IT Taskforce
Basic Background Report

 

VIII.    FINANCING INFORMATION TECHNOLOGY

Information Technology (IT) Industry, in the long term, has a high propensity for generation of internal resources obviating the need for external financing. Financing IT is therefore, required only during the initial start-up phase until the company stabilises its operations. For such initial funding, software companies have the disadvantage of a market, which is not visible or quantifiable. Assets which are difficult to be submitted as collaterals with unconventional risk profiles, high tech obsolescence triggered by unexpected innovations, etc., make it difficult for the enterprise to resort to the normal process of borrowings and long term loans from banks and other financial institutions. The traditional lending norms, cannot be used for funding this industry.

World-wide the software industry is tending towards a structure enabling the amortization of the technological assets in the year of procurement itself due to fast technological change. The banks will accept their assets mainly in the form of land and buildings, accounts receivables and cash. In the long term, there is no need for any debt as the internal generation of funds increases and all the assets would be funded out of the funds of shareholders. The long term funds are, however, required for expansion of software facilities within the country as well as abroad, acquisition of companies abroad, development of new products, etc. The short term financing will be for the Working Capital requirements to bridge any short term cash flow deficit.

While traditional avenues of financing in the form of bonds, debentures, preference shares and promoter's fundings can be raised as required and available, the following long term financing instruments will be required to be developed in the shortest possible time:

  • Venture Capital funds and private equity

  • Working Capital and Project Finance

  • Public Issue

  • Overseas Listing like ADRs/GDRs

  • Loans from available resources

Recommendations of IT Action Plan : Parts I and II :

The IT Action Plan Part-I of the National Task Force on Information Technology and Software Development, which was notified in the Gazette of India, Extraordinary, Part I, Section I, No. 160 dated July 25, 1998, has the following Policies concerning financing of IT:

  1. As the traditional method of asset-based funding of working capital would not meet the adequate and timely requirements of fund of the software sector, a differential and flexible approach shall be adopted by giving special dispensation towards working capital requirements of this sector in view of the unique nature of the industry. Accordingly, RBI shall issue, by 15th August 1998, new guidelines with regard to working capital requirements for the IT software and services sector which would be based on simple criteria such as turnover. Banks shall be advised to give 25 percent of the contract value for 18 months, with the first six months as term loan (without collaterals) and from the 7th month onwards annualized Cash Flow Statements shall be accepted instead of collaterals.

  2. IT software and services industry shall be treated as a Priority Sector by banks for the next five years. This would help to meet the requirements of IT software and services exports, and also the IT industry and applications within the country. Major banks will be advised to create specialised IT financing cells in important branches, where IT Software and Services units are sufficiently large in number. Performance in this dimension will be monitored by the Ministry of Finance.

  3. Against the present estimate of Rs. 400 crores of working capital for the industry, the amount shall be increased to around Rs. 1200 crores by the year 2000 subject to the broad criteria of pro-rata increase for the prospective requirements 24 months ahead as compared to the actuals of the current requirements at any given time. A system will be put in place which would enable substantial increase in working capital provided by the banks.

  4. Bank lending to IT Software and Services exporters shall be made eligible for RBI refinancing with sufficiently low interest rates.

  5. The banks shall be allowed to invest in the form of equity in dedicated venture capital funds meant for IT industry as part of the 5 percent of increment in deposits currently allowed for shares.

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 37.     `Banks/FIs like ICICI, IDBI, UTI and SBI shall set up joint ventures with Indian or foreign companies for setting up of at least four different venture capital dedicated funds of a corpus of not less than Rs. 50 crores each to cater to the credit need of the industry.

38. `Venture capitalists shall be allowed to set off losses in one invested company and profit in another invested company during the block of years for the purpose of income tax.

39. For Sweat Equity, an additional new proviso shall be added to Clauses 73 and 74(7)(6) of Companies Bill, 1997: ' The Computer Software Companies in India or their subsidiaries abroad may also issue Sweat Equity to their Promoter-Directors or whole time Directors or employees for providing any know-how, intellectual property or value addition to the Company on exclusive basis on such terms and conditions as may be prescribed by SEBI or the Central Government as the case may be.'A new definition No. (66) will be added after definition No. (65) in Clause 2 as under as "(66) Sweat Equity means equity allotted to promoter-Directors, whole time Directors or employees for providing any know-how intellectual property or value addition to the Company".

Amendments shall also be made in the Company Law to provide for buy-back of shares as well as differential pricing of shares.

40.     Ministry of Finance shall include IT software and IT service sector while issuing general guidelines for dual listing of companies, as well as while considering two-way fungability for ADRs/GDRs.

41. Dollar Linked Stock Options to employees of Indian Software companies were announced in the 1998 Budget and detailed guidelines on this have been issued   by DEA, Ministry of Finance. This shall be modified in accordance with the  definition of IT Software and IT Services given under (19)(a) and (b) above.

  • Employee Stock option schemes for stock listed in India would also be encouraged. Also, clarification shall be issued that income tax is applicable only at the time of sale and not at the time of excise of option.

The IT Action Plan Part-II: Development, Manufacture and Export of Information Technology Hardware, has recommended the following policies for financing IT hardware ventures:

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52. Ministry of Finance will notify the IT products sector as a priority sector for investments by FIs.

53. IT industry will be given the status of Infrastructure Industry in order to be globally competitive and be able to tap funds globally.

54. IT industry will be included by a Definition in Schedule-3 (priority industries) of the Industrial Policy.

55. Working Capital:

(i) From an amount of Rs.750 crores of working capital for the IT Products industry during 1998-99, the amount will be increased to Rs. 2000 crores by the year 2000-2001. A system will be put in place which would enable adequate increase in working capital provided by the banks.

(ii) IT products and related IT Services industry will be treated as a Priority Sector by banks for the next five years. This would help to meet the requirements of IT Products and related service exports, and also the IT industry and applications within the country. Major banks will be advised to create specialised IT financing cells in important branches, where IT units are sufficiently large in number. Performance in this dimension will be monitored by the Ministry of Finance.

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56. Venture Capital

(i) The banks will be allowed to invest in the form of equity in dedicated venture capital funds meant for IT industry.

(ii) Banks like ICICI and TDICICI will set up joint ventures with Indian or foreign companies for setting up at least two different venture capital dedicated funds of a corpus of not less than Rs.100 crores each to cater to the credit need of the Hardware industry.

(iii) Venture capitalists will be allowed to set off losses in one invested company and profit in another invested company during the block years for the purpose of income tax.

(iv) All IT products and related services will be considered eligible for exemption under section 10(23)F of the Act for venture capital investment.

The term "Computer Software" shall be replaced by "IT Products including IT Software and IT Services" in the explanation of the term 'Venture Capital Undertaking' appearing below Section 10(23F).

v) The NSE threshold will be reduced to Rs. 1 crore level for the IT industry.

vi) The following General measures will be progressively implemented to remove bottlenecks in the growth of venture capital funds, which is crucial to the high growth of the IT industry

i) Section 10(23D) of Income Tax Act applicable to Mutual Fund should be extended to include Venture Capital Funds to bring them at par with Mutual Funds.

ii) To permit investment to be made in "Equity, Quasi-Equity and Loans which are part of the financial structure" in place of the present dispensation which only permits investments in Equity to be eligible for benefit under Section 10(23F) of the Income Tax Act. The term "Computer Software" should be replaced by 'IT Products including IT Software and IT Services' in the explanation of the term 'Venture Capital Undertaking' appearing below Section 10(23F).

iii) Rule 2(d) of the Income Tax Act, 1962 should be modified to remove present time-bound investment schedules. It should be replaced by 'VCFs should invest 80% of the corpus in 4 years'.

iv) SEBI Guidelines should be changed to permit Mutual Funds to invest 5% of the corpus in Venture Capital Funds.

v) OTCEI should be revitalised to help small companies raise money from the public and also help Venture Capital Funds make an exit from the smaller companies.

vi) Facilitate exit by the Venture Capital Funds from the healthy companies through Buy-back of shares by the companies by introducing a Companies Bill.

vii) The present legislation may be replaced with a new "Limited Partnership Act" on the lines adopted in UK to facilitate formation of Venture Capital Funds.

viii) 50% of the funds invested by an investor into a VCF should be made tax-exempt.

ix) Rules under Indian Provident Fund Act should be changed to allow them to invest a small percentage, say 5% of the corpus, in the VCFs. Insurance companies which are also starting in the Private Sector should be asked to support Venture Capitals by making investments in VCFs.

x) For introduction of Limited Partnership Act for the regulatory framework for structuring of VCFs the following provisions are made

Investors to Venture Capital fund and Managers constitute a partnership which is of limited life. Investors to the fund are called Limited Partners and Managers who manage the fund are called General Partners. General Partners, besides receiving a salary from management fee also get percentage of the Profit. Limited Partners are investors to the fund and their liability on account of investments being made by the fund is limited to the extent of their investment in the fund.

  • 57. Definition of IT Products company will be included in the Company Law.

    58. A separate set of norms will govern the Employees Stock Option (ESOP) schemes for the IT industry on the following lines:

    i) Companies Act will be amended to allow IT companies to increase their total paid up capital by additional 10 percent for allocating the same to employees, promoters, directors, as stock options with post-facto endorsement by the AGM at 30% below the average market price for the last six months. For additional public or Rights offering the absolute volume of share in the pool will increase, while the percentage ceiling remains at 10 percent. IT companies will be allowed to increase this pool of share (for allocating to employees, promoters, directors) beyond 10 percent upto a maximum of 25 percent with the approval from the AGM.

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    ii) All Public limited IT companies will be allowed to issue shares to its employees, directors, promoters under the ESOP scheme at 30 percent below the average market price for the last six months, provided the same is approve din the AGM. All private limited IT companies will be allowed to issue shares to its employees, directors and promoters at a price which has the approval of the Government approved valuers like I-Sec and other FIs.

    iii) IT companies will be allowed to distribute shares under the ESOP scheme to employees based on the management's judgement of the employees value addition.

    iv) Clarifications will be issued that Income Tax and Capital Gains Tax will not be applicable on the disinvestment of shares received through an ESOP scheme.

    v) The employees should be allowed to pay for stocks at the time of exercising the option and not at the vesting point. However, the exercising of such option will have to be done within 8 years of the grant of stocks provided the employee continues in the company.

    59. For Sweat Equity, an additional new proviso will be added to Clauses 73 and 74(7)(6) of Companies Bill, 1997: 'The IT Hardware Companies in India or their subsidiaries abroad may also issue Sweat Equity to their Promoter-Directors or whole time Directors or employees for providing any know-how, intellectual property or value addition to the Company on exclusive basis on such terms and conditions as may be prescribed by SEBI or the Central Government as the case may be. A new definition No.(66) will be added after definition No(65) in Clause 2 as under as "(66) Sweat Equity means equity allotted to promoter-Directors, whole time Directors or employees for providing any know-how, intellectual property or value addition to the Company."

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    60. Dollar linked Stock options to Indian IT companies were announced in the 1998 Budget and detailed guidelines in this have been issued by the Department of Economic Affairs, Ministry of Finance. This will be modified in accordance with the definition of the IT industry to include all IT Products, Software and Services company.

    61. Ministry of Finance will include IT Products, Software and Service Sector while issuing general guidelines for dual listing of companies as well as while considering two-way fungability for ADRs/GDRs.

  • Additional Policy Recommendations

    Additional Policy recommendations are made with specific reference to the raising of venture capitals and Working Capital financing, the former based on the recommendations of NASSCOM and the latter from the proceedings of the International Software Business Conference - NASSCOM '99 :

    Raising Venture Capital

    Historically, venture capital has always been complimentary to Information Technology and software industry. In the US, venture capital tend to follow "hot industries" such as Internet, electronics and biotechnology, investing in companies with a viable product at the point when they are ready for significant expansion. It is therefore, not surprising that electronics and information technology constitute the largest share of venture capital disbursement in USA. Typically, a venture capitalist brings more than money to portfolio companies by providing specialised industry expertise and connections, and by creating keiretsu-style synergies across their portfolio.

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    Venture capital financing could be in the form of :

    • Relatively small amount of capital provided to an entrepreneur to prove a concept

    • Finance provided to companies for use in product development and initial marketing

    • Finance provided to companies that have expanded their initial capital and requires funds for sales and manufacturing

    • Working Capital for the initial expansion of the company that is producing and shipping but may not yet be showing profit.

    • Funds provided for the major growth of a company whose sales are increasing and that are break-even or profitable.

    • Financing for a company expecting to go public in 6 to 12 months.

    • Funds provided to enable operating management to acquire a product line or business.

    The Indian software industry has come a long way in the past few years. Projects executed by Indian software companies have moved up the value chain from low level programming to re-engineering, systems integration, tools and utilities into Intellectual property regime. Advent of Internet has created greater opportunities for Indian software industry to come out with world class tools, utilities, products and services. It is not surprising, therefore, that more and more companies are now shifting towards niche product/services which offer exponential sales growth. Whilst in the case of professional services, the requirements of the companies are small and relatively low risk, in the latter case, not only is the requirement of fund is large, but so is the risk involved. Banks and financial institutions are therefore adverse to funding these projects as these are non-asset based.

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    The risk and asset profile of most software companies post a natural barrier to traditional financing options. These rely heavily on knowledge workers and their asset base is much lower than conventional manufacturing concerns; banks and financial institutions are therefore averse to funding start-ups and small companies in knowledge-intensive industries. Also, equity issues are not feasible for start-ups due to the requirements of a 3-year track record and a threshold level of Rs. 5 crore and Rs. 10 crore for regional and national stock exchanges respectively.

    The software industry is a case in point. Start-ups engaged in the development of shrink-wrapped packages have huge funding requirements in the initial phases. The business risks associated with such ventures are much higher as compared to software services firms. Even for software services start-ups, financing from banks and Financial Institutions is not forthcoming due to the lack of a huge asset base.

    Thus, there is a need for software companies without any material asset based security to search for a partner who understands the business environment and is ready to share risk equally during the initial and growth stage. Venture capital is intended to play this role in India.

    The Venture Capital (VC) industry in India consists of offshore and domestic funds. Offshore VC funds usually invest a minimum of US $ 1 million and cater to established players with large requirements. Domestic VC funds constitute a minority at present and usually cater to small scale start-ups. However, the negative impact of the Asian crisis on overseas funds and the current unfavourable sentiment of foreign investors towards the Indian stock market will result in local funds gaining in importance in the future. Moreover, local institutions and banks have been encouraged to set up or participate in VC funds.

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    Working Capital Financing

    NASSCOM has made the specific recommendations for Working Capital Financing :

    1. Financing should be in the form of business based financing and financing against receivables and not asset based financing

    2. Conventional collateral securities should be waived

    3. Financing proposals should be appraised on parameters like credentials of entrepreneurs, company performance, etc.

    4. Small start-up units should be provided funding at concessional rates of   interest.

    The following are the suggested RBI Guidelines:

    1. Banks may consider sanction of working capital finance to IT companies engaged in software services, project services and software products irrespective of the age of the borrower unit and/or the quantum of turnover achieved by it in the previous year.

    2. Applications for working capital finance to be evaluated on criteria like track record of the founders, management team, professional qualifications, work experience in the software industry and infrastructure available.

    3. Working capital limits may be assessed by banks on the basis of 20% of projected turnover for units having working capital limits of upto Rs. 2 crore.

    4. Assessment of bank finance for units having working capital limits of over Rs. 2 crore will be on the basis of peak deficit as per the cash budget.

    5. Documents to be submitted for availing working capital finance:

    • Operating statement
    • Balance sheet
    • Cash budget
    • Statement of contract economics
    • Detailed project report and business plan

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    10. Nature of credit facilities:

    • Credit facilities upto Rs. 10 crore. Banks have freedom to sanction credit facilities by way of cash credit facility or overdraft.

    • Credit facilities above Rs. 10 crore. Cash credit component would be restricted to 20% of the aggregate credit limit after excluding export credit sanctioned with the balance being disbursed as a demand loan component.

    11.    Security - Banks free to obtain collateral security, where available

    12. Rate of interest - Concessional rates to apply for pre-shipment and post-shipment credit.

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