to actively consult the Private Equity Investors
prior to making such initial public offering.

It is provided that the minimum IPO price shall be the higher of
o (i) the price at which any of the Private Equity Investors subscribe to the
Equity Shares anytime prior to such initial public offering and
o (ii) the price at which any person purchases or subscribes to the Equity
Shares prior to such initial public offering.

An initial public offering at a price lower than the minimum IPO price requires
the consent of the Private Equity Investors.

The MIA seeks to protect the shareholding of the Private Equity Investors by
providing that except in the case of an IPO by the Bank, if there is any issue of
any Equity Shares, or any appreciation rights, or rights issues, or options or
warrants, the Private Equity Investors would be entitled to acquire such an
additional number of Equity Shares of our Bank so as to maintain/ increase their
current proportion, provided that the stake of Citicorp in our Bank may not exceed
15.0% and the stake of ChrysCapital and AIF Capital may not exceed 10.0% of
our capital.

After the IPO, Citicorp, ChrysCapital and AIF Capital are prohibited from
exercising voting rights on poll in excess of 14.9%, 10.0% and 10.0%,
respectively, of the total voting rights of all the shareholders, without the prior
written consent of the Promoters and the Promoter Group Companies.
Bharti telecommunications and Warburg4445
Warburg made a total investment of $292 million in Bharti televentures Ltd. between
September 1999 and July 2001 and acquired a stake of 20.5%. It was one of the largest
investment made in the world. This gives the valuation figure of the BTVL to be around
$1.537 billion. The firm had only one lakh subscribers then. Warburg's cash infusions in
Bharti allowed it to invest in the network as well as make acquisitions like JT Mobile in
1999.
As Akhil Gupta, Joint MD of Bharti TVL says, “They brought in global
experience, a fresh perspective, and knowledge of aspects like scaling up. They gave us
the confidence that we could be a big company, bigger than even what we had thought
initially,” In October 2005, when the PE company announced the final exit the company
was valued at $ 15 billion, with 14 million users. The exit of Warburg from BTVL
happened in three steps
1) In August 2004 Warburg sold a 3.35% stake for about $208 million. The
company valuation was $6.210 billion
2) Warburg Pincus sold a 3.39% stake in Bharti Tele-Ventures for US$306 million
3) In March, Warburg sold a $ 561 million stake in BTVL in a transaction on the
Bombay Stock Exchange. Billed as the largest block trade ever on the Indian
market.
44
45
Hindustan Times, October 2005
Capital Comes Calling on India, L. Brooks Entwistle
4) In October 2005, Warburg completes the exit by selling its remaining 5.65% stake
to industry major Vodafone for $830 million. Vodafone acquired 10% stake in
BTVL following the transaction. The rest 4.4% was acquired from the promoters.
The second and third steps which happened through stock exchanges showed that the
Indian capital markets are deep and robust enough to support significant, and profitable
exits.
In the meanwhile, in January 2002 the company had announced its IPO at Rs. 45 per
share. This was lower than the Rs 53 at which private equity placements were made.
Warburg’s holdings came down to 18.5% following the IPO. This caused a moment of
concern to the private equity firms since IPO was offered at a lower price than the price
at which they acquired stake in the firm.
But the final profit made by Warburg equals to $1.6 billion for an investment of 300
million in almost 4 years. The IRR obtained is around 58%. This was the second most
profitable deal in the firm’s business after NASDAQ-listed software-provider BEA
Systems.
Patni Computers4647
Patni Computer Systems (PCS) is a mid-size company engaged in providing software
solutions and services, domestically and internationally. The company’s sphere of
offerings includes application development and integration, application maintenance,
enterprise application systems, R&D services and business process outsourcing services.
Two major private equity players had invested in the firm; GE Capital invested $ 6
million in September 2000 and General Atlantic Partners invested $100 million in
October 2002. The latter investment was one of the largest private equity investment
made in India during the period. The new capital was be used to fund internal growth and
expansion through selected strategic acquisitions globally
46
47
www.equitymaster.com
www.dspml.com
In January 2004, the company announced the IPO for 18.7 million shares (15% stake)
comprising fresh issue of 13.4 million shares and an offer for sale of 5.324 million shares.
The IPO was priced at a price band of 200-230. The company was valued at $ 634
million. This provided an exit route to GA Partners.
The share holding pattern and the IRR of the PE investors before and after IPOs is shown
below. Taking into account the valuation at IPO the returns for each investor is also
shown. The high return shows the profitability of the market.
PE Fund
Pre-IPO Post-IPO
IRR
GA Partners
31.70%
28.30%
55%
GE
7.50%
5.40%
68%
Later in September 2005, General Atlantic Partners partially exits by selling out 3% of
the equity to the Japan’s Nomura India Investment Fund and Sloane Robinson of
Mauritius for $ 37 million. The valuation figure obtained then is $ 1220 million; almost
double the IPO valuation.
Biocon48
The IPO of Biocon in March, the first by a biotechnology company in India, was
especially well received. Private equity investors GW Capital and AIG together held a
18% stake in Biocon prior to the $70 million offering. The IPO valued Biocon at over
$700 million, and the company's market capitalization crossed $1 billion post listing.
AOF HS Mauritius (AOF), a wholly owned subsidiary of AIG Opportunity Fund, which
owned 9 percent equity in Biocon post IPO, sold 4.8% percent of the equity in the open
48
Venture Intelligence
market at Rs 607. According to the industry experts, AOF HF made a profit of over Rs
150 crore in the entire transaction.49
IndiaBulls Financial Services Ltd50
Indiabulls Financial Services is the holding company of three other firms:

Indiabulls Securities, the broking and investment activities-related arm;

Indiabulls Insurance Advisors, a distributor of insurance products; and

Indiabulls Commodities, a commodities trading broker.
Indiabulls Financial Services also now provides retail credit to its customers.
Farallon bought into Indiabulls Financial Services at just under Rs 25 per share. The
company is perhaps the only one in recent times to IPO under that price, in the Rs 16-19
band. That Indiabulls share price increased hugely after that (an all-time high of Rs 257
per share, 14 months after its listing). Farallon continued making investments even after
its IPO.
NDTV 51,52,53
The Prannoy Roy-controlled NDTV, one of the finest TV production houses and a
broadcasting house in the country is another case of venture backed IPO. It was a public
Issue of 15,571,429 Equity Shares comprising Fresh Issue of 9,660,492 Equity Shares for
Rs. 70 offer for Sale of 5,910,937 Equity Shares thus aggregating Rs.1,090 million . The
Issue would constitute 25.61% of the fully diluted post Issue paid-up capital of the
Company. The valuation of the firm obtained through the IPO was Rs. 4360 million.
Equity Shares were allotted by the Company through private placement to GS television
Holdings, GS media, GS commn, Saffron Fund, JF India, JP Morgan Holdings, SBI
49
Biospectrum India, June 2004
Business Today, March 2006
51
www.indiatelevision.com
52
NDTV Book Building Prospectus
53
www.tribuneindia.com
50
Capital Markets in May 1995. The total amount paid was Rs. 319 million. In July 2003
shares were allotted to ICICI bank for a consideration of Rs. 830 million
The major PE investors and their pre-IPO and post-IPO stakes are as follows:
Company
Pre-IPO Stake
Post-IPOstake
IRR
GS television Holdings
2.61%
2.2%
3.176%
GS media
0.83%
0.7%
3.176%
GS communications
0.48%
0.4%
3.176%
Saffron Fund
1.54%
1.3%
3.176%
JF India
3.21%
2.7%
3.176%
JP Morgan Holdings
1.19%
1%
3.176%
SBI Capital Markets
1.66%
1.4%
3.176%
ICICI bank
21.09%
17.75%
(7%)
Bur here ICICI didn’t give away their stake during IPO. This is the IRR at the time of
IPO. But later, the share price increased sharply.