Financial Services

A Project Report on

The Concept of
Venture Capital

And a Case Study of

 Concept of Venture Capital
The term venture capital comprises of two words that is, “Venture” and “Capital”. Venture
is a course of processing, the outcome of which is uncertain but to which is attended the
risk or danger of “loss”. “Capital” means recourses to start an enterprise. To connote the
risk and adventure of such a fund, the generic name Venture Capital was coined.

Venture capital is considered as financing of high and new technology based enterprises. It
is said that Venture capital involves investment in new or relatively untried technology,
initiated by relatively new and professionally or technically qualified entrepreneurs with
inadequate funds. The conventional financiers, unlike Venture capitals, mainly finance
proven technologies and established markets. However, high technology need not be pre-
requisite for venture capital.

Venture capital has also been described as ‘unsecured risk financing’. The relatively high risk
of venture capital is compensated by the possibility of high returns usually through
substantial capital gains in the medium term. Venture capital in broader sense is not solely
an injection of funds into a new firm, it is also an input of skills needed to set up the firm,
design its marketing strategy, organize and manage it. Thus it is a long term association with
successive stages of company’s development under highly risk investment conditions, with
distinctive type of financing appropriate to each stage of development. Investors join the
entrepreneurs as co-partners and support the project with finance and business skills to
exploit the market opportunities.

Venture capital is not a passive finance. It may be at any stage of business/production cycle,
that is, start up, expansion or to improve a product or process, which are associated with
both risk and reward. The Venture capital makes higher capital gains through appreciation
in the value of such investments when the new technology succeeds. Thus the primary
return sought by the investor is essentially capital gain rather than steady interest income
or dividend yield.

The most flexible definition of Venture capital is-

“The support by investors of entrepreneurial talent with finance and
business skills to exploit market opportunities and thus obtain capital gains.”

Venture capital commonly describes not only the provision of start up finance or ‘seed corn’
capital but also development capital for later stages of business. A long term commitment
of funds is involved in the form of equity investments, with the aim of eventual capital gains
rather than income and active involvement in the management of customer’s business.

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What kind of businesses are attractive to venture capitalists?

Venture capitalist prefer to invest in "entrepreneurial businesses". This does not necessarily
mean small or new businesses. Rather, it is more about the investment's aspirations and
potential for growth, rather than by current size. Such businesses are aiming to grow rapidly
to a significant size. As a rule of thumb, unless a business can offer the prospect of
significant turnover growth within five years, it is unlikely to be of interest to a venture
capital firm. Venture capital investors are only interested in companies with high growth
prospects, which are managed by experienced and ambitious teams who are capable of
turning their business plan into reality.

For how long do venture capitalists invest in a business?

Venture capital firms usually look to retain their investment for between three and seven
years or more. The term of the investment is often linked to the growth profile of the
business. Investments in more mature businesses, where the business performance can be
improved quicker and easier, are often sold sooner than investments in early-stage or
technology companies where it takes time to develop the business model.

Where do venture capital firms obtain their money?

Just as management teams compete for finance, so do venture capital firms. They raise
their funds from several sources. To obtain their funds, venture capital firms have to
demonstrate a good track record and the prospect of producing returns greater than can be
achieved through fixed interest or quoted equity investments. Most UK venture capital
firms raise their funds for investment from external sources, mainly institutional investors,
such as pension funds and insurance companies.

Venture capital firms' investment preferences may be affected by the source of their funds.
Many funds raised from external sources are structured as Limited Partnerships and usually
have a fixed life of 10 years. Within this period the funds invest the money committed to
them and by the end of the 10 years they will have had to return the investors' original
money, plus any additional returns made. This generally requires the investments to be
sold, or to be in the form of quoted shares, before the end of the fund.

Venture Capital Trusts (VCT's) are quoted vehicles that aim to encourage investment in
smaller unlisted (unquoted and AIM quoted companies) UK companies by offering private
investors tax incentives in return for a five-year investment commitment. The first were
launched in Autumn 1995 and are mainly managed by UK venture capital firms. If funds are
obtained from a VCT, there may be some restrictions regarding the company's future
development within the first few years.

What is involved in the investment process?

The investment process, from reviewing the business plan to actually investing in a
proposition, can take a venture capitalist anything from one month to one year but typically
it takes between 3 and 6 months. There are always exceptions to the rule and deals can be

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done in extremely short time frames. Much depends on the quality of information provided
and made available.

The key stage of the investment process is the initial evaluation of a business plan. Most
approaches to venture capitalists are rejected at this stage. In considering the business
plan, the venture capitalist will consider several principal aspects:

- Is the product or service commercially viable?

- Does the company have potential for sustained growth?
- Does management have the ability to exploit this potential and control the company
through the growth phases?
- Does the possible reward justify the risk?
- Does the potential financial return on the investment meet their investment criteria?

In structuring its investment, the venture capitalist may use one or more of the following
types of share capital:

Ordinary shares
These are equity shares that are entitled to all income and capital after the rights of all
other classes of capital and creditors have been satisfied. Ordinary shares have votes. In a
venture capital deal these are the shares typically held by the management and family
shareholders rather than the venture capital firm.

Preferred ordinary shares

These are equity shares with special rights.For example, they may be entitled to a fixed
dividend or share of the profits. Preferred ordinary shares have votes.

Preference shares
These are non-equity shares. They rank ahead of all classes of ordinary shares for both
income and capital. Their income rights are defined and they are usually entitled to a fixed
dividend (eg. 10% fixed). The shares may be redeemable on fixed dates or they may be
irredeemable. Sometimes they may be redeemable at a fixed premium (eg. at 120% of
cost). They may be convertible into a class of ordinary shares.

Loan capital
Venture capital loans typically are entitled to interest and are usually, though not
necessarily repayable. Loans may be secured on the company's assets or may be unsecured.
A secured loan will rank ahead of unsecured loans and certain other creditors of the
company. A loan may be convertible into equity shares. Alternatively, it may have a warrant
attached which gives the loan holder the option to subscribe for new equity shares on
terms fixed in the warrant. They typically carry a higher rate of interest than bank term
loans and rank behind the bank for payment of interest and repayment of capital.

Venture capital investments are often accompanied by additional financing at the point of
investment. This is nearly always the case where the business in which the investment is
being made is relatively mature or well-established. In this case, it is appropriate for a
business to have a financing structure that includes both equity and debt.

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Other forms of finance provided in addition to venture capitalist equity include:

- Clearing banks - principally provide overdrafts and short to medium-term loans at fixed or,
more usually, variable rates of interest.

- Merchant banks - organise the provision of medium to longer-term loans, usually for
larger amounts than clearing banks. Later they can play an important role in the process of
"going public" by advising on the terms and price of public issues and by arranging
underwriting when necessary.

- Finance houses - provide various forms of installment credit, ranging from hire purchase
to leasing, often asset based and usually for a fixed term and at fixed interest rates.

Factoring companies - provide finance by buying trade debts at a discount, either on a

recourse basis (you retain the credit risk on the debts) or on a non-recourse basis (the
factoring company takes over the credit risk).

Government and European Commission sources - provide financial aid to UK companies,

ranging from project grants (related to jobs created and safeguarded) to enterprise loans in
selective areas.

Mezzanine firms - provide loan finance that is halfway between equity and secured debt.
These facilities require either a second charge on the company's assets or are unsecured.
Because the risk is consequently higher than senior debt, the interest charged by the
mezzanine debt provider will be higher than that from the principal lenders and sometimes
a modest equity "up-side" will be required through options or warrants. It is generally most
appropriate for larger transactions.

Making the Investment - Due Diligence

To support an initial positive assessment of your business proposition, the venture capitalist
will want to assess the technical and financial feasibility in detail.

External consultants are often used to assess market prospects and the technical feasibility
of the proposition, unless the venture capital firm has the appropriately qualified people in-
house. Chartered accountants are often called on to do much of the due diligence, such as
to report on the financial projections and other financial aspects of the plan. These reports
often follow a detailed study, or a one or two day overview may be all that is required by
the venture capital firm. They will assess and review the following points concerning the
company and its management:

- Management information systems

- Forecasting techniques and accuracy of past forecasting
- Assumptions on which financial assumptions are based
- The latest available management accounts, including the company's cash/debtor positions

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- Bank facilities and leasing agreements
- Pensions funding
- Employee contracts, etc.

The due diligence review aims to support or contradict the venture capital firm's own initial
impressions of the business plan formed during the initial stage. References may also be
taken up on the company (eg. with suppliers, customers, and bankers).

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 Features of Venture Capital
1. High Risk

By definition the Venture capital financing is highly risky and chances of failure are high as it
provides long term start up capital to high risk-high reward ventures. Venture capital
assumes four types of risks, these are:

 Management risk- Inability of management teams to work together.

 Market risk- Product may fail in the market.
 Product risk- Product may not be commercially viable.
 Operation risk- Operations may not be cost effective resulting in increased cost
decreased gross margins.

2. High Tech

As opportunities in the low technology area tend to be few of lower order, and hi-tech
projects generally offer higher returns than projects in more traditional areas, venture
capital investments are made in high tech. areas using new technologies or producing
innovative goods by using new technology. Not just high technology, any high risk ventures
where the entrepreneur has conviction but little capital gets venture finance. Venture
capital is available for expansion of existing business or diversification to a high risk area.
Thus technology financing had never been the primary objective but incidental to venture
capital.

3. Equity Participation & Capital Gains

Investments are generally in equity and quasi equity participation through direct purchase
of shares, options, convertible debentures where the debt holder has the option to convert
the loan instruments into stock of the borrower or a debt with warrants to equity
investment. The funds in the form of equity help to raise term loans that are cheaper
source of funds. In the early stage of business, because dividends can be delayed, equity
investment implies that investors bear the risk of venture and would earn a return
commensurate with success in the form of capital gains.

4. Participation In Management

Venture capital provides value addition by managerial support, monitoring and follow up
assistance. It monitors physical and financial progress as well as market development
initiative. It helps by identifying key resource person. They want one seat on the company’s
board of directors and involvement, for better or worse, in the major decision affecting the
direction of company. This is a unique philosophy of “hands on management” where
Venture capitalist acts as complementary to the entrepreneurs. Based upon the experience
other companies, a venture capitalist advise the promoters on project planning, monitoring,
financial management, including working capital and public issue.

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 5. Length of Investment

Venture capitalist help companies grow, but they eventually seek to exit the investment in
three to seven years. An early stage investment may take seven to ten years to mature,
while most of the later stage investment takes only a few years. The process of having
significant returns takes several years and calls on the capacity and talent of venture
capitalist and entrepreneurs to reach fruition.

6. Illiquid Investment

Venture capital investments are illiquid, that is, not subject to repayment on demand or
following a repayment schedule. Investors seek return ultimately by means of capital gains
when the investment is sold at market place. The investment is realized only on enlistment
of security or it is lost if enterprise is liquidated for unsuccessful working. It may take
several years before the first investment starts to locked for seven to ten years. Venture
capitalist understands this illiquidity and factors this in his investment decisions.

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 Difference between Venture Capital & Other Funds

Venture Capital Vs Development Funds

Venture capital differs from Development funds as latter means putting up of industries
without much consideration of use of new technology or new entrepreneurial venture but
having a focus on underdeveloped areas (locations). In majority of cases it is in the form of
loan capital and proportion of equity is very thin. Development finance is security oriented
and liquidity prone. The criteria for investment are proven track record of company and its
promoters, and sufficient cash generation to provide for returns (principal and interest).
The development bank safeguards its interest through collateral.

They have no say in working of the enterprise except safeguarding their interest by having a
nominee director. They do not play any active role in the enterprise except ensuring flow of
information and proper management information system, regular board meetings,
adherence to statutory requirements for effective management control where as Venture
capitalist remain interested if the overall management of the project o account of high risk
involved I the project till its completion, entering into production and making available
proper exit route for liquidation of the investment. As against this fixed payments in the
form of installment of principal and interest are to be made to development banks.

Venture Capital Vs Seed Capital & Risk Capital

It is difficult to make a distinction between venture capital, seed capital, and risk capital as
the latter two form part of broader meaning of Venture capital. Difference between them
arises on account of application of funds and terms and conditions applicable. The seed
capital and risk funds in India are being provided basically to arrange promoter’s
contribution to the project. The objective is to provide finance and encourage professionals
to become promoters of industrial projects. The seed capital is provided to conventional
projects on the consideration of low risk and security and use conventional techniques for
appraisal. Seed capital is normally in the form of low interest deferred loan as against
equity investment by Venture capital. Unlike Venture capital, Seed capital providers neither
provide any value addition nor participate in the management of the project. Unlike
Venture capital Seed capital provider is satisfied with low risk-normal returns and lacks any
flexibility in its approach.

Risk capital is also provided to established companies for adapting new technologies.
Herein the approach is not business oriented but developmental. As a result on one hand
the success rate of units assisted by Seed capital/Risk

Finance has been lower than those provided with venture capital. On the other hand the
return to the seed/risk capital financier had been very low as compared to venture
capitalist.

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Venture Capital Vs Bought Out Deals

The important difference between the Venture capital and bought out deals is that bought-
outs are not based upon high risk- high reward principal. Further unlike Venture capital they
do not provide equity finance at different stages of the enterprise. However both have a
common expectation of capital gains yet their objectives and intents are totally different

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 The Venture Capital Spectrum
The growth of an enterprise follows a life cycle as shown in the diagram below. The
requirements of funds vary with the life cycle stage of the enterprise. Even before a
business plan is prepared the entrepreneur invests his time and resources in surveying the
market, finding and understanding the target customers and their needs. At the seed stage
the entrepreneur continue to fund the venture with his own or family funds. At this stage
the funds are needed to solicit the consultant’s services in formulation of business plans,
meeting potential customers and technology partners. Next the funds would be required
for development of the product/process and producing prototypes, hiring key people and
building up the managerial team. This is followed by funds for assembling the
manufacturing and marketing facilities in that order. Finally the funds are needed to expand
the business and attaint the critical mass for profit generation. Venture capitalists cater to
the needs of the entrepreneurs at different stages of their enterprises. Depending upon the
stage they finance, venture capitalists are called angel investors, venture capitalist or
private equity supplier/investor.

Venture capital was started as early stage financing of relatively small but rapidly growing
companies. However various reasons forced venture capitalists to be more and more
involved in expansion financing to support the development of existing portfolio
companies. With increasing demand of capital from newer business, Venture capitalists
began to operate across a broader spectrum of investment interest. This diversity of
opportunities enabled Venture capitalists to balance their activities in term of time
involvement, risk acceptance and reward potential, while providing on going assistance to
developing business. Different venture capital firms have different attributes and aptitudes
for different types of Venture capital investments. Hence there are different stages of entry
for different Venture capitalists and they can identify and differentiate between types of
Venture capital investments, each appropriate for the given stage of the investee company,
These are:-

1. Early Stage Finance

 Seed Capital
 Start up Capital
 Early/First Stage Capital
 Later/Third Stage Capital

2. Later Stage Finance

 Expansion/Development Stage Capital

 Replacement Finance
 Management Buy Out and Buy ins
 Turnarounds

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  Mezzanine/Bridge Finance

Not all business firms pass through each of these stages in a sequential manner. For
instance seed capital is normally not required by service based ventures. It applies largely to
manufacturing or research based activities. Similarly second round finance does not always
follow early stage finance. If the business grows successfully it is likely to develop sufficient
cash to fund its own growth, so does not require venture capital for growth.

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Profile
ICICI Venture is one of the largest and most successful private equity firms in India with
funds under management to the tune of USD 2 billion.

ICICI Venture, over the years has built an enviable portfolio of companies across sectors
including pharmaceuticals, Information Technology, media, manufacturing, logistics,
textiles, real estate etc thereby building sustainable value.

It has several “firsts” to its credit in the Indian Private Equity industry. Amongst them are
India’s first leveraged buyout (Infomedia), the first real estate investment (Cyber Gateway),
the first mezzanine financing for a acquisition (Arch Pharmalabs) and the first ‘royalty-
based’ structured deal in Pharma Research & Development (Dr Reddy’s).

ICICI Venture is a subsidiary of ICICI Bank, the largest private sector financial services group
in India.

People
The team at ICICI Venture is a mix of investment professionals, entrepreneurs, industry
professionals, and structured finance professionals.  The complementary strengths of the
various team members ensures not only the best deal sourcing and the most optimum
structuring but also the ability to add significant value to the portfolio companies.

ICICI Venture has the largest team strength amongst all private equity firms in India. In
addition, what makes the team unique is the presence of in-house legal, finance,
compliance and risk departments. The management team at ICICI Venture has the
experience of executing large and complex transactions, structuring innovative deals and
creating new investment landscapes through each of its investments.

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Funds Under Management
1. Private Equity
ICICI Venture currently manages 3 third party capital funds in its Private Equity practice:
India Advantage Fund Series 1, India Advantage Fund Series 2 and India Advantage Fund
Series 3, representing an aggregate original corpus of USD 1.45 billion between the 3
funds.The firm is currently investing out of Series 3 which is a diversified, buyout & late
stage growth capital Fund, India Advantage Fund Series 3.

India Advantage Fund Series 3 (IAF Series 3)

USD 400 million*

India Advantage Fund Series 2 (IAF Series 2)

USD 810 million

India Advantage Fund Series 1 (IAF Series 1)

USD 245 million

ICICI Emerging Sector Fund / Others

USD 692 million

2. Real Estate Fund

ICICI Venture manages a dedicated real estate fund with a corpus of USD 562 million that
was raised in 2006. The Fund invests in both domestic and Foreign Direct Investment (FDI)
projects through equity, quasi-equity and equity related instruments.
India Advantage Fund (Real Estate Series 1)
USD 562 million

3. Mezzanine Fund

This new segment was added in 2007. ICICI Venture is a first mover in Mezzanine in the
Indian PE industry. The India Advantage Fund VII (Mezzanine Fund I) is conceptualized as a
USD 51 million fund that would focus on Mezzanine investment opportunities. The fund has
already concluded its first few investments.

Mezzanine finance typically is a structured debt like instrument, with a component of cash
income and benefits from potential upside return from equity kickers. It often bridges the
gap in corporate capital structure between senior debt and equity. Mezzanine offers
flexibility to meet both the investor’s and investee company’s requirements and also
provides medium to long term capital without significant ownership dilution.

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 India Advantage Fund (Mezzanine Series 1)
USD 51 million

Investment Strategy

Investment Focus

1. Private Equity Practice

ICICI Venture currently manages 3 third party capital funds in its Private Equity practice:
India Advantage Fund Series 1, India Advantage Fund Series 2 and India Advantage Fund
Series 3, representing an aggregate original corpus of USD 1.45 billion between the 3
funds.The firm is currently investing out of Series 3 which is a diversified, buyout & late
stage growth capital Fund, India Advantage Fund Series 3.

The investment philosophy is to pursue transactions with a established enterprise that are
leaders or potential leaders in their respective markets and where there is a clear
proposition for value creation.

The investment thesis is driven by our focus on the following:

Buyouts
ICICI Venture has been a pioneer in buyout investing in India. Buyouts continue to form a
key focus area for the firm and its funds. ICICI Venture has developed the requisite
capability to manage these buyouts and has developed a rich repository of knowledge and
experience through its earlier buyout transactions.

While managing these buyouts, there is a strong involvement of the investment teams in
reorganizing, restructuring and re-strategising the bought out companies, so that, by the
time of exit, these companies reach newer heights and generate handsome returns for our
investors as well as for themselves.

Structured transactions
Focused on effective structuring of transactions through innovative use of multiple
investment instruments.

Growth Capital
The Funds managed by ICICI Venture endeavor to provide financial assistance to well
established/existing enterprises with robust business models and healthy balance sheets
through a variety of investment instruments.

Roll-ups
ICICI Venture is also a pioneer in identifying unique scalable platforms that are ideal for
investments in the form of roll-ups. The firm seeks to use its vast experience and resources
to effectively structure such transactions and add value to realize significant synergies.

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Investment Themes

ICICI Venture, through its earlier Funds has invested in private equity across retail, media,
IT/ITES, consumer services, consumer goods, textiles, pharmaceuticals, biotech, oil, non-
consumer goods etc. The intention is to broad-base the investments across certain focus
sectors and pro actively create deals in these sectors.

For the current Fund (IAF Series 3), investment themes have been developed around three
macro drivers:

Domestic consumption growth

The India outsourcing advantage in both services and manufacturing
Infrastructure creation and allied services

2. Real Estate Practice

ICICI Venture manages a dedicated real estate fund with a corpus of USD 562 million that
was raised in 2005. The Fund invests in both domestic and Foreign Direct Investment (FDI)
projects through equity, quasi-equity and equity related instruments.

Credited with being the first institutional private equity real estate investor in India. ICICI
Venture's real estate team has built a strong and diverse portfolio comprising of premium
housing, integrated townships, commercial, retail, hospitality and IT real estate projects
spread across the country.

Our investment thesis is driven by our focus on the following:

Target projects in growing cities in India with strong economic fundamentals

Establish partnerships with strategic developers and institutional investors
Capitalize on redevelopment opportunities
Invest in assets which can be closely monitored and utilize strong risk mitigation practices
Maximize value by making structured investments

3. Mezzanine Practice

ICICI Venture is in the process of closing India Advantage Fund VII (Mezzanine Fund 1),
India’s first Mezzanine fund. The corpus of the fund is roughly USD 51 million.

About Mezzanine Finance

Mezzanine finance typically is a structured debt-like instrument, with a component of cash

income and benefits from enhanced returns from equity-linked component. It often bridges
the gap in corporate capital structure between senior debt and equity. Mezzanine offers
flexibility to meet both the investor’s and investee company’s requirements and also
provides medium to long term capital without significant ownership dilution.

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The Mezzanine team seeks to provide funds for financing various areas including:

Buyouts, merger and acquisitions

Growth for medium-sized businesses
Asset backed businesses such as real estate or financial markets

Given its structure and flexibility, mezzanine financing can be an extremely useful financing
option for a growing economy such as India.

Investment Approach
1. Deal Sourcing
ICICI Venture's investment process starts with the sourcing of deals. Being the premier
private equity player in India, ICICI Venture's reputation and brand equity has been
attracting investment proposals and deals from entrepreneurs, management teams,
promoters and intermediaries. Deals are also directly sourced from industry contacts of the
management team. Besides, ICICI Venture also leverages its network with investment
banks, fund investors, and also draws upon its access to the ICICI Bank Limited network with
its large corporate clientele.

2. Deal Evaluation
ICICI Venture engages in a rigorous and disciplined decision-making process prior to making
an investment. When considering a potential transaction, ICICI Venture conducts a timely
and thorough due diligence investigation. The skills of the ICICI Venture investment
professionals are important to the due diligence process, as they are able to determine the
optimal structure and financing methods for a particular transaction, as well as negotiate
favorable acquisition terms. ICICI Venture has an in-house risk, legal & compliance team
which provides transactionary support to the investment teams & greatly enhance the
response time.

The investment proposal would move through various stages of preliminary analysis, initial
meeting, internal valuation discussion, valuation negotiation, term sheet negotiation,
management committee meeting, & due diligence appraisal meeting before it is proposed
in the Investor Committee meeting.

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 3. Investment Decision
The Investment Committee reviews a deal recommended for investment and either
approves or rejects the investment proposal. The Investment Committee may, if considered
necessary, ask for further analysis, additional due diligence or any other clarifications. The
final decision is based on a majority vote in the Investment Committee.

4. Post-Investment Process
ICICI Venture endeavours to ensure that the Portfolio Companies are governed effectively
and that there is active involvement and timely intervention by the team once the
investment is made. The team creates value in the Portfolio Companies by taking strategic,
operational and financial initiatives aimed at strengthening their competitive position vis-à-
vis competitors and industry benchmarks.

The Investment team works with management teams to identify opportunities for
enhancing value through cost reduction and internal rationalization. They also work
together to implement growth strategies based on market definitions, customer
segmentation, price management, focused marketing and sales plans, strategic capital
investments and /or the introduction of proven technologies. The Investment teams also
help in further strengthening the management teams. ICICI Venture works actively with
management teams to identify and execute acquisitions.

5. Exit Strategy
ICICI Venture seeks to achieve a timely and appropriate exit to return cash and profits for its
Investors. Such exit strategies may include:

Selling off the stake to strategic investors

Initial Public Offering in India or overseas
Sale to any other private equity fund or venture capital fund
Secondary sale on stock markets
Merger with an existing listed company
Management / Company buy-backs.

The holding period of each investment is generally between 3 to 5 years. This however
depends upon the stage of investment and the performance of the sector and the
company.

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