The Finance Need:
Expansion Of Disinvestment Options

Venture capital is a long-term illiquid investment. Funds are locked up in a risky venture for long periods because venture capitalists expect large capital appreciation on their investments at the time of exit. If money is to flow in, it must also be able to flow out. Concurs Pradip Shah, 44, chairman, Indocean Venture: "We need an efficient exit mechanism in place for venture capital if foreign direct investment is to flow in." But thanks to a thicket of regulations and a far-from-perfect capital market, CFOs have often not been able to provide for a smooth, and efficient, exit for venture capital.

The Structured Solutions: In a developed market, the menu of disinvestment options includes a sell-off to another venture capital fund, promoter buybacks or management buy-outs, public issues, or a sale in the over-the-counter market. Apart from the occasional sale to another venture capital fund, a la Microland, promoter buyback has been, by far, the most popular exit route for start-ups in this country.

Most venture capital deals include a clause that provides a repurchase option to the entrepreneur. For medium-sized listed companies, this route has been blocked as the law currently does not permit share buybacks by the promoter. However, the proposed Companies Act, 1997, will do away with that ban, reinforcing the shift towards medium-sized companies.

Yet, for the CFO, buybacks are an expensive way of assuring investors an exit route. If the project is beginning to generate returns, share prices will appreciate substantially. Internal accruals alone may be inadequate to bankroll the repurchase, and institutional funding for such buy-outs is rarely forthcoming. Sure, there is no legal bar to such funding, but the risks of extending debt against the shares of a newly-established company have kept away most banks and financial institutions.

Creative financial engineering can find a way around this problem. To provide the lenders with an additional degree of security, a Special Purpose Vehicle (SPV) can be created, which would hold the shares bought back from the venture capital firm in trust until the firm achieves a certain targeted rate of return. Meanwhile, a certain proportion of the firm's sale proceeds can be funnelled directly to the SPV to amortise the debt.

An exit via the capital market is certainly less expensive, but this option is open only to the more established firms. A listing on a stock exchange, which would enable the venture capitalist to easily offload his stake, is obviously a far more feasible proposition for a firm already in existence for a few years than for a new venture. Concurs Vimal Bhandari, 39, executive director, InFRAstructure Leasing & Financial Services: "When you carry out a risk-structuring exercise, you would prefer investments from which you can exit in a much shorter time-FRAme, and a much less risky environment."

Then, there are the stiff capital requirements. For a listing on either the Bombay Stock Exchange or the National Stock Exchange, the minimum capital requirement is Rs 10 crore. While the Over-The-Counter Exchange of India (OTCEI) would have been an ideal solution for a young company contemplating listing, since its inception in 1992, the exchange has been plagued by poor liquidity, negative returns, and a general lack of investor interest.

Even if the otcei does manage to perk up, do not expect small start-ups to enlist. Global experience indicates that, despite liberal admission requirements, over-the-counter exchanges for unlisted securities tend to be dominated by fast-growing or medium-sized companies.

Clearly, the economics of exit dictate a shift away from start-ups. And this spells the end of the venture capital company as the business buccaneer in the next millennium.