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:
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:
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.
The IT Action Plan Part-II: Development, Manufacture and Export of Information Technology Hardware, has recommended the following policies for financing IT hardware ventures:
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:
56. Venture Capital
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.
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.
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."
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.
Venture capital financing could be in the form of :
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.
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.
Working Capital Financing
NASSCOM has made the specific recommendations for Working Capital Financing :
The following are the suggested RBI Guidelines:
10. Nature of credit facilities:
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.