Department of Commerce,

St. Xavier’s College (Autonomous), Palayamkottai

Financial Services

FINANCIAL SERVICES
UNIT – III
VENTURE CAPITAL

INTRODUCTION
Venture capital is a growing business of recent origin in the area of industrial financing in India. The
various financial institutions set up in India to promote industries have done commendable work. However,
these institutions do not come up to the benefit of risky ventures when they are undertaken by new or relatively
unknown entrepreneurs. They contend to give debt finance, mostly in the form of term loans to the promoters
and their functioning has been more akin to that of commercial banks. The financial institutions have devised
schemes such as seed capital scheme, risk capital fund, etc., to help new entrepreneurs. However, to evaluate
the projects and extend financial assistance, they follow the criteria such as safety, security, liquidity and
profitability and not potentiality. The capital market with its conventional financial instruments/schemes does
not come much to the benefit or risky venture. New institutions such as mutual funds, leasing and hire purchase
companies have been established as another source of finance to industries. These institutions also do not
mitigate the problems of new entrepreneurs who undertake risky and innovative ventures.
India is poised for a technological revolution with the emergence of new breed of entrepreneurs with required
professional temperament and technical know-how. To make the innovative technology of the entrepreneurs
a successful business venture, support in all respects and more particularly in the form of financial assistance
is all the more essential. This has necessitated the setting up of venture capital financing division/companies
during the later part of eighties.

CONCEPT OF VENTURE CAPITAL

The term 'Venture Capital' is understood in many ways. In a narrow sense, it refers to, investment in new and
tried enterprises that are lacking a stable record of growth.
In a broader sense, venture capital refers to the commitment of capital as shareholding, for the formulation
and setting up of small firms specialising in new ideas or new technologies. It is not merely an injection of
funds into a new firm, it is a simultaneous input of skill needed to set up the firm, design its marketing strategy
and organise and manage it. It is an association with successive stages of firm's development with distinctive
types of financing appropriate to each stage of development.

Meaning of venture capital

Venture capital is long-term risk capital to finance high technology projects which involve risk but at the same
time has strong potential for growth. Venture capitalists pool their resources including managerial abilities to
assist new entrepreneurs in the early years of the project. Once the project reaches the stage of profitability,
they sell their equity holdings at a high premium.

Definition of a venture capital company

A venture capital company is defined as 'a financing institution which joins an entrepreneur as a copromoter
in a project and shares the risks and rewards of the enterprise'

AUGUST 2023
1
 Department of Commerce,
St. Xavier’s College (Autonomous), Palayamkottai
Financial Services

FEATURES OF VENTURE CAPITAL

Some of the features of venture capital financing are as under:
1. Venture capital is usually in the form of an equity participation. It may also take the form of convertible
debt or long-term loan.
2. Investment is made only in high risk but high growth potential projects.
3. Venture capital is available only for commercialisation of new ideas or new technologies and not for
enterprises which are engaged in trading, booking, financial services, agency, liaison work or research and
development.
4. Venture capitalist joins the entrepreneur as a copromoter in projects and share the risks and rewards of the
enterprise.
5. There is continuous involvement in business after making an investment by the investor.
6. Once the venture has reached the full potential, the venture capitalist disinvests his holdings either to the
promoters or in the market. The basic objective of investment is not profit but capital appreciation at the time
of disinvestment.
7. Venture capital is not just injection of money but also an input needed to set up the firm, design its marketing
strategy and organise and manage it.
8. Investment is usually made in small and medium-scale enterprises.

SCOPE OF VENTURE CAPITAL

Venture capital may take various forms at different stages of the project. There are four successive stages of
development of a project, viz., development of a project idea, implementation of the idea, commercial
production and marketing and finally large-scale investment to exploit the economies of scale and achieve
stability. Financial institutions and banks usually start financing the project only at the second or third stage
but rarely from the first stage. But venture capitalists provide finance even from the first stage of idea
formulation. The various stages in the financing of venture capital are described below:

(1) Development of an idea-seed finance: In the initial stage, venture capitalists provide seed capital for
translating an idea into business proposition. At this stage, investigation is made in depth which normally takes
a year or more.
(2) Implementation stage-start-up finance: When the firm is set up to manufacture a product or provide a
service, start-up finance is provided by the venture capitalists. The first and second stage capital is used for
full scale manufacturing and further business growth.
(3) Fledging stage-additional finance: In the third stage, the firm has made some headway and entered the
stage of manufacturing a product but faces teething problems. It may not be able to generate adequate funds
and so additional round of financing is provided to develop the marketing infrastructure.
(4) Establishment stage-establishment finance: At this stage, the firm is established in the market and
expected to expand at a rapid pace. It needs further financing for expansion and diversification so that it can
reap economies of scale and attain stability. At the end of the establishment stage, the firm is listed on the
stock exchange and at this point the venture capitalist disinvests their shareholdings through available exit
routes.
Before investing in small, new or young hi-tech enterprises, the venture capitalists look for percentage of key
success factors of a venture capital project. They prefer projects that address these problems.
After assessing the viability of projects, the investors decide for what stage they should provide venture capital
so that it leads to greater capital appreciation

AUGUST 2023
2
 Department of Commerce,
St. Xavier’s College (Autonomous), Palayamkottai
Financial Services

IMPORTANCE OF VENTURE CAPITAL

Venture capital is of great practical value to every corporate enterprise in modern times.

I . Advantages to investing public

1. The investing public will be able to reduce risk significantly against unscrupulous management, if the public
invest in venture fund who in turn will invest in equity of new business. With their expertise in the field and
continuous involvement in the business, they would be able to stop malpractices by management.
2. Investors have no means to vouch for the reasonableness of the claims made by the promoters about
profitability of the business. The venture funds equipped with necessary skills will be able to analyse the
prospects of the business.
3. The investors do not have any means to ensure that the affairs of the business are conducted prudently. The
venture fund having representatives on the Board of Directors of the company would overcome it.

II. Advantages to promoters

1. The entrepreneur for the success of public issue is required to convince the underwriters, brokers and
thousands of investors. But to obtain venture capital assistance, he will be required to sell his idea to justify
the officials of the venture fund. Venture capital provides a solid capital base for future growth by injecting
long-term equity financing.
2. Public issue of equity shares has to be preceeded by a lot of efforts, viz., necessary statutory sanctions,
underwriting and broker's arrangement, publicity of issue, etc. The new entrepreneurs find it very difficult to
make underwriting arrangements which require a great deal of effort. Venture fund assistance would eliminate
those efforts by leaving entrepreneur to concentrate upon bread and butter activities of business.
3. Costs of public issues of equity share often range between 10 per cent to 15 per cent of nominal value of
issue of moderate size, which are often even higher for small issues. The company is required, in addition to
above, to incur recurring costs for maintenance of share registry cell, stock exchange listing fee, expenditure
on printing and posting of annual reports, etc. These items of expenditure can be ill-afforded by the business
when it is new. Assistance from venture fund does not require such expenditure.

Business partner: The venture capitalists act as business partners who share the rewards as well as the risks.
Mentoring: Venture capitalists provide strategic, operational, tactical and financial advice based on past
experience with other companies in similar situations.
Alliances: The venture capitalists help in recruitment of key personnel, improving relationship with
international markets, coinvestment with other VC firms and in decision making.

III. General
1. A developed venture capital institutional set-up reduces the time-lag between a technological innovation
and its commercial exploitation.
2. It helps in developing new processes/products in conducive atmosphere, free from the dead weight of
corporate bureaucracy, which helps in exploiting full potential.
3. Venture capital acts as a cushion to support business borrowings, as bankers and investors will not lend
money with inadequate margin of equity capital.
4. Once venture capital funds start earning profits, it will be very easy for them to raise resources from primary
capital market in the form of equity and debts. Therefore, the investors would be able to invest in new business
through venture funds and, at the same time, they can directly invest in existing business when venture fund
disposes its own holding. This mechanism will help to channelise investment in new hi-tech business or the

AUGUST 2023
3
 Department of Commerce,
St. Xavier’s College (Autonomous), Palayamkottai
Financial Services

existing sick business. These business will take-off with the help of finance from venture funds and this would
help in increasing productivity, better capacity utilisation, etc.

ORIGIN
Venture capital as a new phenomenon originated in the US and developed spectacularly worldwide since the
second half of the seventies. American Research and Development Corporation, founded by Gen. Doriot soon
after the Second World War, is believed to have heralded the institutionalisation of venture capital in the USA.
Since then, the industry has developed in many other countries in Europe, North America and Asia. The real
development of VC took place in 1958 when the Business Administration Act was passed by the US Congress.
In the US alone, there are 800 venture capital firms managing around $ 40 billion of capital with annual
accretions of between $ 1 billion and $5 billion. It is reported that some of the present-day giants like Apple,
Microsoft, Xerox, etc., are the beneficiaries of venture capital.
UK occupies a second place after US in terms of investment in VC. The concept became popular in late sixties
in UK. The Government's Business Expansion Scheme which permitted individuals to claim tax reliefs for
investment in companies not listed in stock exchange led to the success of VC in UK. The CHARTER House
Development Limited is the oldest venture capital company established in 1934 in UK. The Bank of England
established its venture capital company in late 40s. The UK. witnessed a massive growth of industry during
70s and 80s. During 1988, there were over 1,000 venture capital companies in UK which provided 3,700 crore
to over 1,500 firms.
The success of venture capital in these countries prompted other countries to design and implement measures
to promote venture capital and their total commitment have been rising.

INITIATIVE IN INDIA
Indian tradition of VC for industry goes back more than 150 years when many of the managing agency houses
acted as venture capitalists providing both finance and management skill to risky projects. It was the managing
agency system through which Tata Iron and Steels and Empress Mills were able to raise equity capital from
the investing public. The Tatas also initiated a managing agency house, named Investment Corporation of
India in 1937 which by acting as venture capitalist, successfully promoted hi-tech enterprises such as CEAT
tyres, Associated Bearings, National Rayon, etc. The early form of venture capital enabled the entrepreneurs
to raise large amount of funds and yet retain management control. After the abolition of managing agency
system, the public sector term lending institutions met a part of venture capital requirements through seed
capital and risk capital for hi-tech industries which were not able to meet promoter's contribution. However,
all these institutions supported only proven and sound technology while technology development remained
largely confined to government labs and academic institutions. Many hi-tech industries, thus, found it
impossible to obtain financial assistance from banks and other financial institutions due to unproven
technology, conservative attitude, risk awareness and rigid security parameters.
Venture capital's growth in India passed through various stages. In 1973, R.S. Bhatt Committee recommended
formation of 100 crore venture capital fund. The Seventh Five Year Plan emphasised the need for developing
a system of funding venture capital. The Research and Development Cess Act was enacted in May 1986 which
introduced a cess of 5 per cent on all payments made for purchase of technology from abroad. The levy
provides the source for the venture capital fund.

United Nations Development Programme in 1987 on behalf of Government examined the possibility of
developing venture capital in private sector. Technology Policy Implementation Committee in the same year

AUGUST 2023
4
 Department of Commerce,
St. Xavier’s College (Autonomous), Palayamkottai
Financial Services

also recommended the same provisions. Formalised venture capital took roots when venture capital guidelines
were issued by Comptroller of Capital Issues in November 1988.

GUIDELINES
The following are the guidelines issued by the Government of India.
1. The public sector financial institutions, State Bank of India, scheduled banks, foreign banks and their
subsidiaries are eligible for setting the venture capital funds with a minimum size of 10 crore and a debt-equity
ratio of ₹ 1:1.5. If they desire to raise funds from the public, promoters will be required to contribute a
minimum of 40 per cent of capital. Foreign equity up to 25 per cent subject to certain conditions would be
permitted.
The guidelines provide for non-resident Indians investment up to 74 per cent on a repatriable basis and 25 per
cent to 40 per cent on a non-repatriable basis. It should invest 60 per cent of its funds in venture capital activity.
The balance amount can be invested in new issue of any existing or new company in equity, cumulative
convertible preference shares, debentures, bonds or any other security approved by Comptroller of Capital
Issues.

2. The venture capital companies and venture capital funds can be set up as joint venture between stipulated
agencies and non-institutional promoters but the equity holding of such promoters should not exceed 20 per
cent and should not be largest single holder.

3. Venture capital assistance should go to enterprises with a total investment of not more than 10 crore.

4. The Venture Capital Company (VCC)/Venture Capital Fund (VCF) should be managed by professionals
and should be independent of the parent organisation.

5. The VCC/VCF will not be allowed to undertake activities such as trading, broking, money market
operations, bills discounting, inter-corporate lending. They will be allowed to invest in leasing to the extent
of 15 per cent of the total funds developed. The investment on revival of risk units will be treated as a part of
venture capital activity.

6. Listing of VCCs/VCF can be according to the prescribed norms and underwriting of issues at the
promoter's discretion.

7. A person holding a position or full-time chairman/president, chief executive, managing director or

executive director/whole-time director in a company will not be allowed to hold the same position
simultaneously in the VCC/VCF.

8. The Venture Capital assistance should be extended to:

(i) The enterprise having investment up to 10 crore in the project.
(ii) The technology involved should be new and untried or it should incorporate significant improvement
over the existing technologies in India.
(iii) The promoters should be new, professionally or technically qualified with inadequate resources.
(iv) The enterprise should be established in the company form employing professionally qualified person for
maintenance of accounts.

AUGUST 2023
5
 Department of Commerce,
St. Xavier’s College (Autonomous), Palayamkottai
Financial Services

9. Share pricing at the time of disinvestment by a public issue or general sale offer by the company or fund
may be done subject to this being calculated an objective criteria and the basis disclosed adequately to the
public

THE INDIAN SCENARIO

Methods of venture financing
Venture capital is available in four forms in India:
1. Equity participation.
2. Conventional loan.
3. Conditional loan.
4. Income notes.

1. Equity participation: Venture capital firms participate in equity through direct purchase of shares but their
stake does not exceed 49 per cent. These shares are retained by them till the assisted projects making profit.
These shares are sold either to the promoter at negotiated price under buyback agreement or to the public in
the secondary market at a profit.

2. Conventional loan: Under this form of assistance, a lower fixed rate of interest is charged till the assisted
units become commercially operational, after which the loan carries normal or higher rate of interest. The loan
has to be repaid according to a predetermined schedule of repayment as per terms of loan agreement.

3. Conditional loan: Under this form of finance, an interest-free loan is provided during the implementation
period but it has to pay royalty on sales. The loan has to be repaid according to a predetermined schedule as
soon as the company is able to generate sales and income.

4. Income notes: It is a combination of conventional and conditional loans. Both interest and royalty are
payable at much lower rates than in case of conditional loans.

AUGUST 2023
6