Economics of Venture Capital Industry in India : An Analysis of the Macro Ecosystem and Micro Decision Making

Abstract

Venture Capital (VC) is regarded as one of the most powerful financial innovations of the 20th century (Schwienbacher, 2009). Venture Capitalists are financial intermediaries focused on funding projects in emerging high – technology realms. Some of the world’s most visible companies today (Microsoft, Google, Apple, Sun Microsystems, HP, Facebook, and so on) have all been VC funded during their earlier stages. The Indian Venture Capital (VC) ecosystem has been rapidly evolving over the past decade. As of 2013, India ranks among the top five nations in terms of the deployment of global VC funds (Ernst and Young, 2014). Today, there are more than 350 VC funds operating in India (Securities and Exchange Board of India, 2012). About one-third of the top 500 companies in India today are VC funded (Bain Consulting, 2012). Thus, it can be said beyond doubt that VC has played a very important role in the promotion of entrepreneurial ventures in the Indian economy. Yet, there exists a limited understanding about the operations of the VC firms in India. The aim of this study was to fill this gap.

The VC firms (fund managers or the General Partners) typically raise funds from the fund providers (Limited Partners) and invest them in fledgling companies. Such investments are highly risky, and most of them fail entirely; however, the few large winners more than compensate for the failures (Dossena and Kenney, 2002). In return for investing, the VC firms receive a major equity stake in the firm and seats as the members of the board of directors. By active intervention and assistance, VC firms act to increase the chances of success of a new firm. The VC process is complete when the company is sold through either listing on the stock market or is acquired by another firm, or when the company fails (Dossani and Kenney, 2002). The funds raised via exits therein are then returned to the respective fund providers and the investment cycle starts all over again (Gompers and Lerner, 2004).

Since, nascent technologies, domains and business models and most importantly intangibility of assets are the mainstay of VC funded projects, it results in an extreme level of information asymmetry. Consequently, funding these projects warrants specialized risk assessment skills. In fact, VC firms are known to possess the forte in selecting and monitoring ventures with an extreme level of information asymmetry (Chan, 1983; Macintosh, 1994; Sahlman, 1990; Amit, et al., 1990, 1993, 1998). Information asymmetry results in two distinct kinds of risks – Adverse Selection and Agency problems. Adverse Selection risks are those resulting from hidden information (i.e. entrepreneurs possess certain information not known to the VCs). Agency risks are the ones emanating from hidden actions (i.e. entrepreneurs can take certain actions not observable by the VCs). As niche financial intermediaries, VC firms are known to be well-versed with strategies to tackle both of these. While Adverse selection is tackled by intensive proposal screening and due diligence, syndication of deals (co-investing with other VC firms) and specialization (by domain, funding size, stage of funding); agency risks are overcome by staging of investments, legal contracting and extensive monitoring of the investee firms (Gupta and Sapienza, 1992; Rosenstein et al., 1993; Barry, 1994; Lerner, 1994; Fried and Hisrich, 1994; Gompers and Lerner, 1999, Pruthi et al., 2003). Typically, the adverse selection risks are dominant during the investment phase while agency risks are prominent during the portfolio management and exit phases of the VC firm’s lifecycle