Is the Venture Capital Market in India Getting Overheated?

Introduction

The Venture Capital market in India seems to be getting as hot as the country’s famous summers.
However, this potential over-exuberance may lead to some stormy days ahead, based on sobering
research compiled by global research and analytics services firm, Evalueserve.

Evalueserve research shows an interesting phenomenon is beginning to emerge: Over 44 US-based
VC firms are now seeking to invest heavily in start-ups and early-stage companies in India. These
firms have raised, or are in the process of raising, an average of US $100 million each. Indeed, if these
40-plus firms are successful in raising money, they would garner approximately $4.4 billion to be
invested during the next 4 to 5 years. Taking Indian Purchasing Power Parity (PPP) into
consideration, this would be equivalent to $22 billion worth of investment in the US. Since about
$1.75 billion (or approximately 40% of $4.4 billion) has been already raised, even if only $2.2 billion

is raised by December 2006, Evalueserve cautions that there will be a glut of VC money for early-
stage investments in India. This will be especially true if the VCs continue to invest only in currently

favourite sectors such as IT, BPO, software and hardware products, telecom, and consumer Internet.
Given that a typical start-up in India would require $9 million during the first three years (i.e., $3
million per year) and even assuming that the start-up survives for three years, investing $2.2 billion
during 2007-2010 would imply investing in 150 to 180 start-ups every year during this period, which
simply does not seem practical if the VCs continue to focus only on their current favourite sectors.

In contrast to the emerging trend highlighted above, Indian companies received almost no Private
Equity (PE) or Venture Capital (VC) funding a decade ago. This scenario began to change in the late
1990s with the growth of India’s Information Technology (IT) companies and with the simultaneous
dot-com boom in India. VCs started making large investments in these sectors, however the bust that
followed led to huge losses for the PE and VC community, especially for those who had invested
heavily in start-ups and early stage companies.

After almost three years of downturn in 2001-2003, the PE market began to recover towards the end
of 2004. PE investors began investing in India again, except this time they began investing in other
sectors as well (although the IT and BPO sectors still continued to receive a significant portion of
these investments) and most investments were in late-stage companies. Early-stage investments have
been dwindling or have, at best, remained stagnant right through mid-2006.

Based on Evalueserve’s experience that includes several hundred research engagements focused on
India and the Indian market for our globally dispersed client-base over the last five years, and also
interviews with VCs, Indian entrepreneurs, consultants, and experts within this ecosystem and our
analysis of data from the Indian Venture Capital Association (IVCA) and Venture Intelligence India,
this article examines whether this new, very large total investment can actually be “absorbed” by
start-ups and early-stage companies in India. We will also describe some of the “ground realities” and
highlight a couple of “best practices” that may help VCs to invest more effectively in India.

Note: Most of this article is restricted primarily to early-stage VC investments, i.e.,
investments in a start-up or a small company when the total amount of external money
invested is typically $9 million or less during its entire period of existence. This will be
followed by a separate article, which will focus entirely on Private Equity investments in
India.

1. The PE and VC Investment Boom in 2000 and Its Aftermath:

1996-1997 – Beginning of PE/VC activity in India: The Indian private equity (PE) and venture
capital (VC) market roughly started in 1996-1997 and it scaled new heights in 2000 primarily because
of the success demonstrated by India in assisting with Y2K related issues as well as the overall boom
in the Information Technology (IT), Telecom and the Internet sectors, which allowed global business
interactions to become much easier. In fact, the total value of such deals done in India in 2000 was
$1.16 billion and the average deal size was approximately US $4.14 million. See Figure 1.

2001-2003 – VC/PE becomes risk averse and activity declines: Not surprisingly, the investing in
India came “crashing down” when NASDAQ lost 60% of its value during the second quarter of 2000
and other public markets (including those in India) also declined substantially. Consequently, during
2001-2003, the VCs and PEs started investing less money and in more mature companies in an effort
to minimize the risks. For example:

• The average deal size more than doubled from $4.14 million in 2000 to $8.52 million in 2001
• The number of early-stage deals fell sharply from 142 in 2000 to 36 in 2001
• Late-stage deals and Private Investments in Public Equity (PIPEs) declined from 138 in 2000 to 74
  in 2001, and
• Investments in Internet-related companies fell from $576 million in 2000 to $49 million in 2001.
  This decline broadly continued until 2003.

2004 onwards – Renewed investor interest and activity: Since India’s economy has been growing at
7%-8% a year, and since some sectors, including the services sector and the high-end manufacturing
sector, have been growing at 12%-14% a year, investors renewed their interest and started investing
again in 2004. As Figure 1 shows, the number of deals and the total dollars invested in India has been
increasing substantially. For example, US $1.65 billion in investments were made in 2004 surpassing
the $1.16 billion in 2000 by almost 42%. These investments reached US $2.2 billion in 2005, and
during the first half of 2006, VCs and PE firms have already invested $3.48 billion (excluding debt
financing). We forecast that the total investment in 2006 is likely to be $6.3 billion, a number that is
more than five times the amount invested in 2000.

Figure 1: Total Number and Value of PE and VC Investments

PE investment expands beyond IT and ITES: A very important feature of the resurgence in the PE
activity in India since 2004 has been that the PEs are no longer focussing only on the IT and the ITES
(IT Enabled Services, commonly known as “Business Process Outsourcing” or BPO) sectors. This is
partly because the growth in the Indian economy is no longer limited to the IT sector but is now
spreading more evenly to sectors such as bio-technology and pharmaceuticals; healthcare and medical
tourism; auto-components; travel and tourism; retail; textiles; real estate and infrastructure;
entertainment and media; and gems and jewellery. Figure 2 shows the division across various sectors
with respect to the number of deals in India in 2000, 2003 and the first half of 2006.

Figure 2: Percentage of the number of deals by PEs in various sectors

2. Early Stage VC Investments during 2000-2006:

Since the Purchase Power Parity (PPP) in India is approximately a factor of 5 (as in, a factor of 5 is
used to normalize the GDPs of US & India on a PPP basis), our analysis shows that early stage VC

investments in India should include those that are $8 million or less. In fact, we can classify early-
stage investments further into Seed, Series A and Series B investments depending upon their value.

Figure 3: Investment Range of Early-stage VC Deals in India and the US (in US $)

Figure 4 given below provides a break-up of the total value of investments into early-stage
investments (primarily by VCs) and late-stage investments and PIPEs (primarily by PEs). Even within
early-stage investments, seed investments declined the most during 2000-2003 and have essentially
remained negligible during 2004-2006.

Figure 4: Value of Deals (in $ millions) Based on the Type of the Investment

Figure 5 shows the break-up of early-stage investments by Seed and Series A and B investments. In a
nuance, perhaps unique to India, after interviewing several entrepreneurs and experts in India, we
believe that since the Indian upper middle class has become quite affluent during the last 7-10 years,
the entrepreneurs are relying more and more on family and friends for seed funding, and since
emerging entrepreneurs come from this upper middle class, the need for seed funding from VCs could
remain low for many years to come!

Figure 5: Number of Early-stage VC Deals

The remaining portion of this article is limited to early-stage VC investments only, i.e.,
investments in a start-up or a small company when the total amount of external money
invested is up to $9 million during its entire period of existence.

3. VCs that are likely to invest in Early Stage Companies in India

Barring occasional forays by VC firms into India in the early to mid-1990s, the first major rush of
VCs to India in recent times was witnessed during the dotcom boom in 1999-2000. However, several
ended up closing shop during 2001-2003 because of the bust that followed. The period 2004-2006 has
seen a resurgence of VC activity. The various VC players operating in India can be broadly classified
as follows:

3.1. Government Funds: Some Indian state government funds are actively investing in India. These
include SIDBI Venture Capital Limited, Gujarat Venture Fund Limited, RVCF, APIDC, Canbank
Venture Capital Fund Limited, IFCI Venture Capital Funds Limited, Rajasthan Asset Management
Co. Private Ltd., KITVEN and Kerala Venture Capital Fund Private Limited. Investments from these
institutions have the advantage of lower ‘cost’ of capital and hence can be more attractive to
entrepreneurs; however, the maximum amount of capital available is typically $500,000.

3.2. Non US-based Funds: These international funds largely invest in early stage and mid stage
companies and include Barings, 2iCapital Private Limited, Aavishkaar India, 3i, (private equity firm
headquartered in Europe), Gaja Capital, Chryscapital Management Companies, HSBC Private Equity
Management (Mauritius) Limited, IL&FS Investments Managers Limited, Information Technology
Venture Enterprises Limited, Indian Direct Equity Advisors Private Limited, Kotak Mahindra Finance
Ltd, Merlion India Fund (Standard Chartered Private Equity), Punjab Venture Capital Limited and
SICOM Capital Management Limited.

3.3. Large Company Funds: For the last 3 to 5 years, many large companies have also been making
early stage and mid-stage VC investments. Such companies are mostly investing in their own
industries and leveraging their expertise with a longer-term view of potential acquisitions. Large
company funds operating in India include those set up by high-tech firms such as Intel, BlueRun
Ventures (owned by Nokia), Motorola, SAP Ventures, Siemens, Acer Technology Ventures, and
Cisco. In addition, several financial companies and a few Indian conglomerates including the
following have small VC funds: Kotak, IDFC, Reliance Capital, JM Financial, Religare (owned by

Ranbaxy), State Bank of India, Banc of America Equity Partners Asia, Unitech (a very large real-
estate developer and manager in India) and Piramal (a well known pharmaceutical company).

3.4. VC Entrants from the US: Evalueserve’s research indicates that several US-based VC funds
have also been investing in the Indian market for the last six years. So far, these funds have been
investing in early and mid-stage technology companies dealing primarily with consumer Internet,
mobile devices, wireless and wire-line, IT services, BPO services, software and hardware products,
electronics and semiconductors. Most of these VC firms are listed in Figure 6.

Figure 6: US-based VC funds investing in India

3.5. New Groups Raising Money for Investing in India: In addition to the US-based VC groups that
have already invested in cross-border start-ups and in “pure” India-based companies, and excluding
US-based PE firms (e.g., Francisco Partners, Texas Pacific Group, General Atlantic Partners,
Warburg Pincus, Kohlberg Kravis Roberts & Co.) that are likely to make late-stage investments or
PIPEs, our research shows that more than 19 other groups are raising – or have raised – money to
establish funds in India. These groups are primarily US-based VCs, usually with Non-Resident
Indians who are based in the US, who have by and large not made any investments in India. These 19
groups do not include some well known US-based funds (e.g., Greylock and Mayfield) that are in the
process of formulating an “investing strategy for India.” Since some groups have requested anonymity
and confidentiality because they are still in the process of raising money, only 14 out of 19 are
mentioned below:

• Helion VCs (with its Principals Ashish Gupta, Rahul Chandra and Kanwaljit Singh, who very
  recently, made their first investment in JiGrahak Mobility Solutions)
• Nexus India (with its Principals Naren Gupta, Suvir Sujan and Sandeep Singhal)
• Quattro BPO Solutions (with its Principal Raman Roy, who very recently, made his first
  investment in Annik Technology Solutions)
• Inventus Capital Partners (with its Principals Kanwal Rekhi and John Dougery)
• Inc3 (with its Principal Dimant Bhayani)
• IDG Ventures India (with its Principal Manik Arora)
• Silicon Valley Bank (with its Principals Ash Lilani and Suresh Shanmugham)
• Venrock Associates (with its Principal Dev Khare)
• Lightspeed Venture Partners (with its Principal Ajit Deora)
• Diamondhead Ventures (with its Principal Raman Khanna)
• Globespan Capital (with its Principal Venky Ganesan)
• Storm Ventures (with its Principal Sanjay Subhedar)
• Shasta Ventures (with its Principal Ravi Mohan)
• Outlook Ventures (with its Principals Carl Nichols and Sandeep Aneja).

3.6. Future of Early Stage Investments in India: In summary, our research shows that there are
more than 44 VC groups that have either already raised — or are in the process of raising — between
$40 and $400 million for early-stage investments in Indian companies. If all these groups were
successful in raising money, then jointly they would raise $4.4 billion (i.e., an average size of $100
million per fund) that would need to be invested during the next 4-5 years. Considering the Purchase
Power Parity (PPP) in India is approximately 5, this is equivalent to investing around $22 billion in
the US, which is really large no matter the geography! Since about $1.75 billion (or approximately
40% of $4.4 billion) has already been raised, if we assume just half of this money (i.e., $2.2 billion) is
eventually raised, it would clearly result in a glut of VC money for early-stage and mid-stage
investments in India, especially true if the VCs continue to invest only in currently favourite sectors
such as IT, BPO, software and hardware products, telecom, and consumer Internet.

Given that a typical start-up in India would require $9 million during the first three years (i.e., $3
million per year), and assuming that the start-up in fact survives for three years, investing $2.2 billion
during 2007-2010 would imply investing in 150 to 180 start-ups every year during this period, which would simply not be possible if the VCs continue to focus on their current favourite sectors. This, of
course, would be a marked contrast to the current situation in India (wherein such funding is rather
scarce) and it will also make the market for the ‘right deals’ extremely competitive for these VCs.
Keeping this in view, in the next section, we analyze some of the on-the-ground realities and best
practices for VCs to invest effectively in India.

4. On-the-Ground Realities and Some “Best Practices” for Investing in India

In many respects, the sophistication and maturity of VC investments in India today are probably at the
same level as in the early 1970s in the US. This section advocates some “best practices” and
highlights some of the key differences between investing in early-stage and mid-stage companies in
the US versus investing in similar companies in India.

4.1. Maniacal focus on early profitability might be counter-productive for a product company: Unlike most start-ups in the US, which are usually product-based and are usually expecting 2-3 stages
of investment, entrepreneurs in India are usually focussed on making their companies profitable as
soon as possible. This mindset might be because Indian entrepreneurs have, to some extent,
traditionally founded services and trading companies. From an Indian entrepreneur’s perspective, the
reasons for making their company profitable quickly include: (a) the scarcity of available venture
capital in India so far, (b) reluctance in giving up too much equity, and (c) since most Indian start-ups
have been in the service sector so far, they require a significantly smaller amount of venture capital.
Of course, the disadvantages of such a maniacal focus on profitability include (a) the possibility that
an Indian start-up may not able to grow very quickly or realize its full potential and (b) the possibility
of an Indian start-up being upstaged by some other firm somewhere else in the world. Hence, the VCs
must play a crucial role in educating Indian entrepreneurs to think differently in the context of
product-based companies compared to how they have traditionally run their companies.

4.2. Need for continued funding but in small amounts: Since the Purchase Power Parity in India is
5, and since many – if not most – Indian start-ups still continue to be created in the services business,
and since the entrepreneurs for even those product-based start-ups wish to achieve profitability
quickly, we believe the VCs should not look at funding Indian companies in distinct stages (i.e., seed
funding, Stage A funding, Stage B funding, mezzanine funding etc). Rather they should provide small
portions of “continuous” funding based on continued attainment of predefined metrics such as
revenues, profits, development expenses, etc. Of course, this would imply that the VC has to be more
involved operationally with the Indian start-up and simply attending a board meeting every two or
three months might not be sufficient. It would also imply that the VC would essentially act as a
“bank” that provides money in exchange for equity, as and when needed.

4.3. Indian entrepreneurs lack marketing, sales and business development expertise: During our
interviews and research, we found Indian entrepreneurs to be quite adept technically and definitely at
par with similar entrepreneurs in developed countries. However, we also found the entrepreneurs in
India generally lacked expertise in marketing, sales and business development areas, especially when
compared to their counterparts in the US. Furthermore, since India had socialistic economic policies
during 1947-1992, there is a lack of good talent in marketing and sales professionals who can thrive in
an extremely competitive environment. Hence, finding the appropriate marketing, sales and business
development people is one area where Indian start-ups need help. This problem is further exacerbated
because the Indian economy has been growing at 8% and most start-ups have to compete for talent not
only with other companies who are exporting similar or dissimilar products and services but also with
many Indian domestic companies. In fact, finding and retaining the ‘right talent’ has become an issue
not only in marketing, sales and business development but also in research, technical and advanced
development areas. Finally, if the eventual market were a developed country, then such expertise can
be potentially found in that country. However, if the market for the corresponding product or service
is India, China or some other developing nation, then finding such people can be a Herculean task!

4.4. Indian entrepreneurs are hesitant to give up control: Indian entrepreneurs are usually hesitant about giving up control. In fact, most of the entrepreneurs in India currently receive their initial 8 funding from family and friends, and even if they do not do so, the Indian social system is such that
relatives and friends still end up being a major influence. Also, since the Bombay Stock Exchange
(BSE) has been growing quite rapidly (in spite of the recent 20% drop) and a company with $20
million in annual revenue can be easily listed on it, many Indian entrepreneurs would rather list their
companies on BSE than give up a substantial share to the VCs. Consequently, the VCs will have to
provide a very clear value proposition to the start-ups and cannot simply state that they bring value to
the table just because they are well connected, etc. In fact, we believe that in some cases the VCs may
even have to go to the extreme of closing contracts and bringing in the revenue on behalf of a start-up
rather than simply “opening doors” by providing the contacts in their “Rolodex.”

4.5. Lack of financial transparency and other processes: Again, partly because the Indian economy
was a “socialistic and closed” economy and partly because Indian entrepreneurs are not as proficient
at business development as their counterparts in the US, Indian start-ups lack financial transparency
and often have limited experience in implementing effective financial processes. This usually makes
the task of the VC much more difficult not only during the due-diligence phase, but also in helping the
start-up grow rapidly. Consequently, we believe that immediately after making its investment, the VC
may have to “roll up the sleeves” and help the entrepreneurs in “process-izing” the company. We also
believe that simply directing the Indian entrepreneurs to implement processes during monthly or
quarterly board meetings may prove to be futile because many entrepreneurs might not know how to
execute on these instructions.

4.6. Investment thesis and the current model is un-sustainable: One of the most worrisome aspects
of the VCs’ new-found zeal to invest in India is that most VCs want to continue to invest in Indian
start-ups in areas they are most familiar with, i.e., in IT, telecom and Internet products and services.
So, it is not surprising that eight consumer-travel Internet websites have already been funded in India,
and given that this sector only accounted for approximately $152 million worth of booking
transactions in 2005, and given that this number is likely to grow to only to $1.2 billion by 2010, the
actual revenue and profits earned by this sector even in 2010 are likely to be $75 million and $9
million respectively, which is miniscule by any standards! Similarly, if we study the cross-border and
“pure” India-based companies listed in Section 2.4, more than 90% are in the IT, ITES and BPO,
Telecom, and Consumer Internet.

So, going forward, the VCs may want to investigate the following rapidly emerging sectors for
potential investment: auto-components, travel and tourism, domestic healthcare and medical tourism,
retail, textiles, biotechnology, pharmaceuticals, real estate and infrastructure, entertainment and
media, gems and jewellery, and of course, the traditional sectors that include telecom, IT, and
Business Process Outsourcing services. An overview of these sectors has been provided in a separate
research paper from Evalueserve.

Finally, it is interesting to note that in this regard, several VC firms (e.g., ChrysCapital, Westbridge –
now a part of Sequoia Capital, India) are beginning to follow a well-rounded and diversified strategy,
but so far most of it is limited to late stage investments and PIPEs. For example, during the last 2-3
years, Bessemer has invested in the following companies:

• Shriram EPC, a specialized engineering services company addressing the Indian infrastructure
  sector
• Sarovar Hotels & Resorts, a company that manages a diverse portfolio that includes hotels, resorts,
  restaurants, and corporate hospitality
• Rico Auto Industries, which designs and manufactures auto components for such firms such as
  Ford, GM, and Cummins, and
• Motilal Oswal Financial Services Ltd, a financial services and brokerage company serving the
  needs of both institutional and retail investors in India.

4.7. Lack of VCs who have cross-border experience: The other really worrisome aspect is that many
US-based VCs believe they can help the growth of Indian start-ups, and provide good returns to their
own shareholders by:

• Making decisions by periodically visiting India: This usually requires conducting frequentconference calls and either the VCs flying to India or the executive management of the start-
  up flying to the US every two or three months (for a face-to-face meeting). Since the Indianstart-ups require a lot of handholding in the areas mentioned above, this approach is unlikely
  to be very effective.
• Sending one of the senior partners in the VC firm to India to set up a subsidiary that can help
  its portfolio companies: Although this approach may work, it is likely to fail in instances
  where the partner has not lived and managed any organization in India for at least two to three
  years. This is because even Indians living in the US are usually not familiar with the typical
  business practices in India unless they have had 2-3 years of recent experience on the ground
  in India.
• Hiring a junior partner in India: This approach has three major disadvantages: First, the
  challenges required by Indian start-ups vary from hiring good talent inside and outside the
  country to setting up effective and efficient processes. Second, if the partner is fairly junior
  then this person may not have sufficient experience to advise this start-up effectively, and
  third, such a junior partner would have a ‘low standing’ within the VC firm and hence, both
  the junior partner and its portfolio companies in India would feel they are being dictated to by
  senior partners in the US (who may not understand the environment in India adequately).

4.8. Well-known US VCs may not have the same brand recognition in India yet: Since venture
capital investing in India is a relatively recent phenomenon, VCs who may be well known in the US
may not yet be able to take their brand recognition in India for granted. In fact, we believe that
successful Indian entrepreneurs and VCs who have lived in the US and have at least ten years of
experience in running their own companies, or have been actively involved in helping others and can

get down in the “trenches” with the Indian entrepreneurs are more likely to succeed and build a brand-
name for themselves and their groups. Of course, on the other hand, since most – if not all – of these

groups are raising the money in the US, brand name VCs in the US will definitely be able to raise this
money much more efficiently and effectively than those groups that are not known in the US. Again,
the implication for the VC firm is that it will have to articulate a very clear value proposition.