Entrepreneurs: A Study of Indian Biotechnology Industry
9.1 Introduction
The quest for knowledge economy in 1990s, where industries like information tech- nology (IT), biotechnology etc. are in the forefront, has brought the role of venture capital into prominence. Since these industries are “ideas driven,” traditional mode of financing is not available to them. Venture capitalists (VCs) play an intermediary role in financial markets to provide funds to firms which otherwise have difficulty in acquiring funds. In the entrepreneurial setting, financial intermediaries such as venture capital fundings (VCFs) have been cited as perhaps the dominant source of selection (Anderson, 1999). VCs affect selection by providing financial resources to cash-hungry firms and by favoring new firms with, or requiring them to adopt, particular strategies, practices or other characteristics so as to convert ideas into products. VCs may also provide management expertise or access to other capa- bilities that bolster the competitive advantage of firms that they fund (Hellmann and Puri, 2000). Since VCs are perceived to be “informed agents” able to iden- tify particularly promising firms, their investment provides a certification benefit that can enable the firm to obtain other resources (Megginson and Weiss, 1991).
Gompers and Lerner (2001) argue that entrepreneurs have long had ideas that require substantial capital to implement but lack the funds to finance these projects themselves. Since knowledge based, innovative and cutting edge technol- ogy projects are risky in nature and traditional modes of financing such as banks are not available to them, venture capital has evolved as a response to this felt need.
Venture capital thus represents one solution to financing the high risk, potentially V. Kathuria
Madras School of Economics, Chennai, India e-mail:[email protected]
V. Tewari
American Express, Gurgaon, India
e-mail:[email protected]
M. Keilbach et al. (eds.), Sustaining Entrepreneurship and Economic Growth – Lessons in Policy and Industry Innovations from Germany and India.
doi: 10.1007/978-0-387-78695-7, cSpringer Science + Business Media, LLC 2008
125
126 V. Kathuria and V. Tewari Table 9.1 Principal concerns of VCs and banks
Business aspects Venture capitalists Banks
1 Market Risk1 High Low
2 Setting of Targets High Low
3 Feedback and Involvement High Low
4 Agency risk2 Low High
Source:www.armchaireconomist.com/VCpolicyhints.pdf
high-reward projects. There are other differences too between VCs and traditional loan financing by banks. More importantly, VCs are active investors as opposed to banks. VCs concentrate on and also have a comparative advantage in financing small technology oriented high growth companies, where the entrepreneur has supe- rior knowledge about the prospects of further product development and the required efforts to be put in, but has fewer assets, can thus offer only limited collateral. Even, the commercial experience and know-how as possessed by the entrepreneur is lim- ited.Table 9.1briefly summarizes the differences in business concerns between the formal VCs and banks.
Since banks tend to be “passive” investors, as compared to VCs, the strategies needed to promote and encourage these investment flows are quite different. Iron- ically, banks lend money to people who have money. Apart from the risk-bearing stand point, another major key distinction relates to the problem of asymmetric information. The lack of collateral and a track record make it difficult for new entrepreneurs to obtain bank financing. Moreover, VCs do not simply provide finance but also a whole range of value added services. These include manage- rial expertise, addressing informational asymmetries by extensively scrutinizing and monitoring entrepreneurial projects, among others. Since VCs are exposed to the risk of a company failure, they prefer investing in companies that have the ability to grow rapidly and give higher-than-average returns to compensate for the risk. Once a new firm gets going, the VC monitors its development, establishes key contacts with customers, suppliers and outside professionals who may be hired by the firm.
When VCs invest in a business, they become part owners and typically require a seat on the company’s board of directors. The high risk of the projects also has a direct bearing on the future of new companies. Successful ones are often sold at an IPO; the less successful, but still viable, at a private trade-sale, whereas part of the investments must be written off completely. The exit decision—when to get out and in which way—is the final consideration on the part of the VC. Thus VCs focus on industry with knowledge base, skill base, having global presence with cutting-edge technology and capital and infrastructure needs. VCs also benefit from sustained growth and profitability of the funded firm, as this is essential to create a premium exit value in a sale or public offering.3Emerging markets and industry like IT and biotechnology have these characteristics, thereby attracting over two- thirds of ven- ture capital funding in recent times. Venture capital has been widely studied in the developed countries context, especially the US (see Gompers and Lerner, 2001, for
9 Venture Capitalist’s Role in Choosing Entrepreneurs 127 Table 9.2 VCs action in developing countries compared to developed countries
VCs Approach in developed Approach in developing
action countries countries
1 Selection of Financial and accounting Such information not available easily.
firms information of the firm to Not reliable also.
initially evaluate the proposal Other means used such as and assess the risk. relationship with the Geographic proximity is entrepreneur.
not the key factor. Proximity a key factor for funding. Firms near to VCs are funded often.
2 Monitoring Govt. plays no role in the Profit motive not profound.
of funded funded firms monitoring Govt. may also have a strong firms and structuring. influence on firm goals.
Shares no goals. Regulatory control weak. Monitoring Strong regulatory body. of firms’ activities closely
works as a substitute.
3 Value- Advice given is often direct. Advice to be provided diplomatically.
added Should not be given as an
services order to hurt ego of the top
provided management in front of others.
4 Exit of VCs Exit through IPO is common. IPOs still limited and purchase of firm by a strategic buyer is
more prevalent.
Notes: Adapted from Bruton and Ahlstrom (2003, p. 251).
a review of this work). However, the applicability of these studies in other settings, mainly the developing countries, is not only limited but also questionable. This is because of different institutional set up in these countries.Table 9.2summarizes the key points of departure across two institutional setups with respect to VCs selection, monitoring and guidance to the firms and what exit routes are available to them.
These institutional differences have come to the fore in an interesting study of 36 Chinese VCs and 3 funded firms by Bruton and Ahlstrom (2003). In developed countries, geographic proximity is important but not the sole key factor for VC funding. This is because financial and accounting information about the firms are available in general to the VCs, whereas, in absence of ready availability of finan- cial and accounting information, developing countries VCs fund only those firms that are located nearby (ibid., 242). Exit route through IPO is generally available in developed countries, but in developing countries, the absence of IPO route makes VCs rely more on purchase by a strategic partner. These institutional differences and a recent upsurge in venture capital funding in Asia, where the industry raised investable capital of over US$ 7.4 billion in 1998 alone implies that there is a need to study VC financing in developing countries context. Thus, an important research question is to see how do VCs select their investments, especially in a develop- ing country setting? In general, young and small firms confront more obstacles
128 V. Kathuria and V. Tewari (Stinchcombe, 1965), as they often lack employee commitment, knowledge of their environment, and working relationships with customers and suppliers. Similarly, since they have little operating experience, start-ups frequently operate using imma- ture and unrefined routines. According to Aldrich and Auster (1990), since startups tend to be small, they are unable to withstand a sustained period of poor perfor- mance. This implies startups are in greater need for VC funding. The data however, indicates otherwise. For example, in 2004, out of US$ 820 million invested in India- based companies by VCs, less than 10% went to start-ups (TSJ Media, 2004). This points to the need to see how VCs select investment in start-ups. Thus, this chapter contributes to the literature by looking into VCs investment decision in a devel- oping country setting and investigates whether the criterion differs across the two groups—start-ups and existing firms. The analysis is carried out for firms in Indian biotechnology industry. The organization of the remaining chapter is as follows:
Section 9.2gives a brief review of literature, which traces out what has been done in the past and why there is a need to study the issue.Section 9.3gives in brief the relevance of biotechnology industry in the Indian context.Section 9.4talks about the methodology followed by the data and the variables.Section 9.5deals with the results of the study. The chapter concludes withSection 9.6giving the avenues for further study.