Creating an Environment for Venture Capital in India

Creating an Environment for Venture Capital in India

RAFIQ DOSSANIStanford University, California, USA

and

MARTIN KENNEY *

University of California, Davis and Berkeley Roundtable on theInternational Economy, USA

Summary. — The institution of venture capitalism is a difficult one to initiate through policyintervention, particularly in developing countries with unstable macroeconomic environments andhistories of state involvement in the use of national capital and in the composition of production.India has all these constraints. The emergence of a thriving software services industry after 1985created the raw material that venture capital could finance, thus achieving a critical preconditionfor venture capital’s growth. It was followed by efforts to create a venture capital industry. Afterseveral setbacks, some success has been achieved largely due to a slow process of moulding theenvironment of rules and permissible institutions. The process was assisted by the role of overseasIndians in Silicon Valley’s success in the 1990s. Yet, in terms of what is needed, most of the workremains to be done. Inevitably, this will be the result of joint work by policymakers andpractitioners. � 2002 Elsevier Science Ltd. All rights reserved.

Key words — venture capital, India, entrepreneurship

1. INTRODUCTION

In the last decade, one of the most admiredinstitutions among industrialists and economicpolicymakers around the world has been theUS venture capital industry. A recent OECD(2000) report identified venture capital as acritical component for the success of entrepre-neurial high-technology firms and recom-mended that all countries consider strategiesfor encouraging the availability of venturecapital. With such admiration and encourage-ment from prestigious international organiza-tions has come various attempts to create anindigenous venture capital industry. This paperexamines the efforts to create a venture capitalindustry in India.The possibility and ease of crossnational

transference of institutions has been a subjectof debate among scholars, policy makers, andindustrialists during the entire 20th century, ifnot earlier (e.g., Kogut & Parkinson, 1998).National economies have particular path-de-pendent trajectories, as do their national sys-tems of innovation (NIS). 1 The forces arrayed

against transfer are numerous and include cul-tural factors, legal systems, entrenched institu-tions, and even lack of adequately trainedpersonnel. Failure to transfer is probably themost frequent outcome, as institutional inertiais usually the default option. In the transferprocess, there is a matrix of possible interac-tions between the transferred institution andthe environment. There are four possible in-teractions: (a) The institution can be success-fully transferred with no significant changesto either the institution or the environment.

World Development Vol. 30, No. 2, pp. 227–253, 2002� 2002 Elsevier Science Ltd. All rights reserved

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*Rafiq Dossani is grateful to participants at the SEBI

workshop on venture capital held in Mumbai, India, in

August 1999 and to participants at Fairfield University’s

South Asia Conference held in November 1999 for their

comments on an earlier version of this paper. Martin

Kenney would like to thank Frank Mayadas of the Al-

fred P. Sloan Foundation for supporting his portion of

this research. The authors thank Vijay Angadi, Kyon-

ghee Han, Matthew C.J. Rudolph, and Lawrence David

Saez for valuable comments. Final revision accepted:

27 September 2001.

227

(b) The institutional transfer can fail. (c) Theinstitution can be modified or hybridized sothat it is able to integrate into the environment.(d) An interaction between the existing insti-tutions and venture capital to modify the en-vironment occurs. Though (a) and (b) areexclusionary, it is possible for transfer to yield acombination of (c) and (d). 2

The establishment of any institution in an-other environment can be a difficult trial-and-error learning process. Even in the UnitedStates, state and local government policies toencourage venture capital formation have beenlargely unsuccessful, i.e., Interaction (b) (Flor-ida & Smith, 1993). Similarly, efforts in the1980s by a number of European governments tocreate national venture capital industries alsofailed. Probably the only other country to de-velop a fully Silicon Valley-style venture capitalindustry is Israel. Taiwan, perhaps, is anothercountry that appears to have developed a ven-ture capital industry, though there has beenlittle research on the dynamics of this process inTaiwan. Given the general difficulties in morewealthy and developed countries, it would seemthat India would have poor prospects for de-veloping a viable venture capital community.India is a significant case study for a number

of reasons. First, in contrast to the UnitedStates, India had a history of state-directedinstitutional development that is similar, incertain ways, to such development in Japan andKorea, with the exception that ideologically theIndian government was avowedly hostile tocapitalism. Furthermore, the government’spowerful bureaucracy tightly controlled theeconomy, and the bureaucracy had a reputa-tion for corruption. Such an environmentwould be considered hostile to the developmentof an institution dependent upon a stable,transparent institutional environment. Indiadid have a number of strengths. It had anenormous number of small businesses and apublic equity market. Wages were low, not onlyfor physical labor, but also for trained engi-neers and scientists, of which there was a sur-feit. India also boasted a homegrown softwareindustry that began in the 1980s, and becamevisible upon the world scene in the mid-1990s.Experiencing rapid growth, some Indian soft-ware firms became significant successes andwere able to list on the US NASDAQ. Finally,beginning in the 1980s, but especially in the1990s, a number of Indian engineers who hademigrated to the United States became entre-preneurs and began their own high-technology

firms. They were extremely successful, makingthem multimillionaires or even billionaires, andsome of them then became venture capitalistsor angel investors. So there was a group ofpotential transfer agents.For any transfer process, there has to be

some match between the environment and theinstitution. In addition, there must be agentswho will mobilize resources to facilitate theprocess, though these agents can be in thepublic or private sector. Prior to 1985, the de-velopment of venture capital in India was veryunlikely. But the environment began to changeafter 1985, and continues to change. Even inthe United States, venture capital is only asmall component of the much larger NIS, andas such is dependent on many other institu-tions. In the United States and in India thedevelopment of venture capital has been a co-evolutionary process. This is particularly truein India, where it remains a small industryprecariously dependent upon other institutions,particularly the government, and external ac-tors such as international lending agencies,overseas investors, and successful Indian en-trepreneurs in Silicon Valley. The growth ofIndian venture capital must be examined withinthe context of the larger political and economicsystem in India. As was true in other countries,the Indian venture capital industry is the resultof an iterative learning process, and it is still inits infancy. If it is to be successful it will benecessary not only for it to grow, but also forits institutional context to evolve.The paper begins with a brief description of

the development of US, Israeli, and Taiwaneseventure capital industries. Particular attentionis given to the role of the state. The second andthird sections discuss the Indian economic andfinancial environment. This is followed by abrief overview of the Indian information tech-nology (IT) industry and a section on the roleof nonresident Indians (NRIs). These threesections provide the environmental contextwithin which the Indian venture capital indus-try was formed. The actual development of theIndian venture capital is described chronologi-cally. The first period is when government andmultilateral lending agencies are the primaryactors and investors in the Indian venturecapital industry. In the second period there is agradual process of liberalization of the venturecapital market and the entrance of more privateventure capitalists particularly from the UnitedStates. The final sections reflect upon the pro-gress of the Indian venture capital industry,

WORLD DEVELOPMENT228

while also highlighting the institutional barriersto continuing expansion.

2. VENTURE CAPITAL AS ANINSTITUTION IN OTHER COUNTRIES 3

Investing in a fledgling start-up firm is ex-tremely risky, because of the high rate of failureamong new firms, something Stinchcombe(1965) termed the ‘‘liability of newness.’’ Ingeneral, private banks are unwilling to lendmoney to a newly established firm, because ofthe lack of collateral and high risk of losing theprincipal. The alternative of financing growthfrom retained earnings is feasible, however, fora start-up this can be very slow. Moreover,technology-based start-ups often experience aperiod of financial losses prior to the generationof surpluses for reinvestment. Prior to WW II,the source of risk capital for entrepreneurs ev-erywhere was either the government, govern-ment-sponsored institutions meant to invest insuch ventures, or informal investors that usu-ally had some prior linkage to the entrepreneur.After WW II, a set of intermediaries, the

venture capitalists, emerged whose sole activitywas investing in fledgling firms that they be-lieved were capable of rapid growth with aconcomitant capital appreciation. From thesemodest beginnings, venture capital graduallyexpanded and became increasingly formalized.Moreover, the locus of the venture capital in-dustry shifted from the East Coast to the WestCoast (Florida & Kenney, 1988a,b). By themid-1980s, the ideal-typical venture capital firmwas based in Silicon Valley and invested largelyin the electronics sector, with lesser sums de-voted to medical technology. 4 During thisprocess, the US over-the-counter market wasformalized and technically upgraded into whatis now known as the NASDAQ, which spe-cialized in listing technology-based firms.After an evolutionary learning process, the

ideal-typical institutional form for venturecapital became the venture capital firm oper-ating a series of funds raised from wealthy in-dividuals, pension funds, foundations,endowments and various other institutionalsources. Moreover, this form has now diffusedglobally. The venture capitalists were profes-sionals, often with industry experience, and theinvestors were silent limited partners. Atpresent a fund generally operates for a setnumber of years (usually between seven and 10)and then is terminated. Normally, each firm

manages more than one partnership simulta-neously. Even though the venture capital firm isthe quintessential organizational format, thereare other vehicles, the most persistent of whichhave been venture capital subsidiaries of majorcorporations, financial and nonfinancial.The venture capitalist invests in recently es-

tablished firms believed to have the potential toprovide a return of ten times or more in lessthan five years. This is highly risky, and manyof the investments fail entirely; however, thelarge winners are expected to more than com-pensate for the failures. In return for investing,the venture capitalists not only receive a majorequity stake in the firm, but they also demandseats on the board of directors. By active in-tervention and assistance, venture capitalistsact to increase the chances of survival and rateof growth of the new firm. Their involvementextends to several functions, such as helping torecruit key personnel and providing strategicadvice and introductions to potential custom-ers, strategic partners, later-stage financiers,investment bankers and various other contacts(Florida & Kenney, 1988a; Gompers & Lerner,1999). The venture capitalist therefore providesmore than money, and this is a crucial differ-ence between venture capital and other types offunding. The venture capital industry has, morerecently, specialized even by stages of growth:there are early or seed funds, mature-stagefunds, and bridge funds.The venture capital process is complete when

the company is sold through either a listing onthe stock market or the acquisition of the firmby another firm, or when the company fails.For this reason, the venture capitalist is atemporary investor and usually a member ofthe firm’s board of directors only until theirinvestment is liquidated. The firm is a productto be sold, not retained (Kenney & von Burg,1999). The venture capital process requires thatinvestments be liquidated, so there must be thepossibility of exiting the firm. Countries thaterect impediments to any of the exit paths (in-cluding bankruptcy) are choosing to handicapthe development of the institution of venturecapital. Most recently, Jeng and Wells (2000,p. 241) found that the single strongest driver ofventure capital investing is the number of IPOs.They also find that government policies can‘‘have a strong impact, both by setting theregulatory stage and by galvanizing investmentduring downturns.’’ This is not to say thatcountries not providing exit opportunities willbe unable to foster entrepreneurship, only that

VENTURE CAPITAL IN INDIA 229

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it is unlikely that venture capital as an institu-tion will thrive. In fact, Black and Gilson(1998) argue that venture capital industries willbe more vital in countries with stock market-centered capital markets than in nations withbank-centered capital markets. 5

There has been much debate about the pre-conditions for venture capital. One obviousconclusion is that entrepreneurship is the pre-condition for venture capital, not vice versa;however, this is a misleading statement in anumber of dimensions. At some level, entre-preneurship occurs in nearly every society, butventure capital can only exist when there is aconstant flow of opportunities that have greatupside potential. Information technology hasbeen the only business field that has offeredsuch a long history of opportunities. So entre-preneurship is a precondition, but not any typeof entrepreneurship will do. 6 Moreover, ven-ture investing can encourage and increase the‘‘proper’’ type of entrepreneurship, i.e., suc-cessful venture capitalists can positively affecttheir environment.In the US the government played a role in the

development of venture capital, though for themost part it was indirect. This indirect role, i.e.,the general policies that benefited the develop-ment of the venture capital industry, wasprobably the most significant. To list some ofthe most important, the US government gen-erally followed sound monetary and fiscal pol-icies ensuring relatively low inflation; as aresult, the financial environment and currencywere stable. US tax policy, though it changedrepeatedly, has been favorable to capital gains,and several decreases in capital gains taxes mayhave had some positive effect on the availabilityof venture capital (Gompers, 1994). The stockmarket, which has been the exit strategy ofchoice for venture capitalists, has been strictlyregulated and characterized by increasingopenness. This has created a general macro-economic environment of financial stability andopenness for investors, thereby reducing theexternal risks of investing in high-risk firms.Put differently, an extra set of environmentalrisks stemming from government action wasminimized—a sharp contrast to most develop-ing countries during the last 50 years.Another important policy has been a will-

ingness to invest heavily in university-basedresearch. This investment has funded genera-tions of graduate students in the sciences andengineering, and from this research has cometrained personnel and innovations, some of

which have resulted in the formation of firmsthat have been funded by venture capitalists.US universities, such as MIT, Stanford, andUC Berkeley, played a particularly salient role(Kenney & von Burg, 1999; Saxenian, 1998).The most important direct US government

involvement in encouraging the growth ofventure capital was the passage of the SmallBusiness Investment Act of 1958 authorizingthe formation of small business investmentcorporations (SBICs). The legislation was notaimed at encouraging venture capital per se. Itmeant to create a vehicle for funding smallfirms of all types. The legislation was compli-cated, but for the development of venturecapital the following features were most sig-nificant: It permitted individuals to form SBICswith private funds as paid-in capital. Theycould then leverage their paid in capital toborrow money up to a limit that increased overtime with government guarantees. There werealso tax and other benefits, such as income anda capital gains pass-through and the allowanceof a carried interest for the investors. The SBICprogram also provided a vehicle for banks tocircumvent the Depression-era laws prohibitingcommercial banks from owning more than 5%of any industrial firm. The banks’ SBIC sub-sidiaries allowed them to acquire equity insmall firms. This made even more capitalavailable to fledgling firms, and was a signifi-cant source of capital in the 1960s and 1970s.The final investment format permitted SBICs toraise money in the public market. For the mostpart, these public SBICs failed and/or wereliquidated by the mid-1970s. After the mid-1970s, with the exception of the bank SBICs,the program was no longer important to theventure capital industry.The SBIC program experienced serious

problems almost immediately. Starting in 1965Federal criminal prosecution was necessary torectify SBIC corruption. By one estimate, ‘‘nineout of ten SBICs had violated agency regula-tions and dozens of companies had committedcriminal acts’’ (Bean, 2001). Despite the cor-ruption, something valuable also occurred.Particularly in Silicon Valley, several individu-als used their SBICs to leverage their personalcapital, and they were so successful that theywere able to reimburse the program and raiseinstitutional money to become formal venturecapitalists. The SBIC program accelerated theircapital accumulation, and as important, gov-ernment regulations made these new ven-ture capitalists professionalize their investment


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activity, which had been informal prior to en-tering the program. Now-illustrious firms suchas Sutter Hill Ventures, Institutional VenturePartners, Bank of America Ventures, andMenlo Ventures began as SBICs.The historical record also indicates that

government action can harm venture capital.The most salient example came in 1973 whenthe US Congress, in response to widespreadcorruption in pension funds, changed federalpension fund regulations. In their haste toprohibit abuses, Congress passed the Employ-ment Retirement Income Security Act (ERISA)making pension fund managers criminally li-able for losses incurred in high-risk invest-ments. This was interpreted to include venturecapital funds. The result was that pensionmanagers shunned venture capital, nearly de-stroying the entire industry. This was only re-versed after active lobbying by the newlycreated National Venture Capital Association(NVCA) in 1973 (Pincus, 2000; Stultz, 2000).Only in 1977 did they succeed in starting aprocess of a gradual loosening that was com-pleted in 1982 (Kenney, n.d.). The reinterpre-tation of these pension fund guidelinescontributed to a flood of new money into ven-ture capital funds.In a sense, since the mid-1980s the develop-

ment of the US venture capital industry hasbecome a process of formalizing the institu-tions, a process that was even manifested in thecontracts between venture capitalists and en-trepreneurs (Suchman, 2000). After the mid-1980s, the institution of venture capital hadbecome a part of the US NIS with its own in-dustry association, practices, and routines. So,in the United States venture capital as an in-stitution emerged from an organic trial-and-error experimental process prior to maturinginto today’s powerful institution for the en-couragement of new firm formation. In thisprocess, the government played a limited andcontradictory role.Since the mid-1980s there has been much

interest in the transference of institution ofventure capital to other countries. Importantproponents of this transfer were the Interna-tional Finance Corporation and various bilat-eral and multilateral development organiza-tions including the Asian Development Bank,the West German Deutsche Entwicklungs Ge-sellschaft (DEG), and the British Common-wealth Fund among others (Kenney, n.d.).Their modus operandi was to invest in venturecapital firms dedicated to funding start-ups in

various nations. Though these organizationswere not significant for the establishment ofventure capital in Taiwan and Israel, foreigninvestors did play an important role in thosetwo countries.The two most successful adopters of US-style

venture capital practice are Taiwan and Israel,in both cases the national governments played asignificant role in encouraging the growth ofventure capital (see, respectively, Autler, 2000;Kenney, Han, & Tanaka, 2001). There are anumber of similarities between the two coun-tries. They are smaller countries closely alliedwith the United States, that have sizable num-bers of their citizens in the United States. Bothgovernments have relatively good economicrecords and operate with a minimum of cor-ruption. Both are also ‘‘national defense’’states. Importantly, in both countries the gov-ernment developed policies that allowed itsventure capitalists to benefit financially fromtheir successful investments. Yet, despite thesesimilarities, there are also a number of differ-ences between the industries in the two.The Israeli venture capital industry is closely

related to the United States. The first venturecapital investments in Israel were made by thewell-known US venture capitalist, Fred Adler,who began investing in Israeli startups in theearly 1970s (Adler, 2000; Autler, 2000, p. 40).In 1985, a former Commander of the Israeli AirForce Dan Tolkowsky, joined with partnerFred Adler to form the first Israeli venturecapital fund, and it was capitalized at $25 mil-lion with much of the investment coming fromthe United States. The US connection was builtupon Israeli and American Jewish networksthat were able to mobilize large sums of capitaland political support in the US government.Israel had three important sources of entre-preneurs: the military research establishment,its universities, and already existing firms.Moreover, there was a constant flow of entre-preneurs between the United States and, espe-cially, Silicon Valley and Israel. In addition,Israeli firms had begun listing on the NASDAQin the 1980s, so the Tel Aviv stock market wasnot the only exit route.The creation of a venture capital industry

(rather than a few firms) would wait, however,until the 1990s, when the Israeli governmentcreated a government-funded organization,Yozma, meant to encourage venture capital inIsrael. Yozma received $100 million from theIsraeli government. It invested $8 million in 10funds that were required to raise another $12


million each from ‘‘a significant foreign part-ner,’’ presumably an overseas venture capitalfirm (Autler, 2000, p. 44). Yozma also retained$20 million to invest itself. These ‘‘sibling’’funds were the backbone of an industry that in1999 invested in excess of $1 billion during 2001in Israel (PriceWaterhouse, 2001). So, initiallyventure capital investing in Israel was entirelyundertaken by the private sector (though oftenthe investments were in spin-offs of public re-search). But, the government Yozma programcreated a hybrid of private investment withgovernment support that supercharged thegrowth of venture capital. The critical point isthat private venture capital existed beforegovernment involvement, as was true in thecase of the US SBIC program. In the late 1990sgovernment support became less significant.The government was able to play such a pow-erful catalyzing role, because there were sup-portive environmental conditions, and private-sector venture capital had already emerged. Inother words, government support did not cre-ate the industry, but had an effect on its growth.In the case of Israel, the institution of venturecapital was largely an unproblematic transferfrom the United States.The creation of the Taiwanese industry dif-

fers significantly from the Israeli case in someimportant respects. Taiwan did not have thesame level of high-technology research as Israelas it was a developing country. Nor did it havethe same level of relationship to the financialand academic elite in the United States thatIsrael did. There were, however, a large numberof successful Taiwanese and other Chinese sci-entists and engineers in the United States that itcould and did draw upon (Saxenian, 1999).The inception of the Taiwanese venture

capital industry can be traced directly to gov-ernmental initiative. In 1983 the then FinanceMinister, Li-Teh Hsu, and a former FinanceMinister K.T. Li took a study trip to theUnited States and Japan to study how newhigh-technology firms were formed, after thisthey decided to create incentives to catalyze thecreation of a venture capital industry in Taiwan(Saxenian, 1998; Shih, 1996, p. 282). In 1983legislation was passed giving attractive tax in-centives to individuals willing to invest in pro-fessional venture capital firms. The mostimportant feature of the 1983 legislation was anup to 20% tax deduction for Taiwanese indi-viduals provided they maintained their venturecapital investment for at least two years. Oneinteresting and important feature of this effort

was that the Taiwanese venture capitalists werenot forbidden from investing abroad as long asa benefit to Taiwan could be shown.Despite the attractive benefits, investment

grew only gradually. The first venture capitalfirm in Taiwan was the Acer subsidiary, Mul-tiventure Investment Inc., which was formed inNovember 1984 and made its first investment ina Silicon Valley startup that year (Shih, 1996,p. 35). But the venture capital fund that re-ceived the most attention was formed by H&Q.The key person was Ta-Lin Hsu, a former ex-ecutive in IBM’s San Jose Laboratories. H&QTaiwan recruited investment from major Tai-wanese industrial groups and had a total capi-talization of roughly $25 million (Sussner,2001). Its first investment was in the Taiwanesesubsidiary of Data Corporation, a Santa Claramanufacturer of disk drive controllers andfloppy disks (Kaufman, 1986, p. 7D). In 1987,the San Francisco-based Asian-American ven-ture capital firm, the Walden Group becamethe other important early foreign venture cap-ital fund to invest in Taiwan. Its first two in-vestments were in Northern California (Besher,1988, p. C9). This fund evolved into the Wal-den International Investment Group. Noticethat both H&Q and Walden’s first investmentswere in Silicon Valley and this set the bina-tional investment pattern that characterizes theTaiwanese venture capital industry. There is animportant difference between Taiwan and Is-rael, in the that Taiwan received little outsidecapital, whereas Israel was much more suc-cessful in attracting overseas capital.The Taiwanese venture capital industry dif-

fered from that in Israel and in the UnitedStates in one very significant way. Namely,Taiwan, quite simply, did not have the world-class research capability of these other twocountries. But, it honed its manufacturing ex-pertise and found that its firms could grow veryrapidly providing contract manufacturing ser-vices to US firms. The Taiwanese strategy wasto enter product markets that had not yet beencommoditized and transform them into com-modities as it recently has done in notebookcomputers. Success in these markets made itpossible for the Taiwanese firms to grow rap-idly and conduct initial public offerings on ei-ther the Taiwan Stock Exchange or onNASDAQ. In addition, Taiwanese venturecapitalists invested between 20% and 30% oftheir capital in Silicon Valley, especially in firmsstarted by Chinese engineers, thereby diversi-fying their portfolio.


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In this brief discussion it is impossible todescribe fully the differences between the orga-nization and operation of the Taiwanese ven-ture capital industry and that of the UnitedStates and Israel. 7 Even the investments aredifferent, however, because Taiwanese venturecapitalists invest in manufacturing firms. Incontrast to the other two countries, the Tai-wanese government continues to closely regu-late the venture capital industry. Taiwaneseventure capitalists are organized as operatingfirms compensating investors through divi-dends, rather than operating as partnershipmanagers giving investors distributions. Thusin the case of Taiwan it is possible to say thatthe institution of venture capital was hybridizedto fit into the environment.The Israeli environment resembled the

United States far more than it did Taiwan, andthus there was less need to change the institu-tional parameters of the venture capital indus-try when it was transferred. But, in bothcountries there were strong connections to Sil-icon Valley that made the transfer of the socialtechnology of venture capital investing possi-ble. Not coincidentally, venture capitalists inboth countries also used these connections toinvest in Silicon Valley deals. The governmentsin both countries played a significant role incatalyzing the development of the venturecapital industry. Curiously, in historical termsboth countries had had bank-centered financialsystems, but this changed roughly along withthe development of the venture capital indus-try.

3. THE GENERAL INDIANENVIRONMENT

From its inception, the Indian venture capitalindustry has been affected by international anddomestic developments; its current situation isthe result of the evolution of what initially ap-peared to be unrelated historical trajectories.The creation of a venture capital industry inIndia through transplantation required the ex-istence of a minimal set of supportive condi-tions. They need not necessarily be optimal,because, if the industry survived, it would likelyset in motion a positive feedback process thatwould foster the emergence of successful newfirms, encourage investment of more venturecapital, and support the growth of other typesof expertise associated with the venture capitalindustry. In other words, if the venture capital

industry experienced any success, it could en-train a process of shaping its environment. Incontrast to Israel and Taiwan, India wouldhave to experience a hybrid of Interactions(c) and (d) discussed in Section 1, if venturecapital was to thrive. It would have to changeits environment to allow the sustenance of aventure capital industry and the societal insti-tutions would have to modify themselves.Venture capital could begin with a suboptimalthough minimally sustainable set of conditions,the venture capital industry could take root andshape its environment to a more optimal situ-ation, while the institutions themselves wouldalso need to change.Small and medium-sized enterprises have a

long history and great importance to India. Theleaders of the Independence movement weresupporters of small businesses as an alternativeto ‘‘exploitation’’ by multinational firms. Yet,despite the emphasis upon and celebration ofsmall enterprises, the Indian economy was du-alistic. It was dominated by a few massive pri-vate sector conglomerates, such as the Tata andBirla groups, and various nationalized firms,even while there was an enormous mass ofsmall shopkeepers and local industrial firms. Asanywhere else, these small firms were in tradi-tional industries and were not relevant to theemergence of venture capital, but they do in-dicate a culture of private enterprise. This en-trepreneurial propensity also has beendemonstrated by the willingness of Indiansemigrating in other countries to establishshops, restaurants, hotels and enterprises of allsorts.Indians valued education very highly at least

since the colonial era. After Independence, theIndian government invested heavily in educa-tion, and Indian universities attracted excellentstudents. In the 1960s, the Ford Foundationworked with the Indian government to estab-lish the Indian Institutes of Technology (IIT),which adopted MIT’s undergraduate curricu-lum. These Institutes and other top Indian ed-ucational institutions very quickly became theelite Indian engineering schools with extremelycompetitive entrance examinations and towhich only the best students could gain entry.Excellent Indian students were in demanded byoverseas university graduate programs, gener-ally, and in engineering, particularly. Aftergraduating from overseas programs, many ofthese Indian students did not return to India.Many other Indian graduates remained in In-dia, working in the large family conglomerates,


the many Indian universities, and various top-level research institutes such as those for spaceresearch (Baskaran, 2000). This meant thatthere remained in India a large pool of capableengineers and scientists that were underpaid (byglobal standards), and potentially mobile.Despite these strengths, India had many

cultural rigidities and barriers to entrepreneur-ship and change, beginning with an extremelyintrusive bureaucracy and extensive regula-tions. Until recently the labor market was quiterigid. For well-educated Indians the ideal ca-reer path was to enter the government bu-reaucracy, a lifetime position; enter the familybusiness, which was then a lifetime position; orjoin one of the large conglomerates such asTata and Birla, which also effectively guaran-teed lifetime employment. The final career pathwas to emigrate; not surprisingly, among theimmigrants were many seeking better oppor-tunities and release from the rigidities at home.In summation, the institutional context dis-couraged investment and entrepreneurship. Thenext sections examine the features of the Indianeconomy that would evolve to make the cre-ation of the Indian venture capital industrypossible.

4. THE INDIAN FINANCIAL SYSTEM

India has a large, sophisticated financialsystem including private and public, formal andinformal actors. In addition to formal financialinstitutions, informal institutions such as familyand moneylenders are important sources ofcapital. India has substantial capital resources,but as Table 1 indicates, the bulk of this capitalresides in the banking system. In the formalfinancial system, lending is dominated by retailbanks rather than the wholesale banks or thecapital markets for debt. The primary methodfor firms to raise capital is through the public

equity markets, rather than through privateplacements.

(a) The banking system

Prior to independence from Britain, thebanking system was entirely private and largelyfamily-operated. In the pre-war period, thefamily-run banks often invested in new ven-tures. After Independence, the Reserve Bank ofIndia (RBI) and the State Bank of India werenationalized, with the State Bank of Indiacontinuing to play the role of banker to gov-ernment agencies and companies. Then, in1969, the next 14 largest banks were national-ized. With the State Bank of India, the statecontrolled 90% of all bank assets. The nation-alized banking system became an instrument ofsocial policy. During 1969–91, the financialposition of the banks progressively weakened,due to loss-making branch expansions, ev-er-strengthening unions, overstaffing, and po-liticized loans. Until 1991, depositors werereluctant to use banks because although theirsavings were safe, the government set depositinterest rates below the rate of inflation. By1991, the entire bank system was unprofitableand nearing collapse. 8

The socialized banking system had otherperverse effects. For example, although thebank managers were civil servants and veryrisk-averse, they could offer below-market in-terest rates. This created excessive demand forfunds, but, quite naturally, bankers extendedthe loans to their safest customers. These wereprimarily the large firms owned by the gov-ernment, which operated the largest steel, coal,electrical, and other manufacturing industries.The other large bank borrowers were the giantfamily conglomerates such as the Tata andBirla group. This increased the group’s eco-nomic power, but did not lead to economicallyefficient decisions about how to deploy capital.

Table 1. The disposition of indian capital resources and their availability for venture investing in 1996–97

Type of funds Billionsof rupees

Percentageof total

Percentage permitted forventure capital investment

Currency and bank deposits 634.90 50.1 Up to 5% of new funds, since April 1999Government securities 116.36 9.2 NoneLife insurance funds 156.36 12.3 NonePension funds 262.48 20.7 NonePrivately held shares and debentures(including mutual funds)

96.34 7.6 Some

Total 1266.44 100 None

Source: Statistical Outline of India 1988–99 (1999).


Small firms were starved for capital. Thus theIndian banks provided no resources for entre-preneurial firms.

(b) Equity markets

The first Indian stock markets were estab-lished during the British Raj era in the 19thcentury. During the early part of the 20thcentury, Indian equity markets actively fi-nanced not only banking, but also the cottonand jute trades (Schrader, 1997). In 1989 therewere 14 stock markets in India, though Bom-bay was by far the largest (World Bank, 1989).The socialization of the economy and particu-larly banking after independence reinforced thestrength of the stock markets as a source ofcapital, and by the 1960s, India had one of themost sophisticated stock markets in any de-veloping country.There were several reasons for the growth of

the Indian stock market. Motivated by itsegalitarian principles, the government sup-ported the stock markets as an instrument forreducing the concentration of ownership in thehands of a few industrialists (an outcome of thegovernment policy of providing below-marketinterest loans to the large family conglomer-ates). Second, the government industrial li-censing policy instituted in 1961 meant thatbusinesses had to apply for government per-mission to establish new ventures. Permissionswere given only in the context of the Soviet-style national plans for each sector. There was astrong element of favoritism in who receivedpermission. Most important, due to govern-ment central planning controls, shortages wereendemic, and thus, permission to produce was aguarantee of profits.The distortion these policies created by en-

couraging concentration were meant to be off-set by RBI stipulation that private sectorborrowers could not own more than 40% of thefirm’s equity if they wished to receive bank fi-nance. In 1973 the government required allforeign firms to decrease ownership in theirIndian subsidiaries to 40%. Faced with a choicebetween selling stakes privately and listing onthe stock exchanges, most firms chose the latterand issued new stock, which led to a large in-crease in public ownership of such companies.So, to raise money the private sector becamereliant on stock markets. Investors, large andsmall, readily financed ventures since theshortages induced by the planning systemguaranteed a ready market for anything pro-

duced. Curiously, the retention of 40% of theequity by the core investors meant that in re-ality they controlled the firm.The 40% regulation did not liberalize the

markets as much as one might expect. Becauseloans were also necessary for firms and thisrequired collateral in fixed assets, new entre-preneurs were restricted to sectors with asset-heavy projects. This disadvantaged the servicesector, resulting in even greater concentration,and equity markets focused on financing low-risk projects. Moreover, the public’s enthusi-asm for firms operating within a licensed in-dustry meant that it was difficult for other newfirms to secure capital through listing on thestock exchanges.In 1991, as part of a large number of financial

reforms, the Securities and Exchange Board ofIndia (SEBI) was created to regulate the stockmarket. At the time, there were 6,229 compa-nies listed on all the stock exchanges in India(RBI, 1999, p. 16). The reforms and looseningof regulations resulted in an increase in thenumber of listed companies to 9,877 by March1999, and daily turnover on the stock ex-changes rose to 107.5 billion rupees (US$2.46billion) by December 1999. One reform was theremoval of a profitability criterion as a re-quirement of listing. To replace the profitabilityrequirement, it was stipulated that a firm wouldbe de-listed if it did not earn profits within threeyears of listing. This reform meant unprofitablefirms could be listed, providing an exit mecha-nism for investors. Not surprisingly, there wasa dramatic increase in the listings of firms,many of which could be considered as hightechnology.In terms of experience, India contrasted fa-

vorably with most developing countries, whichhad small, inefficient stock markets listing onlyestablished firms. Even in Europe, until thecreation of new stock markets in the mid-1990s,it was extremely difficult to list small high-technology firms (Posner, 2000). But, althoughthese stock markets provided an exit opportu-nity, they did not provide the capital for firmestablishment. Put differently, accessible stockmarkets did not create venture capital forstartups; they merely provided an opportunityfor raising follow-on capital or an exit oppor-tunity.

(c) Other institutional sources of funds

India has a strong mutual fund sector thatbegan in 1964 with the formation of the Unit


Trust of India (UTI), an open-ended mutualfund, promoted by a group of public sector fi-nancial institutions. Because UTI’s investmentportfolio was to consist of longer-term loans, itwas meant to offer savers a return superior tobank rates. In keeping with the risk-averse In-dian environment, initially UTI invested pri-marily in long-term corporate debt. But, UTIeventually became the country’s largest publicequity owner as well. This was because thegovernment controlled interest rates in order toreduce the borrowing costs of the large manu-facturing firms that it owned. These rates wereusually set well below market rates, yet UTIand other institutional lenders were forced tolend at these rates. In response, firms startedissuing debt that was partially convertible intoequity in order to attract institutional funds. By1985, the conversion of these securities led toUTI becoming the largest owner of publiclylisted equity (UTI Annual Report, 1985). By1991, the equity portion of the UTI portfoliohad grown to 30% (UTI Annual Report, 1991).In 1992, in tandem with banking sector reform,permission to form privately-owned mutualfunds (including foreign-owned funds) wasgranted, leading to a gradual erosion in UTI’sthen-dominant market share.Until April 1999, mutual funds were not al-

lowed to invest in venture capital companies.Since then, the mutual funds have been allowedto commit up to 5% of their funds as venturecapital, either through direct investments orthrough investment in venture capital firms.But, the mutual funds have not yet overcometheir risk-averse nature and invested in venturecapital, either directly or indirectly throughinvestment in venture capital funds. Certainly,should the mutual funds decide to invest di-rectly in firms, there would be operational is-sues regarding the capability of mutual funds toperform the venture capital function.The largest single source of funds for US

venture capital funds since the 1980s has beenpublic and private sector pension funds. InIndia, there are large pension funds but theyare prohibited from investing in either equity orventure capital vehicles, thus closing off thissource of capital.In summation, prior to the late 1980s, though

India did have a vibrant stock market, the rigidand numerous regulations made it nearly im-possible for the existing financial institutions toinvest in venture capital firms or in startups.Nearly all of these institutions were politicized,and the government bureaucrats operating

them were risk-adverse. On the positive side,there was a stock market with investors ame-nable to purchasing the equity in fairly early-stage companies. It was also possible to boot-strap a firm and/or secure funds from friendsand family—if one was well connected. But, nofinancial intermediaries comfortable withbacking small technology-based firms existedprior to the mid-1980s. It is safe to say thatlittle capital was available for any entrepre-neurial initiatives. An entrepreneur aiming tocreate a firm would have to draw upon familialcapital or bootstrap their firm.

5. THE INDIAN INFORMATIONTECHNOLOGY INDUSTRY

A viable venture capital industry dependsupon a continuing flow of investment oppor-tunities capable of growing sufficiently rapidlyto the point at which they can be sold yielding asignificant annual return on investment. If suchopportunities do not exist, then the emergenceof venture capital is unlikely. In the UnitedStates and Israel such opportunities occurredmost regularly in the information technologies.Moreover, in every country, with the possibleexception of the United States, any serious newopportunity has to be oriented toward theglobal market, because few national marketsare sufficiently large to generate the growthcapable of producing sufficient capital gains.Since Independence, the Indian government

strove to achieve autarky, and the protection ofIndian markets and firms from multinationalcompetition guided nearly every policy—theinformation technology industries were no ex-ceptions. For example, in the mid-1970s, theIndian government demanded that IBM reducethe percentage ownership of its Indian opera-tions to 40%, but IBM refused and left India in1978. After this the government gave the state-run Computer Maintenance Corporation ‘‘alegal monopoly to service all foreign systems’’(Brunner, 1995 quoted in Lateef, 1997). IBM’sretreat released 1,200 software personnel intothe Indian market, and some of these estab-lished small software houses (Lateef, 1997). Theprotectionist policy had benefits and costs. Thebenefit was that it contributed to the creation ofan Indian IT industry; the cost was that theindustry was backward despite the excellence ofits personnel. After IBM’s withdrawal, therewas little further interest by multinational firmsin the Indian market. Due to this lack of


foreign investment and despite the presence ofskilled Indian personnel, India was a techno-logical backwater even while East Asia pro-gressed rapidly.In 1984, in response to the failure of the

government-run computer firms and the suc-cess of private firms such as Wipro, HCL, andTata Consultancy Services, the Indian govern-ment began to liberalize the computer andsoftware industry by encouraging exports(Evans, 1992). This was particularly timely be-cause there was a worldwide shortage of soft-ware programmers. In 1986, Texas Instrumentsreceived government permission to establish a100% foreign-owned software subsidiary inIndia. The capabilities of the Indian personnel,which was due, in large measure, to a wise de-cision in the 1960s by the government to in-crease its investments in education, soonattracted other foreign software engineeringoperations to India. Contemporaneously, en-trepreneurs exploited the labor cost differentialto ‘‘body-shop’’ Indian programmers overseas.By 1989, this accounted for over 90% of soft-ware revenues (Schware, 1992 cited in Lateef,1997). The body-shopping and the foreign-owned engineering operations provided a con-duit through which Indian engineers couldlearn about the cutting-edge software tech-niques and developments in the West and par-ticularly Silicon Valley. These activities createda network of contacts and an awareness of thestate-of-the-art in global computing and soft-ware technology. The center of this activity was

the South Indian city of Bangalore (Mitta,1999).By the early 1990s, Indian firms also began

the development of a market for off-site con-tract programming. This market grew impres-sively in the 1990s, as shown in Table 2.Moreover, the percentage of on-site contractprogramming revenues fell from 90% in 1988 to45% in 1999–2000 (Nasscom, 1998). But, be-cause an additional 35% of work is off-sitecontract programming, low value-added ser-vices remain dominant. High value-added‘‘next-stage’’ businesses, including turnkeyprojects, consultancy and transformationaloutsourcing make up the balance, and brandedproduct development for the export market isnegligible. A few of these firms, particularlyInfosys and Wipro, grew to be quite large bothin terms of manpower and revenue. They weresuccessful on the Indian stock market in the1990s, and in the late 1990s they listed theirstock on the US NASDAQ. Interestingly, incontrast to Taiwan, Korea, and, increasingly,China, the Indian hardware sector remainsnegligible, although there have been a few no-table recent successes, such as Armedia andRamp Networks.One small conglomerate, Wipro, established

an IT spin-off business in Bangalore in 1980,and grew to become the most highly valuedIndian IT company. Another leading Indianfirm, Infosys, was founded 1981 and listed onthe US NASDAQ. In August 2000 its valuationreached nearly $17 billion. These and other

Table 2. Domestic and export sales of the Indian IT industry, 1994–99 in US$ millions

1994–95 1995–96 1996–97 1997–98 1998–99 1999–2000

SoftwareDomestic 350 490 670 950 1,250 1,700Exports 485 734 1,083 1,750 2,650 4,000Total 835 1,224 1,753 2,700 3,900 5,700

HardwareDomestic 590 1,037 1,050 1,205 1,026 1,450Exports 177 35 286 201 4 86Total 767 1,072 1,336 1,406 1,030 1,536

PeripheralsDomestic 148 196 181 229 329 435Exports 6 6 14 19 18 27Total 154 202 195 248 347 462

OtherTraining 107 145 183 263 302 400Maintenance 142 172 182 221 236 263Networking and other 36 710 156 193 237 310Grand total 2,041 2,886 3,805 5,031 6,052 8,671

Source: http://www.nasscom.org 2001


successes demonstrated that firms capable ofrapidly increasing in value could be formed inIndia. This is despite the fact, as Arora andArunachalam (2000) note, that the develop-ment of globally distributed packaged softwareprograms, which is the source of the greatestprofits, has not occurred. Indian software firmshave an assured market for their contract pro-gramming work and, therefore, little incentiveto take the risk of developing software packages(Naqvi, 1999). Finally, the largest firms, per-haps due to their visibility in overseas marketsthrough their branch offices, have leveragedtheir manpower resources to better advantagethan small firms have, leading to an erosion inthe share of small firms (Naqvi, 1999).By the early 1990s, India had an information

technology industry that centered on softwareand drew upon the large number of relativelyskilled Indian engineers. 9 The Indian IT in-dustry was growing quickly, and newly formedfirms had entered the industry; however, theopportunities had not yet led to the creation ofany information technology-oriented venturecapital firms. In addition, at the time there werenot yet any knowledgeable information tech-nology industry veterans in India who also hadexperienced the startup and venture capitalprocess first hand. In Silicon Valley, however,an entire cadre of Indians was emerging whohad such experiences.

6. NONRESIDENT INDIANS (NRIS)

From the 1950s onward, bright, well-edu-cated Indian engineers attended US universitiesand remained to work in high-technology firms.In the 1960s and 1970s, this was considered a‘‘brain drain.’’ It seems likely, however, thateven if these engineers had returned to India,there would have been few opportunities forthem outside of government research organi-zations and the corporate research laboratoriesfor firms such as Tata and Birla. For this andother reasons, many Indians remained in theUnited States and secured employment in uni-versities and corporations, including SiliconValley electronics firms.Initially, these Indian engineers joined exist-

ing firms, but not surprisingly they were notimmune to the attractions of entrepreneurship,especially in Silicon Valley. The first notewor-thy group included Kanwal Rekhi, who co-founded Excelan, a data networking firm, withthree other Indian engineers in 1981. Excelan

later was purchased by Novell, leaving Rekhiand the other engineers with enormous capitalgains. Another early entrepreneur was VinodKhosla, who in 1982 had co-founded DaisySystems, and was a driving force in the estab-lishment of Sun Microsystems. After leavingSun, he joined the prestigious venture capitalfirm, Kleiner, Perkins, Caufield and Byers. Yetanother Indian engineer, Dalal (2000), co-founded Metaphor in 1982, Claris in 1987, andin 1991 joined the top-tier venture capital fund,Mayfield Fund. Another successful early In-dian entrepreneur was Suhas Patil, who co-founded Cirrus Logic in 1984. These NRIs notonly were successful entrepreneurs, but theysoon began investing in yet other startups.Quite naturally, the NRIs remained in con-

tact with family, friends, and classmates inIndia. Moreover, by the late 1980s, the successof the NRIs came to the attention of Indianpolicymakers. Even while concern about thebrain drain continued, policymakers recognizedthat it would be impossible to retain suchhighly skilled individuals if there were no op-portunities for them in India. NRIs wished toassist India: they visited India and discussedtheir experiences in the United States, and ex-pressed a willingness to invest in ventures theirfriends and classmates might launch in India.They quickly discovered, however, that it wasnot so simple to transform their willingness toinvest capital into the reality of a reasonableinvestment. But this initiated a process throughwhich the NRIs were re-conceptualized frombeing ‘‘defectors’’ to being a potential source ofknowledge, connections, and even capital(Saxenian, 1999).From the perspective of creating venture

capital, India had a stock market that withminimal effort could handle public stock offer-ings from fledgling high-technology firms.There was also a growing IT industry withsome firms that experienced extremely fastgrowth. There was also a cadre of Indians fa-miliar with the operation of the US SiliconValley, and there were sufficient skilled engi-neers in India to staff startups. In other words,by 1990 the environmental preconditions forthe successful establishment of a venture capitalindustry were in place.

7. VENTURE CAPITAL IN INDIA

In the early 1980s, the idea that venturecapital might be established in India would


have seemed utopian. India’s highly bureau-cratized economy, avowed pursuit of socialism,still quite conservative social and businessworlds, and a risk-averse financial system pro-vided little institutional space for the develop-ment of venture capital. With the high level ofgovernment involvement, it is not surprisingthat the first formal venture capital organiza-tions began in the public sector. As in the caseof Israel and Taiwan, from its inception Indianventure capital was linked with exogenous ac-tors, public and private. In India, one of themost autarchic economies in the world, boththe development of venture capital and the in-formation technology industry have been inti-mately linked with the international economy.The earliest discussion of venture capital in

India came in 1973, when the government ap-pointed a commission to examine strategies forfostering small and medium-sized enterprises(Nasscom, 1998). In 1983, a book entitled RiskCapital for Industry was published under theauspices of the Economic and Scientific Re-search Foundation of India (Chitale, 1983). Itshowed how the Indian financial systems’ op-eration made it difficult to raise ‘‘risk capital’’for new ventures and proposed various mea-sures to liberalize and deregulate the financialmarket. Oddly, this book never mentionedventure capital per se. Though this and otherbooks did not have immediate results, theywere an indication of a political discussion ofthe difficulties India had in encouraging entre-preneurship and the general malfunctioning ofthe Indian financial system. Venture capitalwould become one small part of this largerdiscussion.

(a) The first period, 1986–95

Indian policy toward venture capital has tobe seen in the larger picture of the government’sinterest in encouraging economic growth. The1980s were marked by an increasing disillu-sionment with the trajectory of the economicsystem and a belief that liberalization wasneeded. A shift began under the government ofRajiv Gandhi, who had been elected in 1984.He recognized the failure of the old policy ofself-reliance and bureaucratic control. Thepolicy toward venture capital should be seen inthis larger movement.Prior to 1988, the Indian government had no

policy toward venture capital; in fact, there wasno formal venture capital. In 1988, the Indiangovernment issued its first guidelines to legalize

venture capital operations (Ministry of Fi-nance, 1988). These regulations really wereaimed at allowing state-controlled banks toestablish venture capital subsidiaries, though itwas also possible for other investors to create aventure capital firm. There was only minimalinterest, however, in the private sector in es-tablishing a venture capital firm (Ramesh &Gupta, 1995).The government’s awakening to the potential

of venture capital occurred in conjunction withthe World Bank’s interest in encouraging eco-nomic liberalization in India. So, in November1988, the Indian government announced aninstitutional structure for venture capital(Ministry of Finance, 1988). This structure hadreceived substantial input from the WorldBank, which had observed that the focus onlending rather than equity investment had ledto institutional finance becoming ‘‘increasinglyinadequate for small and new Indian compa-nies focusing on growth’’ (World Bank, 1989,p. 6). In addition, ‘‘the [capital] markets havenot been receptive to young growth companiesneeding new capital, making them an unreliablesource for growth capital’’ (World Bank, 1989,p. 8). Though the exact sequence of events isdifficult to discover, some measure of the im-petus for a more serious consideration of ven-ture capital came from the process that led tothe 1989 World Bank study quoted above.Noting that the government’s focus until thenhad been on direct involvement in research anddevelopment (R&D) activities through its ownresearch institutes, in technology selection onbehalf of industry, and promoting of techno-logical self-reliance within Indian industry, the1989 World Bank report described approvinglya new trend in government thinking towardshifting decision making with respect to tech-nology choice and R&D to industry (both pri-vate and public) and a more open attitudetoward the import of technology. The WorldBank was keen to encourage this shift. The1989 World Bank (1989, p. 2) report noted that‘‘Bank involvement . . . has already had an im-pact on the plans and strategies of selected re-search and the standards, institutes and, withsupport from the IFC, on the institutionalstructure of venture capital.’’Making the case for supporting the new

venture capital guidelines with investments intoIndian venture capital funds (a first for theWorld Bank), the World Bank calculated thatdemand over the next 23 years would bearound $67–133 million per annum, and it


proposed providing a total of $45 million to bedivided among four public sector financial in-stitutions for the purpose of permitting them toestablish venture capital operations under theNovember 1988 guidelines issued by the Gov-ernment of India. (One of these operations,TDICI, slightly predated the guidelines, havingbeen established in August 1988.)The venture capital guidelines offered some

liberalization, but not everything the WorldBank wished. The most important feature ofthe 1988 rules was that venture capital fundsreceived the benefit of a relatively low capitalgains tax rate (but no pass through), i.e., a rateequivalent to the individual tax rate, which waslower than the corporate tax rate. They werealso allowed to exit investments at prices notsubject to the control of the Ministry of Fi-nance’s Controller of Capital Issues (whichotherwise did not permit exit at a premium overpar). A funds’ promoters had to be banks, largefinancial institutions, or private investors. Pri-vate investors could own no more than 20% ofthe fund management companies (although apublic listing could be used to raise the neededfunds).The funds were restricted to investing in

small amounts per firm (less than 100 millionrupees); the recipient firms had to be involvedin technology that was ‘‘new, relatively untried,very closely held or being taken from pilot tocommercial stage, or which incorporated somesignificant improvement over the existing onesin India.’’ The government also specified thatthe recipient firm’s founders should be ‘‘rela-tively new, professionally or technically quali-fied, and with inadequate resources or backingto finance the project.’’ There were also otherbureaucratic fetters including a list of approvedinvestment areas. Two government-sponsoreddevelopment banks, ICICI and IDBI, were re-quired to vet every portfolio firm’s applicationto a venture capital firm to ensure that it ful-filled the right purposes. In addition, the Con-troller of Capital Issues of the Ministry ofFinance had to approve every line of businessin which a venture capital firm wished to invest.In other words, the venture capitalists were tobe kept on a very short leash.Despite these constraints, the World Bank

supported the venture capital project, notingthat

the Guidelines reflect a cautious approach designed tomaximize the likelihood of venture capital financingfor technology-innovation ventures during the initial

period of experimentation and thereby demonstratethe viability of venture capital in India. For this rea-son, during the initial phase, the Guidelines focus onpromoting venture capital under the leadership ofwell-established financial institutions (World Bank,1989).

Interestingly, the US experience had shownthat such highly constrained and bureaucrati-cally controlled venture capital operations werethe least likely to succeed. Nonetheless, fourstate-owned financial institutions establishedventure capital subsidiaries under these re-strictive guidelines and received a total of $45million from the World Bank.The World Bank sought to ensure a level of

professionalism in the four new venture capitalfunds, two of which were established by twowell-managed state-level financial organiza-tions (Andhra Pradesh and Gujarat), one by alarge nationalized bank (Canara Bank) and oneby a development finance organization (ICICI).The World Bank loaned the money to the In-dian government that would then on-lend it atcommercial rates to these institutions for 16years, including a seven-year moratorium oninterest and principal repayments. The venturecapital funds were expected to be investingprincipally in equity or quasi-equity. Somemonies were allocated for training personnelthrough internships in overseas venture capitalfunds.This was an innovative project for the World

Bank. The report noted (1989, p. 42) that ‘‘thisis the first experience of this kind in India or inthe Bank.’’ To protect itself, the Bank agreed toengage in ‘‘substantial supervision.’’ The WorldBank would (1989, p. 31) ‘‘Review and approveinitially nearly 30 investments (made by theventure capitalists) . . . In addition, during su-pervision missions, Bank staff would reviewand comment on additional projects beforethey are approved.’’ Each venture capitalistwould have to submit semiannual progress re-ports detailing (1989, p. 33) ‘‘prospects, risks,and reasons for choice of financial instru-ments.’’ The venture capitalists agreed with theWorld Bank that they would operate under thefollowing operating guidelines: (i) the primarytarget groups for investment would be privateindustrial firms with above-average value-added in sectors where India had a comparativeadvantage, and protected industries would beavoided; (ii) the quality and experience of themanagement was key, along with the prospectsof the product; (iii) the portfolio return should


be targeted to be at least a 20% annual return;and (iv) no single firm should receive more than10% of the funds, and the venture capitalistwould not own more than 49% of an investee’svoting stock. It is interesting that, in its spirit,the World Bank’s funding was similar to that ofthe US SBA’s funding of SBICs. 10

In 1988, the first organization to actuallyidentify itself as a venture capital operation,Technology Development and InformationCompany of India (TDICI), was established inBangalore as a subsidiary of the IndustrialCredit and Investment Corporation of India(ICICI), India’s second-largest development fi-nancial institution (at the time, it was state-owned and managed). ICICI had already hadan interest in venture capital investing begin-ning in 1984. It started a small investing divi-sion at its Mumbai headquarters in 1985 thatfocused upon unlisted, early-stage companies(Nadkarni, 2000; Pandey, 1998). This divisionwas run by Kiran Nadkarni, who later went onto become TDICI’s second president. As anICICI division, its venture capital activitieswere circumscribed by the laws of the time.Learning from responses to similar restrictionsin Korea, Nadkarni (2000) and ICICI Chair-man Vaghul implemented a novel instrumentfor India, termed the ‘‘conditional loan.’’ Itcarried no interest but entitled the lender toreceive a royalty on sales (ICICI charged be-tween 2% and 10% as a royalty). They wouldtypically invest three million rupees in a firm, ofwhich one-third was used to buy equity at parfor about 20–40% of the firm, while the rest wasinvested as a conditional loan, which ‘‘was re-payable in the form of a royalty (on sales) afterthe venture generated sales.’’ There was no in-terest on the loan. The problem with thisscheme is, however, that the loan did not pro-vide capital gains (Pandey, 1998, p. 256).In its first year, the division invested in seven

such deals, of which three were in softwareservices, one in effluent engineering, and one infood products (a bubble gum manufacturer).Being a novel institution in the Indian context,as Nadkarni (2000) noted,

There was no obvious demand for this kind of fundingand a lot of work went into creating such deals. Ourobjective was not purely monetary but to support en-trepreneurship. We searched for deals that would earnus 2–3 percent above ICICI’s lending rate. It was ini-tially just a one-person operation [he] and then an-other person joined the team. Looking back, therewas no sectoral focus, so it is remarkable that we in-vested so much in Information Technologies.

Their primary task was identifying good firmsand making sure they were properly financed,although they provided little input on settingcorporate strategy, business developmentideas, or recruitment, as this was not part ofthe mandate. There were some missed oppor-tunities. For example, Infosys, then a fledglingstartup, had approached ICICI, which wasmanaging PACT, a USAID project meant tofund cooperative research between US andIndian firms, for funding a medical diagnosisproject. ICICI rejected Infosys’ request, how-ever, because the project was deemed toorisky.In 1988, the ICICI division was merged into

the newly formed TDICI in Bangalore, whichwas an equal joint venture between ICICI andthe state-run mutual fund UTI. The primaryreason for creating the joint venture with UTIwas to use the tax pass-through, an advantagethat was not available to any corporate firm atthat time other than UTI (which had receivedthis advantage through a special act of parlia-ment). Hence, while the investment managerfor the new funds was TDICI, it was a 50/50partnership between ICICI and UTI, and thefunds were registered as UTI’s Venture CapitalUnit Schemes (Vecaus). Vecaus I, established in1988, had a paid-in capital of 300 million ru-pees. Founded in 1991, Vecaus II had a paid-incapital of one billion rupees.Another reason for forming TDICI was that

venture capital investments were too small rel-ative to ICICI’s own portfolio to be worthmanaging. Furthermore, ICICI did not havethe flexibility or the ability to evaluate ventureinvestments. For example, Praj Industries, aneffluent engineering firm funded by ICICI, usedits funding to build a demonstration unit for asugar cooperative, but delays in project imple-mentation led to a delay in the unit’s comple-tion until after the sugar harvesting seasonended. This meant that the demonstration unitwould not receive raw material for anotheryear. The ICICI investment committee was notequipped to deal with such delays (Nadkarni,2000).Rather than remaining in Bombay where

ICICI was headquartered, TDICI decided toopen its operations in Bangalore. The reasonfor this was that by 1988, when TDICI wasprepared to begin serious investing, interest intechnology had increased due to the success ofmultinationals such as Texas Instruments andHewlett Packard that were operating inBangalore. In addition, the TDICI managers


wanted to escape from ICICI’s large-firm cul-ture. TDICI had to decide between Pune andBangalore, both of which were emerging astechnology centers. Bangalore was chosen be-cause the Indian software firms such as Wipro,PSI Data, and Infosys were based in Bangalore(Nadkarni, 2000). Moreover, Bangalore wasthe beneficiary of an earlier decision by theIndian government to establish it as the na-tional center for high technology. The researchactivities of state-owned firms such as IndianTelephone Industries, Hindustan AeronauticsLimited, the Indian Space Research Organiza-tion (ISRO), and the Defence Research Devel-opment Organization, along with the IndianInstitute of Science (India’s best research uni-versity), were centralized there.TDICI’s Vecaus I assumed ICICI’s venture

capital investments, then valued at 25 millionrupees, and invested in several successful in-formation technology firms in Bangalore. Itsfirst president, P. Sudarshan, was an 18-yearveteran of the Indian Scientific Research Or-ganization and had headed their technologytransfer division. Nadkarni was the head of theventure capital division and became the TDICIpresident in March 1990. Several establishedsoftware firms received funds from TDICI, in-cluding Wipro for developing a ‘‘ruggedized’’computer for army use. There were severalsuccesses, including several firms which wentpublic, such as VXL, Mastek Software Sys-tems, Microland, and Sun Pharmaceuticals.From its inception through 1994, the fund hadan inflation-adjusted internal rate of return of28% (before the compensation of the venturecapitalists), despite several mistakes, such asinitially funding several import-substitutionproducts that were negatively impacted by alowering of import tariffs. 11 Moreover, initiallyTDICI saw itself as an organization fundingtechnology ventures, and did not focus as di-rectly upon commercial objectives, thus it madeinvestments in interesting technology and not,perhaps, the best business opportunities (Pan-dey, 1998, p. 258). There also were organiza-tional failures, the most important of whichwas allowing relatively junior recruits to filterthe deals before the senior professionals sawthem. As a result, several high-quality potentialinvestments were missed. Vecaus I made 40investments to be managed by seven profes-sionals. In retrospect, Nadkarni (2000) believedthat was too large a number. By 1994, the dif-ficulties created by the institutional ownershipin the management and funding of TDICI be-

gan to tell on staff morale, and the performanceof the fund’s new investments was relativelypoor.Despite its difficulties, TDICI was the most

successful of the early government-relatedventure capital operations. Moreover, TDICIpersonnel played an important role in the for-malization of the Indian venture capital in-dustry. Kiran Nadkarni established the IndianVenture Capital Association, and was the In-dian partner for the first US firm to begin op-erations in India, Draper International. Inaddition to Nadkarni, TDICI personnel left tojoin yet other firms. For example, Vijay Angadijoined ICF Ventures, a fund subscribed to byoverseas investors (ICF Ventures, 2001). Inaddition, a number of TDICI alumni becamemanagers in Indian technology firms. So, thelegacy of TDICI includes not only evidencethat venture capital could be successful in In-dia, despite all of the constraints, but also acadre of experienced personnel that wouldmove into the private sector.There were other early funds. For example,

in 1990, Gujarat Venture Finance Limited(GVFL) began operations with a 240 millionrupee fund with investments from The WorldBank, the UK Commonwealth DevelopmentFund, the Gujarat Industrial Investment Cor-poration, Industrial Development Bank of In-dia, various banks, state corporations, andprivate firms (GVFL, 2001). GVFL was es-tablished with a handicap, namely it was meantto invest in the State of Gujarat. Although itsreturns were not high, it was sufficiently suc-cessful so that in 1995, it was able to raise 600million rupees for a second fund. Then in 1997it raised a third fund to target the informationtechnology sector.As with the other firms, GVFL’s investment

targets shifted through time. As Table 3 indi-cates, in 1995 there were fewer food and agri-culture-related firms and a greater emphasis oninformation technology than in 1990. The 1997fund invested exclusively in information tech-nology, discovering what US venture capitalistshad learned 40 years earlier, namely that onlyfast-changing industries in which large returnsare possible can justify venture investing(Kenney, n.d.). As with other firms, GVFL wasrestricted in the financial instruments it coulduse and, as a state institution, they were underpressure to invest in the state of Gujarat. Evenmore than TDICI, GVFL lacked professionalexpertise. In 1998, the president of GVFL es-timated that ultimately he would be able to


achieve a only 15% annualized return (Radha-krishnan, 1998)—a relatively weak return.The other two venture funds had only mod-

est success. The Andhra Pradesh state govern-ment formed a venture fund subsidiary in itsAP Industrial Development Corporation (AP-DIC). As in the case of GVFL, it was mandatedto invest in its state. Though located in a rela-tively strong high-technology region aroundHyderabad, APDIC suffered from all the diffi-culties of state-operated venture capital fundsand has also had a relatively low return. Thefinal venture fund was the only bank-operatedventure capital fund, which was a subsidiary ofnationalized Canara Bank, CanBank VentureCapital Fund (Canbank). Canbank, which washeadquartered in Bangalore, also performedonly modestly. Despite their rather weak per-formance, all of these firms raised new fundsand were able to continue their operations.This first stage of the venture capital industry

in India was plagued by inexperienced man-agement, mandates to invest in certain statesand sectors, and general regulatory problems.The firms’ overall performance was very mod-est, and only TDICI could be considered asuccess. As mentioned earlier, such problemswith government-sponsored venture capital arenot unique. Venture capital investing is a diffi-cult art. Government interference and limita-tions almost invariably increase the risks in analready risky enterprise, making failure morelikely. Yet, from this disappointing first stage,there came a realization that there actually wereviable investment opportunities in India, and anumber of venture capitalists had receivedtraining.

(b) The second period, 1995–99

The success of Indian entrepreneurs in Sili-con Valley that began in the 1980s became farmore visible in the 1990s. This attracted atten-tion and encouraged the notion in the UnitedStates that India might have more possibleentrepreneurs. Figure 1 shows that the amountof capital under management in India increasedafter 1995. 12 Moreover, it also indicates thatthe source of this increase was the entrance offoreign institutional investors. This includedinvestment arms of foreign banks, but partic-ularly important were venture capital fundsraised abroad. Very often, NRIs were impor-tant investors. In quantitative terms, it is pos-sible to see a dramatic change in the role offoreign investors. Notice also the comparativedecrease in the role of the multilateral devel-opment agencies and the Indian government’sfinancial institutions. The overseas private sec-tor investors became a dominant force in theIndian venture capital industry.In the United States, the venture capital in-

dustry is clustered in three specific regions (inorder of descending importance): Silicon Valley(San Francisco Bay Area), New York, andBoston. It is significant to note that SiliconValley and Boston are what can be termed‘‘technology-related’’ venture capital clusters,while New York is a ‘‘finance-related’’ cluster(Florida & Kenney, 1988a,b). In India, asTable 4 indicates, there is also a clustering un-der way. During the last two years, Bombayand New Delhi dramatically increased theirshare of the venture capital offices. This re-sembles the US historical record, in some ways,

Table 3. Gujarat venture finance limited investments in 1990 and 1995 funds

Firm name 1990 Industrial field 1990 Firm name 1995 Industrial field 1995

Premionics India Filtration membranes Computerskill Specialized printingSaraf Foods Dried fruits Srinisons Cables Auto wiringSystech Flight data acquisition

SystemsLokesh Machines Machine tools

Ajay Bio-tech Bio-fertilizers Mark Walker Opticals Designer optical framesColortek Liquid colorants for plastics Apex Electricals High rating transformersAgrochem Tocopherol from fatty acid Akshay Software

TechnologiesTurnkey software

Lactochem Lactic acid from molasses Minda Instruments Auto panel instrument clustersCals Wide area networking Indus Boffa Brakes Disk brake padsTIPCO Thermoplastic Nexstor India Hardware system manageability

productMadhusudanCeramics

Glazed tiles using new firingprocess

20 Microns Micronized minerals

Radiant Software IT training & software

Source: GVFL (2000).


and also indicates the immaturity of the Indianindustry. As late as 1998, Bombay, Bangalore,and New Delhi were comparable in terms ofnumber of offices. In contrast to the UnitedStates, where Silicon Valley asserted its domi-nance as a technology center at the end of the1970s, Bangalore had a smaller share of officeswhen compared with both Bombay and NewDelhi, which are the financial and politicalcapitals of India, respectively.This apparent weakness of Bangalore is

overstated, because the largest venture capital

firms in capital terms, i.e., TDICI, Draper,Walden-Nikko, JumpStartup and e4e, areheadquartered in Bangalore. In fact, Walden-Nikko closed its Bombay offices in 2000 toconsolidate in Bangalore. The other importantprivate venture capital firms, such as Chrysalis(Bombay) and Infinity (Delhi), have operationsin Bangalore as well. In some cases, there weredistinct reasons for locating in Bombay. Forexample, Chrysalis chose Bombay because ofthe internet boom, which was centered inBombay. As in the case of New York’s Silicon

Figure 1. Capital under management by the Indian venture capital industry by year in US$ millions. (Source: IVCA,various years.)

Table 4. The location of the headquarters of the members of Indian venture capital association 1993–98 and 2000

1993 1994 1995 1996 1997 1998 2000

Bombay 4 3 2 4 5 6 31New Delhi 3 3 3 2 3 4 10Hyderabad 1 1 1 1 1 1 1Bangalore 2 2 2 5 5 5 8Ahmedabad 1 1 1 1 1 1 1Calcutta 1 1 1 1 1 1 2Pune 0 0 1 1 1 1 2Chennai 0 0 0 1 1 1 1Lucknow 0 0 0 1 1 1 0

Total 11 11 11 17 19 21 56

Where there was more than one office, only the headquarters was counted.

Source: Indian Venture Capital Association (various years), Nasscom (1998).


Alley, this proved to be a strategic error. In thecase of Infinity, it chose Delhi because thepartners lived there. Another large venturecapital firm, SIDBI, is based in Bombay be-cause it is a subsidiary of a state-owned bankwith corporate headquarters in Lucknow andBombay. Moreover, Citibank’s venture capitaloperation is headquartered in Bombay; but itsportfolio consists mainly of private equity‘‘salvage-type’’ deals and some internet start-ups. Many of the other Bombay venture capitaloperations are involved in what, in the UnitedStates would be considered financial engineer-ing. Thus Bombay has a venture capital com-munity that resembles the New York financialcluster.The involvement of the overseas private sec-

tor in the Indian venture capital industry was apath-dependent experimental process. For ex-ample, in 1993, in an attempt to develop in-vestment opportunities businesses in India,Vinod Khosla (2000) spent three years com-muting between India and Silicon Valley. In1996, he gave up, returning full-time to SiliconValley, as he concluded that the Indian envi-ronment for venture capital development wasinadequate.Khosla was not alone. In 1993, Bill Draper,

who had begun venture investing in 1959, re-turned to Silicon Valley from a series of posi-tions dealing with development in the federalgovernment and then the United Nations. Inconjunction with a Stanford second-year MBAstudent, Robin Richards, Draper decided tobegin venture investing in a developing coun-try. After reviewing a number of countries, hedecided that India’s strength in software andEnglish capabilities made it an ideal candidate.So, in 1995, he formed Draper Internationaland recruited investments from a number ofsuccessful Silicon Valley entrepreneurs and in-vestors of Indian descent (Draper, 2000). Thiswould the first major overseas firm to begininvesting in India. To head their Indian office,they attracted Kiran Nadkarni from TDICI.Though Draper International would be the

first, others soon followed. In late 1996, theWalden Group’s Walden International Invest-ment Group (WIIG) initiated its India-focusedventure capital operation. The first fund, Wal-den-Nikko India Venture Co., was a jointventure between WIIG and Nikko Capital ofJapan, investing in early and late-stage com-panies (WIIG.COM, 2000). In the late 1990s,many more venture capital funds establishedoperations in India.

The formalization of the Indian venturecapital community began in 1993 with the es-tablishment of the Indian Venture CapitalAssociation (IVCA) headquartered in Banga-lore. The prime mover for this was TDICI’sNadkarni, who became its first president.There were nine members, the state-owned ormanaged ones being TDICI, GVFL, the In-dustrial Development Bank of India’s venturecapital division, RCTC, APIDC’s venturecapital division, and Canbank Ventures. Theprivate members were Credit Capital Corpo-ration, a joint venture with CommonwealthDevelopment Corporation, headed by invest-ment banker Udayan Bose, headquartered inMumbai, Indus Ventures of Mumbai (startedby T. Thomas, an ex-Unilever board member,and the Mahindra Group), Grindlays (laterpart of the ANZ banking group, subsequentlypurchased by Standard Chartered Bank), andthe British venture firm 3i Corporation. Ini-tially, the IVCA met only quarterly due totheir geographical dispersion. Since the ma-jority of the firms were subsidiaries of theIndian government agencies or banks and re-ceived funds from international developmentagencies, there was little real need to interactintensively.IVCA had little success in addressing the

main problem of most of its members, theabsence of tax pass-through. The reasons forlack of success were twofold: First, the gov-ernment did not understand the benefits ofventure capital in economic developmentterms. This was a result, in large measure, ofthe lack of recognition of the potential of theIndian-owned portion of the software indus-try. Moreover, the venture capital industrywas tiny with respect to the overall Indianeconomy, having committed funds of threebillion rupees and disbursements of less thanhalf that amount. Hence, they were unable tomobilize sufficient political pressure to moti-vate any liberalization. Second, the largestplayer, TDICI, had few reasons to demandchanges in the regulations, because it was un-affected by them (and, perhaps, benefited bybeing able to attract funding away from itstaxed brethren).As late as 1999, the IVCA was still struggling

to be an effective lobbying force. In fact, muchof the most powerful lobbying for the Indianventure capital industry comes from the Indianinformation technology industry associationNASSCOM. The IVCA does not even have aweb site. The most authoritative web-based


information on the Indian venture capital in-dustry is available from the NASSCOM site.There are internal divisions also. According

to one source, in 1999 approximately 80% ofthe total venture capital investments were de-rived from overseas firms (Singhvi, 1999).These foreign firms registered in Mauritius as astrategy to avoid the onerous regulations andtaxes imposed by the Indian government—amechanism that foreign securities firms seekingto invest in India had pioneered. 13 A Mauri-tius registry allowed tax pass-through, andsince they did not have other issues, such asfinding funds, they had little incentive to joinIVCA or actively lobby the Indian government.IVCA thus was a vehicle for Indian venturecapital funds seeking to obtain a level playingfield with the foreign funds. In fact, in the past,differences within IVCA surfaced, with theoverseas funds arguing for more regulationfrom the Foreign Investment PromotionBoard, which has a liberal record, and less fromthe Ministry of Finance, which has a contra-dictory record. The domestic funds favored asingle regulator, and they ultimately won thisdebate when the SEBI was formed. Still, thedivisions in the IVCA prevented it from be-coming an important player in the regulatorydebates during the late 1990s.Only in 1996 did overseas and truly private

domestic venture capitalists begin investing.This increase in investment was accelerated bySEBI’s announcement of the first guidelines forregistration and investment by venture capitalfirms. Though these changes had a salutaryeffect, the development of venture capital con-tinued to be inhibited because overall the reg-ulatory regime remained cumbersome. Theinhibition is partly expressed in the fact that asof December 1999 nearly 50% of the offshorepool of funds had not yet been invested (IFC,1999).The IVCA also has difficulties; as of De-

cember 1998, only 21 venture capital firms wereregistered with IVCA. Of these firms, eight arein the public sector and seven have receivedfunds from multilateral funding agencies(IVCA, various years). The IVCA, though notyet able to present a united front, has continuedto mature. If the Indian venture capital indus-try continues to expand and a regulatoryframework that ends the benefit for offshoreregistration is enacted, then the IVCA will beable to present unified positions. This will en-able it to become the voice of the Indian ven-ture capital sector.

8. RECENT GOVERNMENT EFFORTS TOENCOURAGE VENTURE INVESTING

In the late 1990s, the Indian governmentbecame aware of the potential benefits of ahealthy venture capital sector. Thus in 1999 anumber of new regulations were promulgated.Some of the most significant of these relatedto liberalizing the regulations regarding theability of various financial institutions to in-vest in venture capital. Perhaps the most im-portant of these went into effect in April 1999and allowed banks to invest up to 5% of theirnew funds annually in venture capital. As of2001, however, they have not made any ven-ture capital investments. This is not surprisingsince bank managers are rewarded for risk-averse behavior. Lending to a risky, fast-growing firm could be unwise because the loanprincipal is at risk while the reward is onlyinterest. 14 In such an environment, even ifbankers were good at evaluating fledglingfirms, itself a dubious proposition, extendingloans would be unwise. This meant that sincebanks control the bulk of discretionary finan-cial savings in the country, there is little in-ternally generated capital available for ventureinvesting.The bureaucratic obstacles to the free oper-

ation of venture capital remained significant.There has been a confusing array of new stat-utes. The main statutes governing venturecapital in India included the SEBI’s 1996 Ven-ture Capital Regulations, the 1995 Guidelinesfor Overseas Venture Capital Investments is-sued by the Department of Economic Affairs inthe Ministry of Finance, and the Central Boardof Direct Taxes’ (CBDT) 1995 Guidelines forVenture Capital Companies (later modified in1999). In early 2000, domestic venture capital-ists were regulated by three government bodies:the Securities and Exchange Board of India(SEBI), the Ministry of Finance, and theCBDT. For foreign venture capital firms theForeign Investment Promotion Board (FIPB)was required to approve every investment, andthe Reserve Bank of India (RBI) had to ap-prove every exit.The stated aim of the Indian regulatory re-

gime is to be neutral with regard to the riskprofile of investment recipients. In sharp con-trast to the United States, however, where aventure capital fund can invest in any industryit wishes, in India only six industries have beenapproved for investment: software, informationtechnology, pharmaceuticals, biotechnology,


agriculture and allied industries. Statutoryguidelines also limited investments in individualfirms based on the firm’s and the fund’s capital.The result of these various regulations has beena channeling of venture capital investment to-ward late-stage financing.Regulations regarding venture capital con-

tinued to be cumbersome and sometimes con-tradictory. Income tax rules provided thatventure capital funds may invest only up to40% of the paid-up capital of a recipient firm,and also not beyond 25% of their own funds.The Government of India guidelines also pre-scribed similar restrictions. Finally, the SEBIregulations did not have any sectoral invest-ment restrictions except to prohibit investmentin financial services firms. The result of thesevarious restrictions was government micro-management of investment, complicating theactivities of the venture capital firms withouteither increasing effectiveness or reducing riskto any appreciable extent.Impediments to the development of venture

capital also exist in India’s corporate, tax, andcurrency laws. India’s corporate law did notprovide for limited partnerships, limited liabilitypartnerships, or limited liability corporations(LP, LLP, and LLC, respectively). Moreover,corporate law allowed equity investors to re-ceive payment only in the form of dividends(i.e., no in-kind or capital distributions are al-lowed). Disclosure requirements were, however,consistent with best international practice. Inthe absence of seasoned institutional investors,advanced-country standards of investor pro-tection that would normally be imposed by suchinvestors have not developed. There was noteven a self-regulatory group.The general regulatory environment contin-

ues to hinder investment. For example, all in-vestors in the venture capital fund had limitedliability, and there was no flexibility in risk-sharing arrangements. There were no standardcontrol arrangements, so they had to be deter-mined by negotiation between managementand investors in the fund. Moreover, Indianregulations did not recognize limited life funds,so in India it was relatively easy to terminate atrust, but this meant that the entire firm wasclosed rather than a specific fund within thefirm. Therefore, each fund had to be created asa separate trust or company. This process wasadministratively and legally time-consuming.Terminating a fund was even more cumber-some, as it requires court approval on a case-by-case basis.

India’s regulatory framework inhibits prac-tices used in the United States to reward em-ployees of startup firms. Currently, in Indiafounders and employees can participate inemployee stock option programs, if the firm isprivate, defined as those having less than 50nonemployee shareholders. India’s corporatelaws allow for flexible risk sharing, control andexit arrangements between financiers and firmmanagement, provided the firms in which theyinvest are private. But, for firms with more than50 nonemployee shareholders, India’s corpo-rate law does not provide flexibility in usingequity to reward employees. This is a significanthandicap in recruiting and motivating high-quality management and engineering talent.The restrictions on venture capital extend

beyond the framework of corporate law. Forinstance, tax restrictions on corporations re-quire that corporations paying dividends mustpay a 10% dividend-distribution tax on theaggregate dividend. 15 On the other hand,trusts granting dividends are exempt from div-idend tax. For venture capital the optimal en-vironment would be a tax regime that is fiscallyneutral. It is also important to be tax-compet-itive with other domestic uses of institutionaland private equity finance, particularly thedomestic mutual funds sector. In 2001, the taxcode was still disadvantageous for the interna-tional venture capital investor. For example,earnings from an international venture capitalinvestor are taxed even if it is a tax-exemptinstitution in its country of origin. 16

Another significant impediment to develop-ing a vibrant venture capital industry was In-dia’s foreign currency regulations. Even in2001, the Indian rupee was nonconvertible. Thelack of convertibility hampered venture capitalinflows from offshore because specific, time-consuming governmental approvals from mul-tiple agencies were required for each investmentand disinvestment.Just as the currency regime inhibited inter-

national venture capital firms from investing inIndia, domestic venture capital firms were notallowed to invest offshore. Synergistic invest-ments in overseas firms that collaborate withdomestic firms were next to impossible. Thecurrency regime also frustrated exit strategies.For example, in early 1999 Armedia, an Indianmanufacturer of high-technology telecommu-nications equipment, was in discussion withBroadcom, a US firm, about being acquired,and it also was seeking an investment from anIndian venture capitalist. But, since Indian


venture capital firms cannot own offshoreshares, the deal with Broadcom would have hadto be changed from a ‘‘pooling-of-interests’’transaction to a cash acquisition. Broadcom,therefore, offered a significantly smaller sum toArmedia, because of the Indian venture capitalfirm’s involvement. Fortunately for Armedia, itwas able to obtain bridge funding offshore anddid not have to use an Indian venture capitalfirm (Dave, 1999). The Indian legal and regu-latory environment continued to inhibit ven-ture capital investors from maximizing theirreturns.

(a) Current political debates

An Indian venture capital industry is strug-gling to emerge and given the general globaldownturn, the handicaps existing in the Indianenvironment are threatening. As we have seen,many of the preconditions do exist, but theobstacles are many. Some of these can be ad-dressed directly without affecting other aspectsof the Indian political economy. Others aremore deeply rooted in the legal, political, andeconomic structure and will be much moredifficult to overcome without having a signifi-cant impact on other parts of the economy. Anumber of these issues were addressed in a re-port submitted to SEBI in January 2000 fromits Committee on Venture Capital. SEBI thenrecommended that the Ministry of Financeadopt many of its suggestions.In June 2000, the Ministry of Finance adop-

ted a number of the Committee’s proposals. Forexample, it accepted that only SEBI shouldregulate and register venture capital firms. Theonly criterion was to be the technical qualifica-tions of their promoters, whether domestic oroffshore. Such registration would not imposeany capital requirements or legal structure—this is very important, because it would allowIndia to develop a legal structure suitable to itsenvironment, while offering tax pass-throughfor all firms registered as venture capital firmswith SEBI. This was an important achievementof the Committee’s report. The proposedguidelines continued, however, to prohibit fi-nance and real estate investments. Whether thistype of micromanagement is good policy seemsdubious. In addition, registered venture capitalfunds must invest 70% of their paid-in capital inunlisted equity or equity-related, fully convert-ible instruments. 17 Similarly, related-companytransactions would be prohibited, and not morethan 25% of a fund’s capital could be invested in

a single firm. In the United States most of theseprovisions are not law, but are codified in thelimited partnership contracts and accepted ascommon sense. Rather than letting the marketdecide which venture capital firms are operatingresponsibly, the Indian government continuesto specify a variety of conditions.A number of suggestions were not accepted

even though they would assist in the growth ofventure capital. Many were related to the muchlarger general issues of corporate governance.For example, there was no change in the reg-ulations regarding restrictions on currencynonconvertibility, providing employees moreflexible stock-option plans, allowing domesticventure capital firms to hold equity in overseasstartups, and regulations allowing greater flex-ibility in voting and dividend rights. Reluctanceto adopt these measures is understandable,because they would strike at some of the fun-damental issues of corporate governance inIndia. Thus they were seen as policy decisionsthat might set in motion a larger chain ofevents.At the end of 2001, the Indian venture capital

environment contained several unresolved is-sues. One important obstacle was the inabilityto pass through unrealized gains or lossesthrough to the venture capital fund’s investorsthrough a direct distribution of stock or othersecurities unless the fund is organized as a trust.In the US, these ‘‘in-kind distributions’’ are themost common method of compensating inves-tors. This method increases the return for so-cially beneficial tax-exempt organizations suchas foundations and pension funds. Private in-dividuals, of course, pay taxes. Allowing legalstructures, such as limited partnerships, willenable such pass-through and encourage in-vestment in venture capital funds.There are also obstacles for overseas venture

capitalists—a seemingly unwise set of barriersto a country wishing to attract much-neededforeign capital and to create incentives for thecontinuing growth of the venture capital in-dustry. Currently, foreign venture capitalistsrequire permission from the RBI/FIPB for eachinvestment and liquidation. The RBI’s formulafor disinvestment is based on physical assetvalue and benchmark price-earnings ratios,both of which are often irrelevant. For exam-ple, a firm that has primarily intellectualproperty but makes a loss may still be valuable,but Indian rules do not allow it to be valuedproperly. Finally, foreign and domestic firmscannot repatriate capital or earnings without


further regulatory involvement. There were re-strictions on the ability of Indian firms to tradetheir stock for that of an overseas firm, and itwas extremely difficult to sell an Indian firm toa foreign firm—something that was simple andcommon for venture capital-funded firms inIsrael, Sweden, Canada, or the United King-dom. Conversely, Indian venture capital fundstoday find it difficult to invest abroad, a sig-nificant handicap when it is considered thatventure capital funds in nearly all other coun-tries were not only allowed to invest abroad,but also did so to secure access to more dealsand spread risk. The ability of Israeli venturecapital funds to invest abroad, especially infirms established by expatriate Israelis, hasbeen crucial to the dramatic growth of the Is-raeli venture capital industry. In effect, the lackof convertibility of the Indian rupee is a struc-tural impediment.Although published data on venture capital

investment after the moderate liberalizationseffected in 2000 were not yet available, therewere indications that investment has increased,suggesting that further liberalization couldelicit even greater venture capital activity. Un-official figures gathered by SEBI and IVCA 18

showed that over $1 billion was invested in2000, although the flow has substantially de-clined in the first two months of 2001 due to theglobal tightening of venture capital investment.Interestingly, because the overseas investorswere not regulated by SEBI, it was difficult tobe certain about the amount of investment.Foreign funds, in the absence of sensible regu-lations for overseas funds (as discussed above),have preferred the more bureaucratic but ulti-mately workable process offered by the FIPB.But, since the FIPB did not classify approvalsby investment stage, all statistics are necessarilyapproximations.

9. CONCLUSION

In the introduction we argued that thetransplantation of an institution could havefour Interactions. In the case of Israel, Inter-action (a), which was the successful transfer ofthe institution with little need to change theenvironment ruled. In the case of Taiwan, weargued that the institution of venture capitalhad to be changed, in some significant ways,i.e., Interaction (c). For India, we have arguedthat the environment itself has had to be andneeds to continue being changed, i.e., Interac-

tion (d). Of course, this is a much more pro-found process than either Israel or Taiwan hashad to undergo. Interestingly, in India we be-lieve that venture capital as an institution mayactually need to be changed less than in the caseof Taiwan, however this conclusion is not yetentirely verified.Earlier patterns of growth or failure in ven-

ture capital industries in other countries andregions indicate that the evolution of venturecapital seems to be either entry into a self-re-inforcing spiral, such as occurred in SiliconValley, Israel and Taiwan, or growth andstagnation, as occurred in Minnesota in the1980s or Germany until recently (on Germany,see Woywode, 2001). In other words, shouldIndia wish to develop a high-technology in-dustry funded by venture capital, then it will benecessary to continue improving the environ-ment by simplifying and eliminating regulationsthat do not perform necessary functions such asconsumer protection.The venture capital industry is emerging in

India as a result of internal and externalfactors. Should the venture capital industrybe sufficiently successful to become self-sus-taining, the Indian NIS will be altered. Dur-ing the 1990s the dominance of governmentinstitutions and family-owned conglomeratesin the Indian innovation system began to shiftsomewhat so that entrepreneurship began toplay a larger role. Moreover, scholars havegenerally treated India as a largely self-con-tained NIS, but during the 1990s the NRIsbecame an increasingly important componentof the NIS through their wealth, contacts,and political and economic influence. Thiswould be interesting because most scholarshave treated the NIS as a relatively fixedsystem.The World Bank, with its agenda of de-

creasing government regulation, funded thecreation of the first venture capital funds.Though these funds experienced limited suc-cess, they were the beginnings of a process oflegitimitizing venture investing and they were atraining ground for venture capitalists who la-ter established private venture capital funds. Itis unlikely that the venture capital industrycould have been successful without the devel-opment of the software industry and a generalliberalization of the economy. Of course, this isnot entirely surprising, because an institution ascomplicated as venture capital could notemerge without a minimally supportive envi-ronment. This environment both permitted the


evolution of the venture capital industry andsimultaneously allowed it to begin changingthat environment and initiating a co-evolu-tionary dynamic with other institutions.India still remains in a difficult environment

for venture capital. Even in 2001 the Indiangovernment remains bureaucratic and highlyregulated. To encourage the growth of venturecapital will require further action, and it islikely that the government will continue andeven accelerate its efforts to encourage venturecapital investing. The role of the governmentcannot be avoided: it must address tax, regu-latory/legal and currency exchange policies,since many of these affect both venture capitalfirms and the companies that they finance.More mechanisms need to be developed to re-duce risk if funds for venture capital must come

from publicly held financial institutions man-aged by highly risk-averse managers.India is an example of how purposive action

in an environment replete with resources canhave long-term impacts on the NIS. The ulti-mate fate of the Indian venture capital industryhas not, as of late 2001, been decided. Even as itgrew rapidly during the global Internet-fedventure capital boom of 1998 through early2000, its continued growth is in no way guar-anteed. If the earlier period provided the re-sources for constituting new firms, then thedownturn beginning in February 2000 will be astringent filter that will remove less viablecompetitors, in terms of venture capital-backedinvestments and many of the venture capitalfunds. Both the venture capital firms and theindustry as a whole will be tested severely.

NOTES

1. On path dependency, see Arthur (1994) and David

(1986). For NIS, see Lundvall (1992) and Nelson (1993).

2. For a more general conceptualization, see Kogut

(2000).

3. There is now a proliferating literature on the

economics of the venture capital industry. See, for

example, Gompers and Lerner (1999) for a guide to this

body of work. Economists have attempted to apply

principal-and-agent theory, information assymetry per-

spectives, game theory, and a variety of other models. In

each of these there seem to be flaws. For example, in the

venture capital–entrepreneur investment decision, there

is a question of which party is less informed. Tradition-

ally, the venture capitalist is considered to not know

what the entrepreneur knows. But, the entrepreneur also

does not know whether the venture capitalist will

perform all the assistance functions promised during

the negotiation. Thus, the information is asymmetrical

on both sides. Similarly, it is usually the firm’s manager

who is the agent of shareholders, who are assumed to

start a firm and then search for a manager to run it. The

agency problem arises because managers may take

decisions that will reduce firm value because of their

personal goals, e.g., taking overly risky investment

decisions because management benefits from the upside

of such decisions but not from the downside of failure.

In the venture capital–entrepreneur relationship, the

agency relationship is unclear. It is the entrepreneur who

starts a firm and searches for a financier while retaining a

substantial portion of the firm. The financier (venture

capitalist) also brings operating experience to the rela-

tionship. Both parties, therefore, have options to

undertake operating actions that can affect firm value.

Thus, the entrepreneur cannot simply be assumed to be

the venture capitalist’s agent with the possibility of

undertaking actions that will reduce shareholder value.

Rather than enter these theoretical discussions, we focus

upon the actual path-dependent development of the

venture capital industry.

4. There are, of course, many important venture

capital firms headquartered in other regions. Moreover,

in the United Kingdom, the very important firm, 3i,

which as part of its remit invested in new firms, was

formed in the immediate postwar period. More recently,

there has been a proliferation of specialist venture

capital firms. For example, there are funds that special-

ize in retail ventures. Some of the largest venture capital

funds, such as Oak Investment Partners and New

Enterprise Associates, have partners devoted to retail

ventures, though their main focus is IT. So, there is

significant diversity in the venture capital industry

(Gupta & Sapienza, 1992).

5. There is significant evidence to support Black and

Gilson’s observation regarding the relatively greater

vitality of the venture capital industry in stock market-

centered economies. But, their reasoning that a public

market offers entrepreneurs an opportunity ‘‘to reacquire

control from the venture capitalists by using an initial

public offering’’ is odd. There are no cases known where

the entrepreneurs have reacquired control at the IPO. In

fact, the true reason is nearly the converse of Black and

Gilson’s assertion. At the IPO, the entrepreneur can also


begin to cash out, thereby surrendering control. After a

successful IPO, however, the entrepreneurs, in most

cases, have achieved enormous capital gains on their low

cost founder’s stock.

6. For example, a recent study found that Brazil has

one of the highest rates of entrepreneurship in the world,

but it also has almost no venture capital to speak of

(Reynolds, Hay, Bygrave, Camp, & Autio, 2000).

7. For a more complete discussion, see Kenney (n.d.).

8. According to a 1991 RBI report, the gross profit

(before provisions on bank assets and taxes) had come

down to 1% of assets (a healthy norm would be about

1% for profits after provisions and taxes). Moreover,

approximately 25% of the total loans were bad.

9. Here we use the term ‘‘relatively skilled,’’ because

Indian postgraduate training was not as good as the

training in the best US graduate schools. Put differently,

the Indians who were trained in the elite US schools may

have been closer to the cutting edge of engineering.

10. Though we could find no direct evidence of

interaction, it is likely that the World Bank personnel

were very much aware of the structure of the SBA and

its initial problems.

11. Here they ignored the World Bank’s suggestion

that they avoid protected industries.

12. The last available information from IVCA is 1998.

The 1999 figures have not yet been released.

13. One of the authors of this paper, Rafiq Dossani,

helped develop this mechanism when he was an invest-

ment banker.

14. It is true that in the United States, banks have

never been an important source of venture capital, even

through their SBIC subsidiaries. For the most part, a

bank’s core competencies are in evaluating and making

loans. The problem with loans to small startups is that

the capital is at high risk, so any interest rate would

have to be usurious. Moreover, since the new firm is

often losing money in its early days, paying interest

and principal would drain money from the firm during

the period when it most requires the money for

investment.

15. The tax was to be raised to 20% in the

tax proposals for the financial year beginning April

2000.

16. There is a loophole available to foreign investors,

which is to register its fund in a country having a special

tax treaty with India providing effective tax exemption,

such as Mauritius or the Dutch Antilles.

17. The 70% rule would prevent financial firms that

are investing primarily in listed firms, in which the

risk-profile of investments could be substantially dif-

ferent from startups, from qualifying for tax pass-

through.

18. From private conversations in February 2001 with

SEBI’s Executive Director L.K. Singhvi and IVCA

President Saurabh Srivastava.

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Documents

Creating an Environment for Venture Capital in India