Multiciteria Model for Risk Evaluation for Venture Capital Firms in an
Emerging Market Context
Jyoti P. Gupta; Professor ESCP-EAP, Paris, France
Alain Chevalier; Professor and Dean ESCP-EAP,Paris, France
Shantanu Dutta; Lecturer Assumption University, Bangkok, Thailand
Abstract. Venture capital is an important financial innovation in financing high
risk new and/or high technology enterprises in developed countries like the USA.
This is also being introduced in a number of developing countries. In order to
minimize risks, however, venture capital firms (VCFs) are shifting their focus
towards growth companies. In the decision making process VCFs put utmost
importance on risk assessment of venture in order to invest in the most
prospective projects. In most of the cases VCFs invest in unlisted companies
without proven track record. Hence given the nature of venture capital activity,
VCFs have to deal with inherent risks associated with the projects. This study
investigates the risk assessment process practiced by VCFs in a developing
country context. Risks involved in a project are divided into several categories.
The major stages and information sources for the risk assessment process are
identified. In order to establish relationship among risk factors, different stages in
risk assessment process and information sources are identified. An integrated
model has been developed based on the experience of VCFs management
team. Finally, decision making process of VCF has been illustrated.
Key words: Emerging country, Entrepreneur, Evaluation, Financial institutions,
Framework, India, Model, Multiciteria, Risk, technology, venture
capital.
1. INTRODUCTION
Venture capital as a concept is recent in the emerging markets, although it is a popular
method of financing high technology and high risk enterprises in the developed countries
(Pandey et al., 1996). Venture capital is generally considered as an investment fund for
high risk ventures. It may be defined as the financing of new, start-up ventures (Dixon,
1990), and the expansion of existing operations intended to move into new stages in the
production and/or the distribution process (Sagari and Guidotti, 1991a). It is also
associated with the financing of high technology firms (Guan and Cheong, 1989; Sagari
and Guidotti, 1991b). Since it is implied that start-ups or high technology ventures
assume high risk, and they are unable to offer suitable collateral for securing capital,
venture capital is also described as unsecured, risk financing (Wan, 1988). The attributes
that are found in most of the definitions include high risk, higher growth expectation,
value addition to investment companies, long term gain and no security or collateral to
secure the capital. By integrating all the factors venture capital may be defined in the
following way (Pandey et al., 1996):
Venture capital is an investment, in the form of equity, quasi-equity and sometimes, debtstraight or conditional (i.e., interest and principal payable when the ventures starts
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generating sales), made in new or untried technology, or high risk venture, promoted by a
technically or professionally qualified entrepreneur, where the venture capitalist
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expects the enterprise to have a very high growth rate
provides management and business skills to the enterprise
expects medium to long-term gains and
does not expect any collateral to cover the capital provided
It appears that, that the venture capital firms are increasingly investing in growth
companies to minimize their risks (Bygrave and Timmons, 1992). This phenomenon is
also true for VCFs in developing countries.
In the decision making process VCFs put utmost importance on risk assessment of
project. VCFs have to share the risk with entrepreneur as they are mostly investing in the
form of equity. Failure of a project would have serious consequences to the return of
VCFs. In spite of rigorous assessment, majority of the projects fail to earn expected
return. For example in India, so far only 15-20% of the assisted projects have become
successful. Hence the area of risk assessment of a new venture needs more focus and
attention.
There are a number of studies on the evaluation criteria and risk assessment of a new
venture in developed countries. Tyebjee and Bruno (1984) investigated the factors which
influence the investment evaluation of VCFs in the USA. The authors categorized the
evaluation factors into five different areas: market attractiveness, product differentiation,
managerial capabilities, environment threat resistance and cash out potential. A study by
Goslin and Barge (1986) revealed that, in the VCFs’ assessment of a venture investment,
the quality of management was a critical factor.
Golis (1993) has identified six different areas for risk assessment, namely development
risk, manufacturing risk, market risk, management risk and financial risk. Hottenstein and
Dean (1992) has also given useful framework to identify and analyze market risk,
strategy risk, technology risk and organization risk. Macmillan et al. (1985) have divided
the risks in five categories: Competitive risk, Bail-out risk, Investment risk, Management
risk, Implementation risk and Leadership risk.
Competitive risk. A venture, with a proprietary product that has an existing market with
little threat of competition, does not have any competitive risk.
In the Guide to Venture Capital in Asia (published by AVCJ holding limited) the
common risk factors are identified as follows:
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A change in industry growth vis. assumptions
A change in competitive pricing vis. assumptions
Difficulties in achieving product development schedule
Difficulties in obtaining parts and raw materials
A change in market structure (e.g. a new entrant or a new technology)
A change in the availability of appropriately priced and trained labour
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But a very few study exist which deals specifically with the investment criteria in the
context of Asian countries (Ray, 1991; Ray and Turpin, 1993; Rah et al., 1994; Pandey,
1995, Gupta et al., 1996). Most of the studies have identified the investment criteria used
by VCFs in the developing countries.
Although a good amount of empirical work exists on the evaluation criteria used by
VCFs in the developed countries, few researchers have tried to identify the criteria used
in the developing countries. But how these criteria are used in assessing the risk of a
project? What is the process of risk evaluation in a developing country perspective? How
are the risk factors and steps in risk assessment related to each other? The purpose of this
study is to investigate these issues from developing country perspective. Thus, the study
is intended to provide empirical evidence on the risk assessment process practiced by
VCFs in India. The specific objectives of the study are:
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to identify risk factors involved in a project
to identify steps involved in the risk assessment process
to identify sources of information pertaining risk factors
to develop an integrated model for risk assessment process
to develop an decision making process for VCFs
We have carried out this study with the help of in-depth case studies of two VCFs in
India. In addition to that, cases of four other investee companies were investigated where
these VCFs have put their funds. In the subsequent section we will briefly discuss the
investment criteria and risk assessment procedure followed by these VCFs.
For the case studies, we have selected Technology Development and Information
Company of India (TDICI) and Gujarat Venture Finance Limited (GVFL). TDICI,
sponsored by all-India financial institution, the Industrial Credit & Investment
Corporation of India (ICICI), is the largest venture capital company in India. The cases
are analyzed on the basis of the data and information obtained from the company reports,
brochures, and extensive interviews with the executives of these VCFs.
The article is divided into seven parts. Part one gives introduction and objectives of the
study. Part two briefly describes the venture capital industry in India. In part three we
will discuss the risk assessment process followed by Indian venture capital firms. Part
four, five and six will present the conceptual framework and model for risk assessment
and evaluation process. The last part provides main conclusions of the study.
2. INDIAN VENTURE CAPITAL INDUSTRY: A BRIEF OVERVIEW
The notion of venture capital is not very old in Indian Economy. It is catching up in India
after it was introduced in the budget for the year 1986-87. A five percent tax was levied
on all know-how import payments for the creation of a venture fund by IDBI (Industrial
Development Bank of India). ICICI (Industrial Credit and Investment Corporation of
India) also started venture capital activity in the same year. Many public and private
sector firms have entered the venture capital industry now.
2.1 Structure of Venture Capital Industry in India
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The venture capital firms in India can be categorised into the following four groups:
1. All-India DFIs (Development Financial Institutions)-sponsored VCFs promoted by
the all-India development financial institutions such as Technology Development and
Information Company of India Limited (TDICI) by ICICI, Risk Capital and
Technology Finance Corporation Limited (RCTFC) by IFCI and Risk Capital Fund
by IDBI.
2. SFCs (State Finance Corporation)-sponsored VCFs promoted by the state-level
development financial institutions such as Gujarat Venture Finance Limited (GVFL)
by GIIC and Andhra Pradesh Venture Capital Limited (APVCL) by APSFC.
3. Banks-sponsored VCFs promoted by the public sector banks such as Canfina and SBI
caps.
4. Private VCFs promoted by the foreign banks / private sector companies and financial
institutions such as Indus Venture Capital Fund, Credit Capital Venture Fund and
Grindlay’s India Development Fund.
2.2 Objectives of VCFs in India
VCFs in India have their stated objectives as the financing and development of high
technology business. This is most significant, but the limited scope of venture capital has
been influenced by the Government guidelines which makes tax concession available
only for investment in high-technology businesses. The major players in the venture
capital industry are public-owned development banks and commercial banks. Therefore,
within high-technology ventures, their focus is more on development-oriented projects.
Being public institutions, their concern in providing risk capital is employment, export,
import substitution, energy saving, pollution control etc. India has a few private sector
VCFs. They have clearly stated their objectives in commercial terms. VCFs in India do
not so far seem favourably inclined to finance development of a new product/process
from the laboratory stage. They are, however, ready to finance prototype projects or pilot
plants which are ready for commercialization (Pandey, 1996).
3. RISK ASSESSMENT BY VCFs IN AN EMERGING MARKET: THE CASE OF
INDIA
3.1 Technology Development and Information Company of India Limited
TDICI was promoted by The Industrial Credit and Investment Corporation of India
Limited (ICICI) and The Unit Trust of India (UTI) in 1988.
ICICI is among the more prominent development banks in India, with assets in excess of
Rs . 183 billion (as on March 31, 1995) and over three thousand corporates in its loan
portfolio. ICICI pioneered several innovations in the Indian Financial market place such
as the first credit rating company, the first screen based stock market and first venture
capital company.
UTI is the largest mutual fund in the country with an investor base of 38 million and
funds under management of over Rs. 517 billion. Through its ingenious savings products
and astute funds management, UTI has effectively catalysed the flow of retail home
savings into Indian corporate equity.
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UTI is a government-owned and one of the largest mutual funds in Asia.
Rs. 35.00 = 1 USD (1997), Rs 45 = 1USD (2000).
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As an Asset Management Company, TDICI raises capital from a variety of domestic and
international investors, constitutes them into distinct pools and deploys them primarily in
unlisted companies that do not have easy access to public sources of debt or equity
capital.
In the recent years TDICI has been able to generate a large number of deal generation
because of its good reputation in the market. However TDICI is very selective in
choosing its investment projects. TDICI accepts only 10 percent of projects which comes
to it and rejects 90 percent. Although TDICI’s investment process is subjective,
investment is considered on the following parameters.
Management: TDICI looks for a sound management team whose members have an
excellent track record. The integrity, commitment, and enterprise of the management
team are important factors in their decision making. TDICI first evaluates the
entrepreneur. At this stage, it does not even look at the proposal. If it does not get
satisfactory feedback on the entrepreneur, it drops the proposal at this stage. The first
thing TDICI checks with people known to the entrepreneur is his competence. It always
has a direct interaction with the entrepreneur when he comes up with a proposal. He
should be knowledgeable about the business he is proposing. Another thing which TDICI
looks for is his integrity. It goes to any extent to check this through his colleagues,
suppliers, customers, bankers, buyers, etc. Next, entrepreneur’s long-term vision is
important for TDICI since it is going to make its investment for a long period of time.
Market: TDICI generally looks for a large and rapidly growing market opportunity for
its investee companies. TDICI is not interested in companies which cannot grow. At least
the company has to be a significant player in a niche market or a moderate to significant
player in a large market. If the investee company is looking for a niche market, there
should be substantial entry barrier. Overall, the main aim is there should be an expected
exponential growth.
Technological Focus: TDICI also considers the stages of technology. If it is completely
new, they are very cautious. Because this kind of project could not give expected return
in earlier period. However they have invested quite successfully in some of the frontier
technologies in India. If it is a declining stage technology, TDICI investigates its
significance in India and other countries with potential markets. For example, in the era
of PC technology, terminals for Mini Super Computers and Mainframes are becoming
unpopular. But if a single company can tap the world market for this product, it will have
a huge potential. Specially if they can set up their production base in a developing
country like India where production cost is expected to be low, they can have a
significant influence in the world market.
Competitive Advantage: Long-term competitive advantage that would pose entry
barriers to competitors.
Profitability: Potential for above-average profitability (TDICI looks for around 30
percent after tax return from their investment) leading to attractive return over a four to
seven year investment horizon.
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After a preliminary analysis, TDICI takes up the detailed evaluation. One important
aspect of this evaluation is presentation of the proposal by the promoter to the TDICI
executives. The group head, president and the person directly concerned go through the
presentation. They try to understand his ideas and ask questions. Then they make a
techno-economic evaluation. It takes around 2-3 months in evaluating a project proposal.
TDICI mainly invest in the form of subscription to equity share capital of the company.
The exit would be planned through sale on the stock markets after the company is listed.
TDICI looks for a minimum investment of Rs. 5 million and do not normally invest in
excess of Rs. 50 million in any one company.
3.2 Gujarat Venture Finance Limited
The World Bank and Government of India decided to select Gujarat Industrial Investment
Corporation (GIIC) limited as one of the first four agencies to establish and develop
Venture Capital in India. The others being Canara Bank, Andhra Pradesh Industrial
Development Corporation (APIDC), Technology Development and Information company
of India Limited (TDICI) - a subsidiary of Industrial Credit and Investment Corporation
of India Limited (ICICI).
In accordance with the Venture Capital Guidelines, GIIC incorporated a new asset
management company on 2nd July, 1990, viz; Guzarat Venture Finance Limited (GVFL),
in association with Gujarat Lease Finance Corporation Ltd., Gujarat Alkalies and
Chemicals Ltd. and Gujarat State Fertiliser Corporation Limited. While GIIC holds 40
percent of the equity capital of GVFL, the rest of the capital has been contributed by the
other three organisations. The GVFL is a fund management company and presently acts
as a trustee manager of venture funds, namely, Gujarat Venture Capital Fund-1990 and
Gujarat Venture Capital Fund-1995. The company, staffed with 4 employees on
deputation from GIIC, started organising the operations and activities with the mission:
To provide financial assistance and hands on management support to innovative and
technology based projects with inherent high risks and promising returns.
GVFL’s risk analysis process is subjective in nature and it is highly company specific.
Here the risk analysis process of GVFL will be discussed with the help of an investee
company of GVFL, namely, Permionics (India) Limited. Permionics is a start-up
company which has been promoted by a technocrat. The promoter has developed ultra
filtration membrane based domestic water purifiers which are being manufactured and
marketed under the brand name of “CRYSTAL CLEAR”. The membrane modules filter
out not only the suspended impurities but also any kind of bacteria and virus. Financial
assistance was given largely for prototype development and product launching. GVFL
carries out risk analysis of the project before the investment is made. Following
parameters are considered by GVFL for risk analysis:
Promoter: GVFL first evaluates the entrepreneur. If it does not get satisfactory feedback
on the entrepreneur, it drops the proposal at this stage. GVFL checks the competence of
the entrepreneur or promoter. It goes to any extent to check this through his colleagues,
suppliers, customers, bankers, buyers, etc. Also GVFL has a direct interaction with the
entrepreneur when he comes up with a proposal. He should be knowledgeable about the
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business he is proposing. GVFL has categorised the risk with promoter in the following
manner:
High Risk: First generation entrepreneur or executive turned entrepreneur
Moderate Risk: Business experience but not in relevant field
Low Risk: Business experience in relevant field.
Promoter of Permionics was qualified and experienced in related technology. Also he had
a good reputation. But he had no experience in consumer marketing. So it can be
considered moderate risk in terms of promoter’s risk.
GVFL also looks for a sound management team whose members have an excellent track
record. The integrity, commitment, and enterprise of the management team are important
factors in their decision making.
Market: GVFL generally looks for a large and rapidly growing market opportunity for
its investee companies. GVFL is not interested in companies which cannot grow. GVFL
has categorised the market risks in the following way:
High Risk: New product; New market to be created
Moderate Risk: New product to substitute existing product
Low Risk: Existing product (produced by new technology
For the product of Permionics, concept awareness was already created by its competitors.
So market was already there, but there were strong foreign competitors. Hence there was
moderate market risk.
Technology: Like TDICI, GVFL also considers the stages of technology. If it is
completely new, they are very cautious. Because this kind of project could not give
expected return in earlier investments. However they have invested quite successfully in
some of the frontier technologies in India. GVFL has categorised the risk analysis in the
following way:
High Risk: New Technology; Developed indigenously at small scale and not yet ready
for commercialization.
Moderate Risk: Existing process/Technology modified at Bench Scale. There may be
problem in high scale production.
Low Risk: Proven technology supplied by collaborators. There may be problem of
absorption of technology.
In the case of Permionics the technology was developed by promoters on bench scale and
the technology is closely held with a few companies world-wide. Hence risk was
considered high with respect to technology.
Product Risk: Long-term competitive advantage of the product is important; that would
pose entry barriers to competitors. Analysis of product risk is highly case specific. The
purifier of Permionics had certain distinctive advantages, such as: low maintenance,
complete purification, price advantage over competitor’s product and difficulty to clone.
Hence product risk was considered low.
Profitability: GVFL investigates Potential for above-average profitability (GVFL looks
for an IRR of 35 percent from their investment) leading to attractive return over a four to
seven year investment horizon. GVFL follows the risk return relationship depicted below:
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Overall Investment Risk
Expected Return
Low
25% - 30%
Moderate
30% - 40%
High
> 40%
For Permionics the overall risk of the project was considered moderate. Hence there was
an expectation of 35% Internal Rate of Return.
After a preliminary analysis, GVFL takes up the detailed evaluation. One important
aspect of this evaluation is presentation of the proposal by the promoter to the GVFL
executives. The group head, president and the person directly concerned go through the
presentation. They try to understand his ideas and ask questions. Then they make a
techno-economic evaluation. It takes around 2-3 months in evaluating a project proposal.
4. A CONCEPTUAL FRAMEWORK FOR RISK ASSESSMENT OF A VENTURE
Since Venture Capitalists invest their funds in risky business, they have to be quite
cautious about the risk assessment of the project, in which they are going to put their
money. In the previous section we have reviewed the risk assessment process practiced
by two VCFs in India. In order to identify risk factors comprehensively and to understand
the risk assessment procedure, their experience with four other investee companies were
investigated. It was noticed that VCFs simultaneously invest in a wide variety of
businesses in terms of nature of business and stages of development. Hence risk
assessment becomes unique for each case. Mostly they deploy subjective methodology
and depend heavily on management expertise to assess the risk involved in a new project.
However the managers of Venture Capitalist Firms visualise the need for a conceptual
framework in this regard (Varshney, 1997). In this section, first, the possible risk factors
involved in a project will be discussed and then on the basis of interview with VCF and
Investee companies with consulting published literature, a framework for the risk
assessment will be developed.
4.1 Risk Factors Involved in a Project
The managers of VCFs have identified certain risk factors which they consider in
evaluating a project. Rind and Martin (1996) have also investigated into the high risk
factors involved in a business venture. The overall risk factors can be grouped into nine
categories as given in table 1.
4.2 Categorisation of the Risks Involved in a Project
On the basis of the risk factors discussed in the last section and the practical experience
of VCF and Investee company management team, the perceived risks in a project are
categorised in the following way (Table 1):
Table 1. Category of risk factors
Risk
Promoter Risk
Component
 Integrity / honesty of the entrepreneur / promoter
 First generation entrepreneur
 Lack of experience in related field
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Product Risk
Technological Risk
Market Risk
Financial Risk
Implementation /
Operational Risk
Organisational Risk
Strategy Risk
 Lack of contacts with resource persons
 Lack of experience about
- market
- technology
 Development stage of product
 Product life cycle
 Risk of reverse engineering
 Manufacturing complexities
 Number of constituent technologies
 Availability of superior technology
 Unpredictable technology development
 Technology life cycle
 Investment requirement for assimilation
 Lack of organisational capability to assimilate
 Source of technology / Goodwill of supplier
 Level of technology (high or low)
 New users; uncertainty in market acceptance
 Market growth rate
 Competitors
 Substitute products
 Potential entrants
 Huge marketing expenditure
 Unorganised sector
 No assured market
 Capital market situation (e.g. lack of exit opportunities)
 Current leverage ratio not in par with industry average
 Growth prospect of the company
 Foreign exchange risk
 Problem with working capital; Liquidity problem
 Expected rate of return
 Lack of understanding of standard financial procedures
 Manufacturing complexities
 Capability of producer / organisation
 Manufacturing set up
 Commitment from manufacturing
 Unavailability of skilled work-force
 Maintenance problem
 Lack of contacts with resource persons
 Problem in arranging additional fund
 Motivation of employees
 Employee turnover
 Dependence on few workers
 Loosing competitiveness
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Environmental Risk
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Unrelated diversification
Changes in Government policy
Lack of understanding about regulations
Pollution / hazard
Availability of raw material
Legal barriers - piracy / patent etc.
4.2.1 Promoter Risk
 Integrity / honesty of the entrepreneur / promoter: This is considered as the most
critical factor to assess a promoter. However in practical situation it is very difficult to
measure.
 First generation entrepreneur: In this case the promoter may lack entrepreneurial
instinct and hence developing a new business would be extremely difficult for him.
 Lack of experience in related field: It will result in low confidence in entrepreneur
and initial phase of business will face lot of difficulties as the entrepreneur would have
a tough time in organising the activities.
 Lack of contacts with resource persons: Business needs help form various experts at
different stages of business. Hence contacts are very important, especially in
developing countries, for smooth operation of business.
 Lack of experience about Market / technology: This may result in wrong technology
selection, poor operation and performance and a poor marketing strategy
4.2.2 Product Risk
 Development stage of product: If it is a early stage of development, it poses high risk
to promoter as well as to VCF. To reach the stage of commercialisation, it may require
intricate manufacturing technology or huge investment.
 Product life cycle: Sustainability of the product in the market-place also depends on
the stage (namely, start-up, growth, maturity and decline) the investee company is
launching its product.
 Risk of reverse engineering: Some products bear considerable risk of being reengineered. Especially the products with less intricate features with longer stay in
machete are susceptible to this risk.
 Manufacturing complexities and Number of constituent technologies make
production process difficult and pose threat to the promoter. However, if the investee
company is capable of carrying out these complex operations, it would enjoy
competitive advantage over its competitors and the risk of reverse engineering would
also be low.
4.2.3 Technological Risk
 Availability of superior technology: Availability of superior technology in the market
would reduce attractiveness of investee company’s operation and may eventually wipe
out its market. However cost effectiveness of comparative technologies is to be
considered in this regard.
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 Unpredictable technology development: As the name suggests, this kind of
development is very difficult to predict. A completely new technology may replace the
existing one. Especially investee companies in high-tech business may encounter this
risk. In computer software, hardware, electronics, telecommunications, biotechnology
etc. sector technology development is very fast.
 Technology life cycle: Whether the technology is new or mature - has an implication
to the investee company’s competitiveness and future profitability. If the technology is
very new, VCF has to be very careful to figure out its potential and for a mature or
decline stage technology, there should be big enough market for investee company.
 Investment requirement for assimilation: The investment requirement to assimilate a
new technology to acquire it may be prohibitive.
 Lack of organisational capability to assimilate: If the technology transfer is not
successful (in case of acquiring a new technology) and the organisation is unable to
assimilate it, assisted company would not be able to create any impact even with a
superior technology.
 Source of technology / Goodwill of supplier: Especially in the case of hightechnology the past track record of the supplier (source) of technology is very
important. Also an exclusive contract should be signed with supplier to cater future
problems.
 Level of technology: High technology has problem of assimilation and low technology
would reduce entry barrier for others.
4.2.4 Market Risk
 New users; uncertainty in market acceptance: There is high risk, if the product is
relatively new in the market. The success of the product depends on its acceptability in
the market. Sometimes product with superior technology and features may fail to
appeal the new users, if they are not ready for it. So the company needs considerable
marketing effort in this regard, especially the product is new in the market.
 Market growth rate: It affects the growth of a company and hence its future
profitability.
 Competitors: Strong competitors in the market would reduce share of investee
company.
 Substitute products: Substitute products may throw the present product of the
company out of the market. In that case the company has to keep track of the
substitute products in the market and if necessary they have to add new features and
dimensions to their products to safeguard against it.
 Potential entrants: If entry barrier is low, there is more probability of new potential
entrants in the market, which would intensify competition level.
 Huge marketing expenditure: To introduce product in the market, marketing
expenditure may be prohibitive.
 Unorganised sector and unavailability of assured market add to market risk of
investee company.
4.2.5 Financial Risk
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 Capital market situation : VCF invests in an organisation with an intention of
divestment after certain years. So there should be suitable opportunity in the capital
market for that, which is lacking in the developing countries. Also, the situation of
stock market (whether it is bullish etc.) at the time of divestment is important as it
would affect he return of VCF.
 Current leverage ratio : It should be in par with industry average. Otherwise it may
affect the smooth business operation of the assisted (investee) company.
 Growth prospect of the company : It is very important for VCF to predict whether the
company can grow enough to go for Initial Public Offering (IPO) in next few years.
This will also determine the future profitability of the assisted company.
 Foreign exchange risk : If the investee company operates in the export market or if it
takes foreign currency loan, this risk arises. Sometimes, they have to import raw
materials and other machinery from abroad, which also make them vulnerable to
fluctuation of foreign currency exchange rate.
 Liquidity problem : When the company starts its operation it may face problem of
insufficient working capital, particularly if their initial phase of business does not go
well. In that case the problem of arranging additional working capital may spill over to
Venture Capital Firm.
 Expected rate of return : Investing is a trade-off between risk and reward. Expectation
of return depends on the degree of risk involved in the project. There is every
possibility that VCF may not be able to get their expected return. It is necessary to
mention here that success rate of Investment Projects for VCF in Indian context is
around 20% (Varshney, 1997).
 Lack of understanding of standard financial procedures : This may create problem
in the company audit, tax payment, financial projection, cost estimation etc.
4.2.6 Implementation / Operational Risk
 Manufacturing complexities: It requires skilled workers with adequate training to
manufacture the products with satisfactory quality.
 Capability of producer/organisation : Success of the production process depends on
the technical knowledge of the concerned people of the company, capability of
employees of the organisation and selection of plant equipment. To select appropriate
technology and plant machinery the management of the company has to be
knowledgeable in that field or they have to consult experts in that field.
 Manufacturing set up : If the plant equipment is procured locally there will be less
problem with maintenance. But if it is imported from outside countries, there should
be exclusive contract with the supplier of technology / plant in this regard.
 Commitment from manufacturing : If the expectation of quality is high, it will create
more pressure on the production team and will lead to high risk in the absence of
sophisticated equipment and trained work-force.
 Unavailability of skilled work-force and Maintenance requirements would create
operational problem.
 Lack of contacts with resource persons and Problem in arranging additional fund
would create problem in smooth implementation process.
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4.2.7 Organisational Risk
 Motivation of employees : This is an organisational problem and the efficiency of the
organisation depends on it. But this is very difficult to figure out.
 Employee turnover : First of all it is always difficult for a new company to attract
competent work-force and if they leave the organisation after a certain period of time
the situation becomes worse.
 Dependence on few workers : This make the production process vulnerable and more
risky.
4.2.8 Strategy Risk
 Loosing competitiveness : Strategy is the link between the market and the
organisation. Without a proper strategy, technological and organisational capabilities
become unfocused and often misdirected. So the promoters have to clear about their
strategic direction from the beginning. They have to define their business precisely
and they have to select their basis of competitive advantage.
 Unrelated diversification : This is considered very risky by the Venture Capitalists if
the assisted company wants to operate in a business where they have no previous
background or experience. For doing so, assisted companies need to present strong
reasons with proper justification.
4.2.9 Environmental Risk
 Changes in Government policy : This may affect the business of the investee
company severely. And hence to avoid this risk, VCF tries to wait until the change in
government policy in that area.
 Lack of understanding about regulations : If the company management is not well
versed with the internal regulations of the country it may risk to do illegal operations
 Pollution / hazard : The product and the operation of the company should abide by the
national and international law in this regard. Otherwise it may face sanction from the
concerned authority.
 Availability of raw material : In many cases availability of the raw materials and
market demand depend on the climatic condition. VCF has to consider this factor.
 Legal barriers : If the legal system is not strong in a country in the field of consumer
and industrial products, a first mover company may lose its competitiveness at the end.
Its products may be pirated or it may be reverse engineered by other companies in the
absence of strong legal system, which is a persisting problem in developing countries.
4.3 Stages in Risk Assessment Process
After receiving a project proposal, VCFs have to carry out overall risk assessment of the
project. This is carried out in different stages, namely Assessment of promoter,
Investigation of soundness of idea, Assessment of product / technology, Assessment of
market, Assessing financial feasibility and assessing implementation feasibility. However
these stages are not independent of each other and it is not a screening process. That
13
means, VCFs carry out risk analysis for each stage and then integrate all risks. After
analysis of overall risk, investment decision is taken.
4.4 Risk Assessment Procedure
According to the management of VCF, risk assessment procedure is a very difficult task
and it requires considerable time and effort for persons involved in it. Identifying the risk
factor is merely an introduction in this process. To carry out the actual assessment VCFs
need to collect information from various sources and they require tremendous efforts.
 Venture Capital Firm looks for the past track record of entrepreneur and try to collect
information from various sources like previous suppliers, employees, buyers,
consultants, friends etc. Top management also interviews the promoter.
 Promoter requires to submit the business plan and he has to present it in front of
concerned VCF management group. There he is asked several questions and these are
verified in the market place afterwards.
 VCF gets the proposal evaluated by technology experts or management experts from
outside the organisation. For example to study the feasibility of PERMIONICS (an
investee company of GVFL which produces purifiers) GVFL appointed two member
committee with experts from related technological area. For the case of GENTECH
(another investee company of GVFL in automation retail business), two IIM-A (Indian
Institute of Management-Ahmedabad) faculty members carried out the feasibility
study.
 Executives of VCF visit the site of investee company to evaluate the situation.
 VCF itself also carries out feasibility study of the protect. It checks the market
projections and other financial projections. Scenario analysis is carried out in this
regard. Promoter has to justify his proposal as per the requirement of VCF.
 VCFs refer to all published information and executives of VCFs attend seminars,
training programs, technology fair etc. to know about new products, technology, their
market and new investment. They also closely follow government policies in related
areas and international regulations.
5. INTEGRATED MODEL FOR RISK EVALUATION
Concepts presented in section 4.2, section 4.3 and section 4.4 can be integrated to
develop an overall risk evaluation model (Figure 1). Risks involved in each stage of
evaluation process can be identified with the help of risk factors presented in section 4.2.
However to carry out the assessment process or to identify risks VCFs need to use
information from various sources as mentioned in section 4.4.
Importance and significance of each stage varies with nature of project. Hence it is very
difficult to allocate weightage to each stage, in a general sense. It is required to carry out
a sectoral analysis to allocate weightage to different stages of risk assessment process
with respect to specific business. This is not a screening process. VCFs carry out risk
evaluation at each stage and then aggregate all of those. However, if there is serious flaw
in a particular stage, the deal is rejected outright. The evaluation process of a venture
proposal is discussed in the next section. The evaluation process is linear and covariance
14
between the risk factors is replaced by the rejection of deals which do not meet certain
important criteria.
15
Risk Factors
Risk Assessment Stages
Project Proposal
Promoter
Risk
Product
Risk
Assessment of
Promoter
Investigation
of soundness
of idea
Technology
Risk
Assessment of
Product and
Technology
(simultaneously)
Market Risk
Assessment of
Market
How to proceed
Information from
 Past employer if any
 Past employee if any
 Supplier/buyer/consultant
 Friends and business partners
Direct Assessment
 Interview
 Presentation
 Verification of facts from
marketplace
Consultation with
 In-house experts/outside
experts/literature/promoter
 Other investee companies in
this area
Information about supplier of
technology




Strategy Risk
Financial Risk
Assessing
Financial
Feasibility



Market survey/study
Information about competitors
Identifying substitute and their
potential



In-house analysis
Consult with earlier investors
Stock market information from
in-house experts, alliance,
business magazines
Company financial report,
auditors
Verify performance projection
at own, sensitivity analysis

Environmental
Risk


Implementation
Risk
Organisational
Risk
Assessing
Implementation
Feasibility
Keep track of technology trend
Attending seminars, technology
fair
Review business magazines,
journals
Visit to the plant/site



Identify contacts with
resource persons
Check for Skilled people in
company, Source of additional
fund, raw material
Ask promoter, visit plant
Follow govt. policy, Intl. law
Figure 5.1 Integrated Model for Risk Assessment
16
5.1 Problems Encountered in Risk Assessment of a Project
Although VCFs try their best to be careful in undertaking the risk assessment process,
still many of their investment projects fail. This is because of the inherent limitation of
traditional risk assessment process (Costa and Michael, 1996). The main reasons for
investment decisions going wrong are, in order of importance : weak management, poor
understanding of market, overpaying, circumstances beyond their control, and financial
matters. In the risk assessment process the venture capitalist is confronted with a number
of obstacles:
 Information can be out of date, particularly in industries where market structures and
trends change rapidly - published information can soon become misleading.
 Not enough detail; Often the only published information available on certain industries
only relates to macro markets whereas the investee company might be operating in
specific market niches which perform very differently from the market as a whole.
For example, the growth trend of Indian car industry moving one way, while the
growth for the investee companies specific engine part, which is losing popularity with
the user, moves another way.
 Financial risk assessment is unable to assess in detail a company’s future potential whether the market will continue to be buoyant, whether the investee company will
win or lose market share in the future.
 Business plans and selling memorandums may be slanted to support a case by those
with a vested interest in its conclusion, or can at times be unaware of the importance
or the imminence of a particular threat or opportunity.
 Wrong source of information; Too often market information is sourced from a few
personal contacts who may be at the wrong level or in the wrong companies.
 Sometimes it is found that published information on smaller companies and their
markets has been non-existent.
 At times confidentiality constrains the amount of information the venture capitalist
can obtain from various sources.
6. EVALUATION OF A VENTURE PROPOSAL
Once the risk factors are identified, the next step is to evaluate the nature of these risk
factors for a proposed venture. If overall risk for a proposed venture is acceptable to VCF
and if the venture meets expected required rate of return, then a VCF can consider
investing in that venture. The risk factors that have been discussed so far, do not have
equal importance as pointed out by VCF management teams. This necessitates allocation
of different weightage to the risk factors. Macmillan et al. (1985) categorised the risk
factors, as identified in their studies, into four different groups; namely Irrelevant,
Desirable, Important and Essential. For the purpose of this study we ignore irrelevant
risk factors and consider the other three categories, which have an impact on the risk
evaluation process. Pandey (1996) has surveyed relative importance of risk factors in
Indian Venture Capital industry. On the basis of the survey and discussions with VCF
management teams, weightage has been allocated to different risk factors.
17
Allocation of Weight
Category
Desirable
Important
Essential
Weight
0.2
0.3
0.5
In the Indian context, it has been found that some of the factors like integrity of the
entrepreneur, market growth rate and expected rate of return are perceived as very
important or essential by the VCFs. But at the same time VCFs do not pay high attention
to technology risk, strategy risk and environmental risk. However, the weightage of risk
factors may differ according to the industrial sector. In this study, the general viewpoint
of VCF management is taken into account in selecting respective weightage of each
factor.
Once we fix up the weightages, the next step is to rank the risk factors (on a five point
scale) for a venture proposal which is under consideration for investment. Then we need
to find out total score for a particular venture and compare it with total average score
(Table 2).
Total Score =  (Weight of risk factor * Rank of that risk factor for a venture)
Total average score has been calculated by multiplying weightage of each risk factor with
average ranking of that particular factor (average ranking is considered as 3 in the 5 point
scale, except for essential risk factors). The table 2 gives the evaluation of the total
average score.
Table 2. Weightage and Ranking of risk factors
Risk
Component
Weigh
t
Ranking of each factor by VCF for
a particular venture
1
Promoter
Risk





Product
Risk











Technological
Risk
Integrity / honesty of the entrepreneur
First generation entrepreneur
Lack of experience in related field
Lack of contacts with resource persons
Lack of experience about
- market
- technology
Development stage of product
Product life cycle
Risk of reverse engineering
Manufacturing complexities
Number of constituent technologies
Availability of superior technology
Unpredictable technology development
Technology life cycle
Investment requirement for assimilation
Organisational capability to assimilate
Source of technology / Goodwill of
18
2
3
4
Averag
e Score
5
0.5
0.3
0.2
0.3
0.2
0.5*4#
0.3*3
0.2*3
0.3*3
0.2*3
0.2
0.2
0.2
0.3
0.2
0.2
0.2
0.2
0.3
0.3
0.2
0.2*3
0.2*3
0.2*3
0.3*3
0.2*3
0.2*3
0.2*3
0.2*3
0.3*3
0.3*3
0.2*3


































supplier
Level of technology (high or low)
New users; uncertainty in market
Market growth rate
Competitors
Substitute products
Potential entrants
Huge marketing expenditure
Unorganised sector
No assured market
Capital market situation
Unfavourable Current leverage ratio
Growth prospect of the company
Foreign exchange risk
Problem with working capital
Expected rate of return
Understanding of financial procedures
Manufacturing complexities
Capability of producer / organisation
Manufacturing set up
Commitment from manufacturing
Unavailability of skilled work-force
Maintenance problem
Lack of contacts with resource persons
Problem in arranging additional fund
Motivation of employees
Employee turnover
Dependence on few workers
Loosing competitiveness
Unrelated diversification
Changes in Government policy
Lack of understanding about regulations
Pollution / hazard
Availability of raw material
Legal barriers - piracy / patent etc.
0.2*3
0.3*3
0.5*4#
0.2*3
0.2*3
0.2*3
0.2*3
0.2*3
0.2*3
0.2*3
Financial
0.2*3
Risk
0.3*3
0.2*3
0.2*3
0.5*4#
0.2*3
0.2*3
Operational
0.3*3
Risk
0.2*3
0.2*3
0.2*3
0.2*3
0.3*3
0.3*3
0.3*3
Organisational
0.2*3
Risk
0.2*3
0.2*3
Strategy
0.2*3
Risk
0.3*3
Environmental
0.2*3
Risk
0.2*3
0.3*3
0.2*3
Total Average Score 38.1
# For essential risk factors, minimum acceptable ranking is considered as 4.0. Therefore in the calculation of Total average score we
consider average (acceptable) ranking for essential factors as 4 instead of 3.
Market
Risk
0.2
0.3
0.5
0.2
0.2
0.2
0.2
0.2
0.2
0.2
0.2
0.3
0.2
0.2
0.5
0.2
0.2
0.3
0.2
0.2
0.2
0.2
0.3
0.3
0.3
0.2
0.2
0.2
0.2
0.3
0.2
0.2
0.3
0.2
6.1 Decision making process for a venture proposal
VCFs have to look for following four conditions before taking their investment decision.
Failing to meet any of these criteria, the venture proposal would be rejected:
1. Total score (from ranking) for a proposed venture should be higher than total average
score.
2. For the essential risk factors, ranking should not go below 4.0 point individually.
Otherwise it will be considered as a seriously flawed venture proposal.
3. Expected rate of return (ERR) from a proposed venture should meet required rate of
return (RRR) of VCF. In the Indian context, the required rate of VCF varies between
30 percent and 35 percent.
4. Although it was not rated highly by the Indian VCFs, they have to be very much
careful about the environmental risk factors. In the long run environmental factors
may pose serious threat to a new venture.
Figure 2 gives the decision making process.
19
Decision Making Process
Investment Proposal
Identification of risk factors and ranking of them
If, TS<TAS
Reject
Find total
score(TS),
compare with
Total average
score(TAS)
If,
TS>=TAS
Consider
environmental
risk factors
If,
ranking<4.0
Reject
Check ranking
of essential
risk factors
Compare ERR
and RRR of
VCF
If,
ranking>=4.0
If,
ERR<RRR
Unfavourable
Reject
Favourable
Reject
If,
ERR>=RR
R
Accept the
Venture
Proposal
Figure 2. Decision Making Process
7. CONCLUSIONS
Risk assessment of project is the most important aspect in the decision making process of
a VCF. Although VCFs put utmost importance to this, so far only 15-20% of their
assisted projects have become successful. Hence in order to aid decision making process
of VCF, an integrated model has been developed in this study. Also the evaluation
procedure is discussed and the framework is presented in the last section.
Among all the risk factors, VCFs in developing countries put maximum weightage to
entrepreneurs capability and his exposure to the business, market growth and expected
return from the venture. In the developing country context, the contacts of entrepreneur
with other interest groups is also considered very important. It helps the entrepreneur to
explore new markets or to raise additional funds for their business. The risks involved in
a project also depend on the state of the technological capability and resources of the
specific country. Government regulations, at times, influence the operations of a
20
particular business. In these areas perception of risks in developing countries would differ
from that of developed countries.
Merely identifying the risk factors is only a part of the process. Evaluation of these risk
factors require meticulous attention of VCF management. Hence they have to develop
pool of expertise and to consult others in the related areas if necessary. The process is not
straight forward. VCFs face a lot of problems in this regard which are discussed in the
earlier section.
The aim of this study was to identify the risk factors and to understand the evaluation
process from a developing country perspective. To establish the relationship and to make
it operational for the management of VCFs, the integrated model for risk assessment
process has been developed. However, the model is general in nature and it needs to
consider specific nature of the business while carrying out the risk assessment process. In
order to incorporate the significance of each stage for difference in nature of business, a
sectoral analysis comprising diverse nature of business can be undertaken. For each
sector, expert opinion can be used to determine the weight of each risk factor and an
integrated expert system can be developed to help in the decision making process of
VCFs.
In the model, a linear approach to risk has been used, in other words the different risk
factors are taken seperately and a combined score is obtained. The overall aggregated
score is used as a basis for decision making. The system proposed takes into account the
strategic importance of certain risk factors in the final decision. The covariance between
the risk factors has not been taken into account. We propose to modify the above model
to include the covariance between the factors. This necessitates the development of a data
base which will enable us to determine the covariance between the risk factors. This is
difficult in the context of an emerging market. The expert opinion could be used as a
substitute.
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