Venture Capital Example In India

The Saraf Foods Investment (A)

Cornell University Johnson Graduate School of Management NBA 593 International Entrepreneurship Auke Cnosssen, MBA ‘04 prepared this case study under the guidance of and with Professor Melvin Goldman as the basis for class discussion rather than to illustrate either effective or ineffective handling of a business situation.1

The Saraf Foods Investment (A) In August 1999, Vishnu Varshney, head of Gujarat Venture Finance Ltd. (GVFL), a venture capital firm in the state of Gujarat, India, was assessing the investment of GVFL in Saraf Foods Ltd. Saraf Foods was a producer of freeze dried vegetables for export. The latest monitoring report showed the financial projections for Saraf Foods for FY 1999-2000. 1998 had been a particularly bad year as a huge increase in the price of raw materials and restrictions on exports had increased costs and limited the ability to deliver products to customers. Sales volume for 1999 would be significantly below the break even volume. As a result, Saraf was now facing serious liquidity problems and needed additional funding. It had been seven years since GVFL had first put money into the venture and Varshney now had to decide whether to write off the Saraf Foods investment or to keep backing the entrepreneur and his company. Writing off the investment would mean that the return on the investment would be very low, if the assets could be sold. On the other hand, Saraf had turned out to be an honest and hard working businessman that had built up a strong relationship with his buyers. Continuing would mean a heavy time allocation by the staff of GVFL and Varshney in particular. And how would he exit?

Entrepreneurship and Venture Capital in India The Indian Government as well as state level administrations had provided various incentives and financing schemes to promote and finance small and medium enterprises (SMEs). SMEs proliferated in India, but Gujarat with its tradition of business and entrepreneurship produced many companies and two relatively successful state level financing organizations. However, these financing organizations were conservative and rarely financed companies with new or untried technologies and /or markets. 1

The authors acknowledge the enormous support provided by GVFL and the company and particularly Messrs Varshney and Saraf. Both opened their files and gave enormous time.

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The Saraf Foods Investment (A)

Venture Capital (VC) was just being experimented with by a development financial organization (DFI) when the World Bank was developing a scheme to promote technology development in the private sector. It identified VC as having enormous potential in India and identified organizations to spearhead the effort including the Gujarat Industrial Investment Corporation. The Government of India announced guidelines for VC funds in India in 1988. With the help of the World Bank the VC industry did eventually gain momentum in the late 1980s and early 90s. The program involved setting up VC firms and recruiting and educating people with proper backgrounds. Internship programs for 18 ‘would-be’ venture capitalists were set up with US firms in order to introduce the required knowledge and develop the man power. In total nine funds were set up with total capital of $180 million for 350 investments. India generally is considered entrepreneurial. However, industry was very much dominated by the public sector and several family-led large industrial conglomerates like Tata and Mahindra. Entrepreneurs tended to start as traders and build their businesses up based on retained earnings. They needed to learn to deal with inadequate financing and infrastructure and a difficult regulatory environment. For new entrepreneurs, it was particularly difficult to obtain bank finance and there was no services industry to support new entrepreneurs with few resources. The problem was far worse for those starting a business based on new technology and new markets.

Gujarat Venture Finance Ltd. GVFL, started in July 1990, was one of the first VC funds set up under the World Bank initiative. Mr. Vishnu Varshney, who had a background in equity investment, project planning and implementation, and turn-around was selected by the parent company Gujarat Industrial Investment Corporation (GIIC) to run GVFL. Mr. Varshney, a senior project manager with GIIC helped set up GVFL. He was joined and assisted early on by a very competent deputy, J M Trivedi another GIIC project manager. After a year of putting together GFVL and initiating the work, Varshney was the first venture capitalist in India to be selected to undergo the World Bank sponsored eighteen-week internship in the US. He worked at Hambro International Equity Partners in Boston in the US and attended a training program in 1991 organized by the National Venture Capital association in the US. Later on, he was one of the founding members of the Indian Venture Capital Association (IVCA) and served as Secretary and Chairman of the Association. Trivedi also was an early intern in a New York early stage VC partnership— Lawrence, Smith and Horey. Key investors in GVFL’s funds were GIIC, the Industrial Development Bank of India, the Commonwealth Development Corporation, the Small Industries Development Bank of India, and a few private and public sector Gujarati companies, many of whom had close relationships to GIIC. Even in the late 1990s, when many VC firms shifted towards later stage investments and private equity, GVFL remained loyal to its initial goal of stimulating entrepreneurship by investing in seed stage innovative start-ups. GVFL adopted a ‘hands on’ approach believing it

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The Saraf Foods Investment (A)

should work hand-in-hand with the entrepreneur. GVFL was pioneering in a number of ways. It convinced the parents and lead investors to invest all over India as well as across industries. The first fund (Gujarat Venture Capital Fund – 1990) was targeted at start-up companies based on new and untried or closely held technologies, innovative products or processes and services. Since there was no experience in India to build on, GVFL took extra time to invest the funds. The broad based fund was invested in over 25 companies. The total fund size was 240 million Rs. and the fund had an intended life span of 15 years. Exhibit 1 shows the details of the fund. As of 1999, the fund was fully invested and pay-outs to investors had started. Following the success of GVCF-1990, in terms of identifying promising VC investment opportunities, GVCF-1995 was launched. Investors included many of the investors of the earlier fund. The second fund was invested nationwide and shifted in focus towards funding new as well as small to medium sized companies with a sustainable competitive edge. Total fund size was 600 million Rs. and the life span was 12 years. By the end of 1998, 240 million Rs. had been invested in 15 companies. The third fund (GVCF – 1997) was started in 1997 with an emphasis on the IT industry. The fund had a size of 400 million Rs. and a life span of 12 years. The fund focused on Software and Information Technology- an area where India has established strong core competencies on a global level. Four investments totaling 71 million Rs. had been made by the end of 1998.

The Indian banking system The mainly government owned banking system in India had been dominated by two kinds of institutions; the commercial banks and the DFIs. DFIs traditionally provided project finance while commercial banks lent money to companies primarily to finance working capital. Project finance by DFIs was related to industrial development or expansion projects. The DFI would provide either term finance or equity financing. In the case of term financing, the DFI would get a board seat in the company. Equity financing would involve a much more active role in the company. Although the board seat would allow the DFI to stay informed on the company, it would generally not be very involved in the decision making within the company. In case of default, a DFI would normally restructure the loan and convert the defaulted interest into a term loan. Term finance loans would typically be six to eight years and would have a maximum grace period of two years. There were three key national DFIs that concentrated on the large industrial companies and projects. Other national DFIs were built for lending to agriculture and to infrastructure. DFIs for SMEs were left to the States to develop. GIIC was among the most successful regional DFIs to provide project lending and investment for SMEs. The GIIC guidelines prescribed that the maximum project cost would have to be less than Rs 50 million (in 1990 that was approximately $3.3 million, while in 1999 it was about $1.25 million)

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The Saraf Foods Investment (A)

and 30 to 35% of equity would have to be brought in by the promoter of the project. Interest rates in 1991 were on the order of 21%. (inflation was in the double digits). DFIs were focused on industrial projects with significant collateral in the form of assets. Service companies, and software companies in particular, had a hard time securing loans for starting or expanding a business. Since the late 1990s there has been a trend in India of mergers between DFIs and banks. This trend was accompanied by these institutions going public and has led to innovation and to one stop financing of enterprises. Another characteristic of the lending industry in India was that loans were based on a pari pasu agreement, meaning that there was no seniority of debt. All parties involved in investing in a company had the same rights on the assets of the company. In case of financial problems, all parties thus had to agree with each other on the action to be taken. Given the nature of the financial system in India, entrepreneurs faced many difficulties financing new ventures. High tech, service oriented, and high growth companies had very different characteristics than the traditional industrial clients of the DFIs. If financing could not be secured through DFIs or banks, the only remaining source would be family, friends and some rare seed funds for “first generation entrepreneurs.”

Venture capital challenges As expected, VC initially was not well understood by entrepreneurs, investors, and government agencies and needed nurturing. Businesses were traditionally closely held family operations and the concept of selling out a company to a strategic investor or rival was foreign. The concept of a financing organization becoming a partner and having veto power over certain decisions would take time to be grasped. Merger and acquisition activity started only slowly in the mid 1990s. Buying and selling companies was not common and the concept of writing off an investment took many years to get accepted and be understood. Bankruptcy remains a long and involved process needing reform. Stock markets in India dated from the late nineteenth century, but trading was relatively thin with only the larger companies being freely traded. While IPOs were not uncommon, prices of shares at the IPO stage were highly regulated and not market determined until the early-mid nineties. Periodic scandals rock the market. When serious, they can chase away many investors depressing stock prices and activity for many years. To overcome these constraints and gain the trust of entrepreneurs, VC in India needed experienced ex-entrepreneurs and businessmen who could nurture companies. VC in India, however, was dominated by people with DFI experience and by inexperienced young MBAs. Few (former) entrepreneurs were found in VC firms. While those who worked at a DFI have good company and industrial experience and a mindset that is frequently helpful to borrowers, it is insufficient. An MBA is also quite useful, but senior entrepreneurs and businessmen find it difficult to accept a “youngster” as their equal partner.

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The Saraf Foods Investment (A)

In India, the typical J-curve for a start-up company was much longer term as growth tended to be slower. The up-side for a VC was thus also more limited, requiring Indian VC investments to be structured differently compared to US VC investments. Amounts invested in start-ups were much smaller and investments were made in phases, because of the higher risks, lower burn-rates, and longer time-frames to reach maturity. VCs needed to look for other ways of putting in money and generating a return, besides equity investments. Examples were convertible stock, debentures, and royalty payments. Royalties allowed the VC to get a significant up side, while limiting the costs to the entrepreneur during economic downturns. In the latter 1990’s, foreign VC groups, particularly angel investors and successful entrepreneurs in the US and UK, began to take a serious interest in India. Most, however, quickly moved to private equity where risks were fewer compared to seed stage VC. Most of the domestic VC firms also changed from seed stage investing to private equity. Although a significant number of seed stage investments had been made, few successful exits had been realized. The shift towards private equity did help develop this industry and would in the long run provide more exit opportunities for VC. However, seed stage investing still had a long way to go as of the late 1990s before being able to attract significant capital from investors. 90% of VC firms were institutional VC firms that were funded by one of the DFIs. Many VC management companies were structured with a CEO with subordinates. The institutional framework hindered the VCs; they were less agile for a dynamic VC industry. People with an institutional background were used to doing larger deals than the typical VC deal. Because the concept of partnership was not fully developed, the incentives for VCs were also not well developed. Cultural issues also complicated VC investments. Indian entrepreneurs were very individualistic, preventing them from being able to let go of their company, hindering an exit in the form of an acquisition or merger. The Indian entrepreneur, typically with an engineering and finance or MBA degree, wanted to control all fields within a company himself. This caused problems when companies grew and were in need of people with more specialized knowledge in for example finance or marketing. The individualistic mindset was overcome by clauses in the term sheet that required the entrepreneur to hire appropriate expertise when requested by the VC. Entrepreneurs frequently came from wealthy and successful business families, the middle class, or were managers from large corporations. Entrepreneurs typically had a high equity stake in their companies as they had difficulties giving up part of their company. In addition, VCs wanted to see a substantial commitment by the entrepreneur. Mr. Varshney commented on how a VC would ensure control over an investment in which it had a minority stake: The large equity stake held by the entrepreneur gives him less incentive to run off with the money invested by the VC and gives him an incentive to work harder. We make sure that we have enough control by making the entrepreneur realize that a VC investment is a partnership and that we are on the same side of the table. A strong relationship with trust is very important. The entrepreneur has to see the benefit of the relationship with the VC.

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The Saraf Foods Investment (A)

VCs generally had one or two board seats. However, few decisions were taken by the board. Board meetings were a formality to inform people. Important decisions were made between the entrepreneur and the head of the VC firm. Industries that were attractive for VC, like telecommunications and IT were not well developed, and VCs thus had difficulties creating a good management team and finding experienced board members. Obviously, this gradually changed by the late nineties as IT and telecommunications grew rapidly. Even though the upside of a VC investment in India was limited by slower growth rates and difficulties getting ventures off the ground, many people felt that VC could work in India as the number of companies that reached maturity tended to be higher compared to the Western World. Indian companies were better able to survive a setback or economic down turn because: - Indian entrepreneurs tended to be conservative about spending money; - Burn rates in India were much lower and it was easier to reduce costs during a set back; - Indian entrepreneurs often came from business families and managed to raise funds within their own network/family when needed when they were in financial distress. As a result, the India VC industry saw fewer companies that gave a return of 100x or 200% IRR, but did show more companies returning a 30 to 40 % IRR compared to their Western counterparts.

Saraf Foods Ltd. Saraf Foods Pvt. Ltd. (Saraf Foods) was started by Mr. Suresh Saraf. After completion of his studies in mechanical engineering and business administration, Saraf joined the family business, which owned roller flour milling plants and warehouses. Not content with running an established business, he decided to start his own business and began with trading in steel in 1986. Based in Delhi, he was on the look out for a suitable project. During this time, he came in contact with the Agricultural and Processed Food Products Export Development Authority (APEDA). APEDA introduced him to the vast potential of the export of fruits and vegetables. Specifically, APEDA believed that there was an opportunity to export vacuum freeze dried foods. Vacuum freeze drying (VFD) was a relatively new technology in the food industry and vacuum freeze dried products were high margin products in the Western World. During 1988 and 1989, Saraf worked on this idea and developed insights in VFD and the application of this technology to various fruits and vegetables. Saraf made enquiries with various foreign suppliers of VFD machineries in Denmark, West Germany and the U.K. During his research on the VFD equipment manufacturers he came across an Indian company, IBP Company Ltd, which manufactured VFD plants for pharmaceutical applications. After discussing the potential for using the machinery of IBP for drying of vegetables, trials were run on the equipment for pharmaceuticals. Results were encouraging and samples were prepared and sent to potential customers in the US, the U.K. and West Germany to assess the interest of consumers in such products. The response was encouraging, which led to additional sample production of various fruits and vegetables. In the mean time, IBP developed a VFD pilot plant for fruits and vegetables to enable its clients to take trials and establish process parameters.

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The Saraf Foods Investment (A)

VFD technology for vegetables India, gifted with a large variety of exotic fruits and vegetables, had a vast potential for exporting these agricultural products to other countries according to APEDA. India’s distance from major markets and the dispersion across India and short shelf life of these perishable products has limited the ability to export. Various methods for preserving fruits and vegetables had been in practice to increase their shelf life, among which air drying has been the most commonly used method. VFD of fruits and vegetables was sophisticated and a relatively new process which had several advantages over traditional preservation methods. VFD involves freezing the substance to be dried while simultaneously creating a vacuum so that the water content of the substance which is frozen to ice directly sublimes into vapor. The major advantage is that the aromatic substances in the fruits and vegetables are not lost in drying as is the case in most other processes. Thus, original flavor, color, texture, as well as nutrients like proteins and vitamins are retained and addition of preservatives is not required. The product has a longer shelf life and does not require storage at low temperature. Whenever they are to be consumed, they can be re-hydrated to achieve quick and complete re-constitution. VFD, however, is a very slow method of drying, requires a high investment in drying equipment, and involves high energy costs. According to APEDA, the health consciousness of users all over the world had spurred numbers of uses of fresh fruits and vegetables. In the West, there was an increasing use of natural ingredients in a wide variety of products such as ice creams, confectionaries, bakeries, soups, sauces, yoghurts, cereal foods, baby foods, ready to make milk shakes, etc. Freeze dried fruits and vegetables were an excellent substitute for fresh fruits and vegetables and had advantages in longer shelf lives and simpler storage conditions. While VFD technology had been known for quite some time and widely used in industrialized countries for various applications including for fruits and vegetables, it had only been applied until very recently in India to pharmaceuticals. A successful application of this technology required Saraf to first develop the time temperature cycles for each product. Saraf approached the Central Food and Technological Research Institute (CFTRI) in Mysore, which had experience in drying of fruits and vegetables and had VFD equipment. Developing these cycles was important in order to obtain the right product in terms of quality (odor and flavor), structure of the product, texture after re-hydration, and to minimize the energy costs.

Financing the idea Once the idea matured, Saraf moved to Gujarat in 1990 and started working towards setting up a 100% export oriented business in Vaghodia near Baroda. This location was chosen because of the availability of a number of different raw materials. Setting up a VFD company would involve

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The Saraf Foods Investment (A)

significant investments in fixed assets. Besides investing family funds, Saraf needed additional financing to get the venture started and therefore approached GIIC. GIIC concluded that Saraf Foods was too risky: project cost particularly for the equipment was high; there was no experience in India of VFD for fruits and vegetables and there was no marketing experience in the area. In addition, it would take at least a couple of years before the company could launch a product on the market, too long to service a traditional term loan. The difficulty that GIIC saw was that it would be hard to secure any contracts without having built a plant. The company would therefore have to invest much time and money into building the plant and developing the product. Mr. Saraf was found to be a very capable entrepreneur who was open-minded to input from others regarding his business idea. Saraf initially had the ambition to develop a product for the end-consumer. Plans were to launch the company’s own product on the shelves of food retailers. It was clear to GIIC that this was too ambitious. GIIC did see the capability of drying tropical fruits (which should be exported to the US) as the competitive edge compared to producers of freeze dried food in the US and Europe. However, capital expenditures would have to be kept low by development of machines in India. Another concern of GIIC was that power was relatively expensive in India (at the time around 10 US cents per kWh). It was also unclear to GIIC if there where any economies of scale. The variable costs, energy and raw materials, didn’t decrease much in price if purchased in larger quantities. In addition, VFD drying units had a maximum size and increasing the capacity would simply mean increasing the number of units. The GIIC officers, however, neither rejected nor approved the idea. Through the VC network of GIIC, the business proposal ended up on the desks of Mr. Varshney and his new deputy Trivedi (who knew about the project from his recent work in GIIC) in January 1991. Both recognized that the idea had potential as it involved a new technology, used indigenously sourced raw materials, and was exported oriented. This was in line with the focus of the GVCF - 1990 fund. The project promised a 25+ % IRR with the prices quoted by Saraf. In addition, Saraf came from a trustworthy and successful business family. GVFL put together a due diligence team for evaluating the technology and market prospects. With Saraf, GVFL further developed the business proposal over the next couple of months. GVFL did the required due diligence on Saraf and his family’s business and concluded that Saraf was very knowledgeable in the area and had a good understanding of the technology, as initial tests had been conducted at the CFTRI. Examination of the family businesses was satisfactory. An appraisal report was written and sent to the World Bank for approval in April of 1991. After a series of communications in May, the World Bank approved and suggested that the project be divided into two phases. Phase one would involve additional testing at the CFTRI to further develop the process and produce samples and a trip to Europe and the US for market research and to gauge interest with potential buyers. Phase two would be initiated if the results of phase one were satisfactory and involve project implementation during which the factory would be set up.

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The Saraf Foods Investment (A)

The appraisal report2 According to the appraisal report, the annual production of fruits and vegetables produced in the country in 1991 was estimated at 33 million tons and 40 million tons, respectively. The world production was 326 million tons and 1000 million tons, respectively. India’s fruit production included about 62% of the world’s mangoes and 11% of the world’s bananas. The export of fruits and vegetables from India was less than 1% in 1983 – 1984 of the world total exports. Total dollar value of these exports in 1983 – 1984 was 107.5 million USD, a meager 0.45% of the 23.56 billion world total. The main reasons for this were the dispersed Indian production without any quality control, the distance to market, the lack of a well developed processing industry for fruits and vegetables, and a proper export marketing strategy. In 1991, there was only one VFD plant being commissioned in India that was planning on producing freeze dried vegetables and prawns (to be used in ready to eat noodle products). In Kerala (South India) there was another plant that engaged in the drying of shrimps. No company was exporting vacuum freeze dried products at the time. Most of the producers of VFD foods were located in Germany, Denmark, Italy, Taiwan, and the US. The major markets for Indian (fresh and processed) fruits and vegetables were found to be Germany, UK, Netherlands, US, and Kuwait. Mangoes constitute the largest part of the fruit export. The appraisal report identified Germany and the US as the likely main markets. Germany imported 40% of its food requirements and had been a major importer of fruits and vegetables. In 1988, Germany imported 1 million tons of fruit and 788,000 tons of vegetables each valued at 1.7million USD. Forecasted annual growth rate for tropical fruits was estimated by the IndoGerman Chamber of Commerce at 15 to 20% per annum for the next five years. The appraisal report concluded that: - Many exotic tropical fruits available in India (Papaya and Mango) were quite popular in Germany and their demand was growing substantially. - Guava had also been introduced in Germany and its consumption was increasing. - Sapota (a similar fruit to Kiwi) had been introduced in Germany. - Germany imported large quantities of Capsicum, Coriander, and Ginger. - Large quantities of banana and tomatoes were imported by Germany, but these were among the low priced common fruits and vegetables. Given the favorable conditions of the German market, Germany had been selected as a target market for the proposed project. Although the size of the VFD market was not spelled out, the appraisal report expected it to be high, well beyond India’s potential capabilities for the short term. In 1991, VFD fruits and vegetables in Germany were mainly imported from the US, Thailand, and Malaysia. The marketing companies in Germany for VFD products were known to market their product all over Europe. German standards and regulation for food products were 2

In VC jargon, this is termed “due-diligence.” In India, however, many VCs initiated by DFIs retained the term used for projects namely, “appraisal.”

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The Saraf Foods Investment (A)

the most stringent, thereby making it relatively easy to approach other European countries at a later date, once the company had moved into Germany successfully. Given the attractive fruit market compared to the vegetable market in Germany, the company chose to devote 75% of total production to tropical fruits and 25% of production to vegetables. The product mix had been chosen based on local availability, marketability, price competitiveness and seasonal availability. Production would include Mango (75 production days), Sapota (60 production days), Papaya (70 production days), Guava (20 production days), Capsicum (30 production days), Ginger (30 production days), and Coriander (15 production days). The pricing strategy would be based on quotations received from the German buyers Prices quoted to Saraf Foods are shown in Exhibit 2. Exhibit 3 shows the pro-forma income statement for Saraf Foods, as used in the appraisal report. The prices of freeze dried vegetable and fruits were about 8 to 15 times higher than those of air dried products. About 25% of the total costs were budgeted for energy, 20% for raw materials, 20% for labor, and 35% for fixed costs like financing, depreciation, and general expenses.

Phase one and phase two The projected costs of the venture were estimated at Rs. 15.7 million. Of this, GVFL would provide Rs. 2.5 million in equity (at Rs. 10 per share) and Rs. 7.5 million in income notes. The project qualified for a Rs. 3 million subsidy from the government of Gujarat. The remaining Rs. 2.7 million would be brought in by Saraf. Of the budget, Rs. 500,000 was needed for phase one (to be equally split between GVFL and Saraf) and the remainder for phase two. Interest on the income notes was set at 10%. In addition, GVFL would receive a 5% royalty on sales. Phase one was completed by December 1991. Saraf had visited France, Germany, Italy, Switzerland, Denmark, and the UK, where he contacted 41 potential customers. At the suggestion of GVFL, Saraf also visited the US. At the conclusion of phase one, GVFL appointed a Monitoring and Project Implementation Committee. During phase two, orders for major machinery was placed with IBP Ltd and work on land development and building construction was started. GVFL started cash disbursements, took an active role in the negotiations with the equipment manufacturers, and assisted in obtaining the required government approvals. Project delay caused by late arrival and installation of the equipment led to cost overruns of Rs. 4.5 million by the end of 1992. Saraf and GVFL agreed to finance equally these additional costs. The delay in project implementation also resulted in a delay in the receipt of the subsidy. Saraf therefore requested GVFL to provide a bridge loan in the amount of Rs. 3 million against the subsidy. GVFL also assisted in obtaining working capital facilities from the State Bank of India.

Commercial production

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On paper, the plant was declared ready in March 1993 in order to receive the subsidy. However, problems were detected in the blast freeze drier supplied by equipment manufacturer Alfa Laval. The defrosting system was not operating properly and the door of the freezer was leaking. Alfa Laval was informed of this problem, however, it took them until July 1993 after intervention of GVFL to rectify the problems. As a result, Saraf Foods suffered significant production losses. Actual production was started in September 1993, eight months behind schedule. The costs associated with the delay was put into expenses, but should have been capitalized. In early 1994, Saraf Foods shipped its first consignments of banana, onion, and okra to the US. The Food and Drug Administration (FDA) detained the load of okra after detecting residues of a banned pesticide. As per the suggestion of GVFL, Saraf Foods subsequently entered into contract farming agreements to minimize future risks regarding pesticides. Saraf Foods offered the customer to destroy the shipment and replace the container free of charges. As a result of all the delays, FY 1993/1994 ended with a loss of Rs. 3,645,000 on sales of Rs. 1,706,000. During 1993, as it became clear that additional financing was needed, GVFL started to sell the venture as an investment opportunity to Canbank Venture Capital Fund (CVCF), a Bangalore based World Bank supported VC. In April 1994, CVCF gave its sanction for funding in the form of equity. CVCF would receive 210,000 shares at a premium of 2 Rs. per share, providing Saraf with Rs 2,592,000 in cash. Exhibit 4 and Exhibit 5 show the balance sheets and income statements of Saraf, respectively.

Marketing of Freeze Dried products Once the company had sorted out all the equipment problems, Saraf strengthened the marketing efforts of the company. Typically the process of market acceptance and securing contracts involved the following steps. Samples were developed and sent to prospective buyers. Buyers then tested the samples for quality and shelf life. The buyer would visit India to check facilities and prices and contract terms would be negotiated. The entire process could take many months. The initial samples produced at CFTRI had been taken on the tour to Europe and the US. It turned out to be extremely difficult to get customer interest without having a product or a facility yet. However, Saraf managed to secure a contract with a large buyer and producer of freeze dried foods in the US in 1993. The tour through Europe was also used to explore what kinds of products would be suitable for production in India. It turned out that demand was highest for more commodity like products like onion, okra, and banana. In 1994, Saraf approached the Center for Promotion and Imports from Developing Countries, a Government of the Netherlands organization. This organization sponsored the company for a three-day seminar on marketing in Europe. They also assisted in setting up a booth at the Food Ingredient Europe (FIE) fair in London, which led to initial contracts with buyers.

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The increased marketing efforts led to the signing of a long term agreement with a German marketer of freeze dried foods in 1995. The contract involved monthly dispatches of one container load of onion and banana.

The growth phase Once the company was receiving regular orders in 1995, additional equipment (a dicer and a metal detector) were purchased in the amount of Rs. 1.2 million. These investments were needed to ensure product uniformity and safety. As a result, the liquidity position of the company would be tight and therefore Saraf requested GVFL to reschedule its Income Note dues. GVFL agreed to this and deferred five quarterly principle installments and six interest installments for 18 months. FY 1994/1995 ended with a loss of Rs. 3,628,000 on a turnover of Rs. 2,806,000. The delays and low utilization of the dryer forced the company to raise additional capital in order to repay the bridge loan against the subsidy. GVFL approved Rs. 1,620,000 on the condition that Saraf would bring in Rs. 1,690,000 and CVCF would also raise its share with Rs. 740,000. By mid 1995, however, the company had booked its entire 1 ton capacity. The factory building had been constructed for three dryers and capacity expansion would thus only involve adding additional dryers. Adding a dryer gave significant economies of scale, as no additional man power was needed and energy costs would only increase by 50%. IBP, the supplier of the first dryer had closed this line of business and Saraf therefore decided to undertake construction of the dryer himself. This decision was justified by the fact that imported dryers where three times as costly as dryers manufactured in India. In addition, 70% of the parts supplied by IBP were bought from suppliers and ex-employees of IBP were available for technical consulting. Saraf had acquired substantial knowledge of the technical side of the dryer operation. After discussing the issue with GVFL, it was decided to self-fabricate a second dryer. GIIC was approached to finance the expansion of the plant. Even though GIIC had initially rejected the project, Saraf Foods was now fully operational and GIIC was the appropriate financing institution. A Rs. 9,400,000 term loan was approved by GIIC in August 1995. At the time of the negotiations, the interest rate was 17%, which was used in the projections. However, between the time of sanctioning and disbursement, the interest rate rose 5% to 22%. GVFL approved additional equity in the amount of Rs. 2,280,000 in December of 1995 as their share of the expansion. The expansion project was completed in November 1996 without any overrun. Even though revenues increased, the financing costs were weighing heavily on the company’s cash position. Saraf therefore approached GVFL again for loan restructuring. GVFL recognized that the company had made good progress on the implementation of the expansion project and that the company had built good relationships with its customers. GVFL therefore approved rescheduling. The outstanding balance of Rs. 7,145,000 on the Income Note was to be paid in 14 quarterly installments starting from October 1st 1996 instead of 20 installments starting on April 1st 1994. Interest was revised from 10% to 13%. The royalty on revenues was revised from 5% to

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The Saraf Foods Investment (A)

7% and GVFL reserved the right to convert an amount not exceeding Rs. 3,700,000 out of the principal amount of the Income Note and / or royalty into equity shares. In FY 1995/1996, the company’s sales increased to Rs. 9,870,000. The company also reported a small profit of Rs. 145,000. FY 1996/1997 saw a further increase in revenues to Rs. 12,971,000. Profits improved to Rs. 537,000. Since the second dryer was not in operation until December 1996, the 1996/1997 numbers only included several months of operation of the second dryer. Although turnover had increased, profitability was still low. GVFL advised the company to increase the proportion of exotic products in order to improve the margins. By 1997, most of the production consisted of banana, onion, and okra, which was produced for two customers, one in US and one in Germany. These products represented the largest market volume in the VFD market and were the easiest products to market but they had low margins. By the end of 1997 Saraf had made a proposal to produce freeze dried curries according to traditional Indian recipes. After a pre-launch survey, four freeze dried curries were launched under the ‘Fairies’ brand name in early 1998. Since this was an innovative product for Indian consumers, the company decided to create awareness through point of sale demonstrations and by deputing personnel in cities. The company also sent samples of these curries to its existing customers abroad for market assessment. The products, however, could not reach projected volumes as the price point was considered too high for the Indian market. As a result, a much lower number of shops displayed the product than was anticipated. In early 1998, the German customer informed Saraf that it could not purchase white onions on a regular basis as they could not create a market for it. 1998 brought another breakdown in one of the dryers, which lasted for a month and resulted in a delayed export consignment. The company was also desperately in need of an in-house laboratory, as both major customers were facing problems with high microbial counts. The laboratory would involve an expenditure of Rs. 600,000. GVFL was once again asked to defer one installment by six months. Even though FY 1997/1998 had shown several problems, the company showed an improvement in the financial results. Turnover and profit increased to Rs. 21,205,000 and Rs. 1,928,000, respectively.

The onion crisis Although turnover had increased, profitability was still low. During 1998, considerable rises in prices of onions in India impacted Saraf’s main line of business. The onion crop was affected by heavy rains in the onion growing areas which led to crop failure. Onions constituted the largest portion of the company’s sales. The company had to supply against committed orders at the originally quoted price even though prices had increased significantly. Besides, the company was unable to take fresh orders and as a result sales dropped. Onion prices stabilized around December 1998 but a delay in customs clearances prevented the company from dispatching onions for export until March 1999. The delay was a result of a temporary export ban on onions, implemented to guarantee that the domestic demand for onions would be filled.

13

The Saraf Foods Investment (A)

As a result of the onion crisis, Saraf Foods started to experience liquidity problems starting in mid 1998. The company had difficulties servicing the GVFL and GIIC installments and once again had to request GVFL to reschedule payments. In December 1998, GVFL approved the rescheduling of four quarterly principle and interest installments on the Income Note and two quarterly royalty installments. These dues were rescheduled to be paid in ten quarterly payments starting April 1st 2000 and would carry an interest of 20%. GIIC decided in March 1999 to extend the repayment schedule of Saraf Foods by three quarters. The company encountered further liquidity problems when the US buyer did not purchase the three containers of banana they had indicated they would buy. Saraf Foods had already processed 1.5 containers, valued at 2.1 million Rs. By mid April the working capital limit of 5 million Rs. was fully used. Saraf requested GIIC to delay cashing a 425,000 Rs check made out to them. GIIC did cash the check, however, resulting in an overdraft. The German buyer had placed an order for one container of red onion (Rs. 1.4 million), scheduled for processing during April. The State Bank of India agreed to give an additional overdraft facility of 1 million Rs. needed to process this order. The overdraft would help sustain operations during April and May. However, if the US buyer failed to buy the processed banana, Saraf’s position would further deteriorate. GVFL officers prepared a detailed cash flow projection and a proposal for rescheduling of dues. The company would need about 2.5 million Rs. for the first half of FY 1999-2000, over and above the rescheduling of income notes. Projected sales for the first quarter of FY 1999-2000 were 3 million Rs., while break even sales were 5.5 million Rs. The resulting cash losses would be around 500,000 Rs. In addition, the company needed between 1.5 million and 2 million Rs. to pay overdue creditors and 425,000 for the GIIC installment. As of mid 1999, the US buyer had placed an order for banana and Okra, totaling 1.7 million Rs. The German buyer had placed an order for banana and white onion, totaling 800,000 Rs. The company had earlier stopped ordering white onions on account of high microbial count. Projected sales for the second quarter were still far below breakeven sales, however. Domestically, the marketing of the curries was still going slow. Several marketing firms, one of which was planning on selling this product in the US, had shown interest but had not given any feedback or placed orders yet. Saraf had also started discussions with the Indian army for the supply of VFD curries, however, there were no firm commitments as of august 1999. It was clear that the company would need additional funding in order to survive. Saraf could request GVFL for funding, but GVFL would demand that Saraf put in a similar about as they put in. Saraf estimated the amount needed from GVFL to be around Rs. 3 million. In addition, Saraf would have to request GIIC to defer an additional four installments on top of three installments that were already deferred. While contemplating the additional investment, GVFL started negotiations with GIIC and SBI to discuss the possibility of increasing the working capital limits. GVFL was concerned that the attitude of the financiers would not be sympathetic, as the company’s turnover for FY 1998/1999 had decreased to Rs. 19,352,000 with a profit of only Rs. 920,000. Exhibit 6 shows the cash disbursements and payments received from Saraf. Saraf had made interest payments to GVFL and paid off a portion of the income notes and the bridge loan. Even

14

The Saraf Foods Investment (A)

if the company would survive the current crises, it would take several more years before an exit could even be considered.

15

The Saraf Foods Investment (A)

Questions Group A: GVFL—Summarize the situation today from GVFL’s point of view. Discuss the options available to GVFL (put in the requested money, write-off the investment, find other sources of capital, etc). What should you do? Group B. Suresh Saraf and family members—Summarize the situation as you see it today. Discuss your options. What should you do? Group C. GIIC and SBI. Summarize the situation from your standpoint. What should you do? The following questions should be addressed by all groups: 1. What do you think of the way the investment was structured? Did GVFL function as a true VC firm or were they acting more like a bank? Could GVFL and Saraf have done things differently with regards to financing the venture? 2. What is there in the company that is of any value? How would you go about valuing the company? 3. Looking back, was this a potential VC investment to begin with? What were the strengths and weaknesses of the venture? 4. Does VC have an opportunity to succeed in this difficult environment?

16

The Saraf Foods Investment (A)

Exhibit 1. Gujarat Venture Capital Fund – 1990 (GVCF – 1990) Date of establishment Date of maturity

November 1990 November 2005

Authorized capital Pay-outs to investors

Rs. 240 million Rs. 96 million

Investment philosophy Preferred stage of investment Target return and period Monitoring Syndications preferred

Start-up / early stage 25%, 15 years Hands-on Yes

Instruments of finance

Instruments Equity shares Convertible pref. shares Convertible debt Income note loan Other (temp., bridge loan) Total

Stages of investment

Stages Seed stage Start-up Other early stage Later stage Turnaround financing Total

Rs. million 120,01 15.55 12.90 52.05 32.40 232.91 Number 2 13 2 7 1 25

Rs. million 37.81 115.61 12.85 53.79 12.85 232.91

Industry Number Biotechnology 1 Computer software, service 1 Consumer related 6 Food & food processing 2 Industrial products 1 Medical 2 Other electronics 2 Tel. & data communications 1 Other 9 Total 25 Source: Venture Activity Report – 1998. Indian Venture Capital Association.

Rs. million 5.00 12.85 38.25 21.65 3.75 25.88 13.45 9.13 102.95 232.91

Investment by industry

17

The Saraf Foods Investment (A)

Exhibit 2. Prices in US dollars per kilogram quoted to Saraf Foods in 1991 for VFD foods Prices assumed by GITCO1

Prices quoted by German importers

Prices assumed by SFPL2

Mango 19 18.9 Papaya 12 11.7 Sapota Guava 8 14.8 Capsicum 11 Coriander 12 Ginger 12 Source: Appraisal report 1 Technical consultancy agency 2 Saraf Foods Private Ltd.

19 11 12 8 11 10 12

Exhibit 3. Pro-forma forecasts for Saraf Foods at project inception Year

1

2

3

4

5

6

7

8

9

10

Production Capacity (metric ton / year) Utilization (%) Production (ton / year)

61 60% 36.6

61 70% 42.7

61 80% 48.8

61 90% 54.9

61 90% 54.9

61 90% 54.9

61 90% 54.9

61 90% 54.9

61 90% 54.9

61 90% 54.9

Costs Raw materials Power, fuel, water Wages and salaries Repairs and maintenance Manufacturing overhead Selling/General/Admin. Royalty to GVFL

1,170 840 850 429 362 571 438

1,365 980 935 433 412 650 511

1,560 1,120 1,029 437 462 732 584

1,755 1,260 1,132 441 512 816 657

1,755 1,260 1,245 441 512 849 657

1,755 1,260 1,370 441 512 886 657

1,755 1,260 1,507 441 512 926 657

1,755 1,260 1,658 441 512 970 657

1,755 1,260 1,824 441 512 1,019 657

1,755 1,260 2,006 441 507 1,073 657

Total cost of production

5,593

6,348

7,118

7,901

8,080

8,279

8,496

8,735

8,999

9,279

Total sales realization

9,284

10,832

12,380

13,928

13,928

13,928

13,928

13,928

13,928

13,928

Gross Margin

3,691

4,484

5,262

6,027

5,848

5,649

5,432

5,193

4,929

4,649

752 84 836 1,543

752 97 849 1,543

694 109 803 1,543

544 122 666 1,543

394 122 516 1,543

244 122 366 1,543

94 122 216 1,543

0 122 122 1,543

0 122 122 1,309

0 122 122 61

Profit before tax

1,312

2,092

2,916

3,818

3,789

3,740

3,673

3,528

3,498

4,466

Profit after tax

1,312

2,092

2,916

3,818

3,789

3,740

3,673

3,528

3,498

4,466

Interest on term loan Interest on working capital Total interest Depreciation

18

The Saraf Foods Investment (A)

Exhibit 4. Saraf Foods Balance Sheet (amounts in thousand rupees) Fiscal year ending 31-03-92

31-03-93

31-03-94

31-03-95

31-03-96

31-03-97

31-03-98

31-03-99

1,221 1,221

17,662 7 17,655

17,952 767 17,185

17,986 1,558 16,427

19,854 2,406 17,449

30,638 3,290 27,348

35,028 4,741 30,287

36,731 6,372 30,360

Current Assets, Loans and Advances Inventory Debtors Cash & Bank Balance 183 Loans & Advances 2,897

2 6 122 675

1,586 6 22 205

3,145 955 13 3,382

4,686 1,026 382 1,229

5,238 975 27 770

6,633 151 24 589

10,930 282 29 461

14 3,066

772 32

580 1,238

748 6,746

849 6,474

1,328 5,682

1,393 6,004

2,672 9,029

4,287

17,687

18,423

23,173

23,923

33,030

36,291

39,389

2,600

4,950 4,750

4,950 4,750

6,640 8,650 2,900 18,780 3,404 22,184

10,060 8,650 2,900 21,610 3,404 25,014

10,060 8,650 2,900 21,610 3,404 25,014

10,060 8,650 2,900 21,610 3,404 25,014

Fixed Assets Fixed Assets Less: Depreciation Net Fixed Assets

Less: Current Liabilities Net Current Assets Total Shareholders Funds Saraf GVFL Canbank Total share capital Reserve & Surplus Net Shareholders Funds

2,600

9,700

9,700

2,600

9,700

9,700

4,950 4,750 2,160 11,860 3,404 15,264

Loan Funds Secured Funds Unsecured Funds

1,683 16

7,995 16

12,098 292

13,897 1,307

8,770 245

17,758 642

15,341 626

18,967 5

(12)

(11) (13)

(10) (3,658)

(8) (7,286)

(135) (7,142)

(3,770) (6,614)

(5) (4,686)

(4) (4,594)

4,287

17,687

18,423

23,173

23,923

33,030

36,291

39,389

Miscellaneous Expenditure To the extent not written off Profit & Loss Account Total

19

The Saraf Foods Investment (A)

Exhibit 5. Saraf Foods Income Statement (amounts in thousand Rupees) Fiscal year ending 31-03-92

31-03-93

31-03-94

31-03-95

31-03-96

31-03-97

31-03-98

31-03-99

Sales Sales Other Income Increase (decrease) in stock

0 0

6 8 0

582 3 1,121

2,806 36 1,534

9,870 12 1,540

12,971 3 591

21,206 1 1,327

19,353 2 4,263

Total Sales

0

14

1,706

4,376

11,422

13,565

22,534

23,618

4 2 14

319 1,649 1,270

642 2,586 2,011

2,050 4,021 2,582

2,548 5,016 3,345

2,944 8,179 4,845

3

15

4,708 9,684 4,219 168 0

Expenses Raw Material Manufacturing Administrative Bank charges Loss on sale of assets Total Expenses

0

20

3,238

5,239

8,653

10,912

15,983

18,779

EBITDA

0

(6)

(1,532)

(863)

2,769

2,653

6,551

4,839

Interest expenses

0

1,353

1,974

1,777

1,237

3,108

3,112

Depreciations

7

760

791

847

888

1,515

1,633

(13)

(3,645)

(3,628)

145

528

1,928

94

(6)

(2,885)

(2,837)

992

1,416

3,443

1,727

EBT Cash Profit (loss)

0

20

The Saraf Foods Investment (A)

Exhibit 6. Cash disbursements and payments received from Saraf Foods by GVFL (amounts in Rupees) Fiscal Year Equity

Total 91-92

92-93

(2,500,000) May

93-94

94-95

95-96

96-97

97-98

98-99

(2,250,000)

(1,620,000)

(2,280,000)

Aug

Mar

Dec

41,855

628,956

1,682,193

710,726

131,247

4,165,524

375,000

1,125,000

2,000,000

500,000

4,000,000

1,379,040

93,493

1,720,824

1,500,000

1,500,000

3,000,000

(8,650,000)

Income Note Disbursement

(7,500,000)

Interest

(7,500,000) 435,185

535,362

Repayment Brigde Loan Disbursement

(3,000,000)

Interest (25%)

210,548

(3,000,000) 37,743

Repayment Soft Loan Disbursement Interest (10%) Repayment Fees and Upfront Charges

17,500

11,250

39,000

Interest on Funded Interest

67,750

135,960

486,867

27,332

650,159

5,849

12,393

56,663

74,905

304

58,893

470,275

691,509

1,114,503

1,028,768

(2,253,786)

(1,339,700)

2,611,531

5,176,190

3,825,229

1,660,015

Other Interest Repayment of NCDs Royalty Net Annual Cash Flow

(9,982,500)

(1,803,565)

21

3,364,252