The past decade has seen India emerge as a software services success story. According to the industry trade association, Nasscom, the sector has been growing at 50% p.a. and is expected to clock rates of 35% p.a. over the next decade to a projected Rs 4,600 bn.
To clock these rates will require initiative from both the Government and the industry. The Government focus should be on creating a suitable business milieu, paying special attention on improving the state of infrastructure especially telecommunications. The industry at the same time will have to continue its quest of climbing the value chain.
To date the industry has quite successfully made the transition along the value chain. It began with body shopping, moved on to onsite programming and now provides offshore software development. The early efforts have yielded a brand equity, which positions India more competitively in the international markets. However, a risk factor still remains, as the business model is a play on labour cost arbitrage. Apart from international competition from cheap labor countries, such as the Philippines and China, India’s high quality labor force can also be used to create high technology products, something already demonstrated by Indian labour offshore.
One solution for moving up the value chain is through the use of venture capital, as has happened for Israel and Taiwan. Currently, VC investments in India are a paltry Rs 16.1 bn in comparison to Israel having VC funds to the tune of Rs 184 bn. The VC business in India was not the upshot of market forces but that of state intervention. In 1990, on the recommendations of the World Bank four funds were created all promoted by PSUs. Overseas and private domestic funds entered only in 1996.
The subdued growth of VC business in India is partly due to the poorly developed tax and regulatory environment. It may also be that the IT industry did not require VC funding as the business was of low risk nature (the top Indian companies TCS, Wipro & Infosys were all started without VC). However, going forward if the value-shift takes place the risk profile of the industry will increase. To foster an entrepreneurial spirit and facilitate the shift access to VC funds will be a prerequisite. Consequently, for the VC business to take off, the Government will have to provide a suitable regulatory, tax and currency environment.
To create a favourable regulatory, tax and currency environment the policy initiatives should address the following issues:
- Political acceptability: e.g. regulation should encourage new business creation rather than help large businesses alone.
- Intended use: Regulation should encourage VC firms to invest primarily in equity or equity related instruments of high-risk small firms. Raising of funds by VC firms should be through the equity route. This will ensure a balancing of risk on the assets and liabilities.
- Intended rewards: The regulations should facilitate a meritocratic environment rewarding good managerial performance of both fund managers and employees of investee companies.
- Prudent use: Should encourage the supplier of capital to VC firms to prudently accept the inherent risks in the VC business.
- Investor protection: The regulations should protect equity investors in VC firms and investee companies according to the best international standards.
Recently, the Government enunciated new VC guidelines based on the recommendations of the Securities & Exchange Board of India (SEBI) committee report. Some of the accepted proposals include:
- SEBI would be the sole regulator of VC firms operating in or from India.
- VC firms registered with the SEBI would be entitled to a pass through of distributable profits. Provided they invest at least 70% of their corpus in equity or equity related instruments, own no more than 40% of a single firm and not more than 25% of the corpus is invested in a single firm.
- The floor on individual investments in a VC firm should be raised from Rs 100,000 to Rs 500,000.
The above reforms will undoubtedly lead to a boost in investment in technology-related companies, while also making new capital available for infrastructural investments and for software services. But, in the absence of general capital account convertibility, a pending issue is that of currency convertibility for both venture capital firms and their portfolio firms. These are needed because of the global nature of the IT industry, where capital flows are global and where acquisitions by multinationals through stock issues are the normal form of exit.
This article is based on a paper, Reforming Venture Capital in India: Creating an Enabling Environment for Information Technology, written by Mr. Rafiq Dossani, consulting professor, Stanford University. The paper played an instrumental role in preparation of the SEBI report on VC regulations. Several of the proposals have been accepted by MoF and put into law. The entire paper will be shortly available on the site.