Informal risk capital in India

Abstract

Young firms, though vital to the growth of the economy, face significant challenges in obtaining external funding in the form of equity and debt. Because of the inherent agency and information asymmetry problems in raising equity and debt in young firms, financial intermediaries such as venture capital funds having an ability to intensively scrutinize their investments and monitor activities of the investee firm on an on-going basis, become an important source of risk capital. Among the institutional sources, only small venture funds would consider investing in risk capital in small size early stage firms. We prove that these too prove to be inadequate in terms of financing as the structure of small venture capital makes them economically un-viable. The scarcity of funding sources at the early stages of development of a start-up results in the creation of an equity gap. We establish the existence of an equity gap in the Indian context by analyzing the financing trends of the institutional risk capital providers, i.e. private equity and venture capital players. We also analyze how traditional sources of financing prove to be inadequate and unhealthy in certain respects in providing capital during early stages of development of start-up firms. We establish the demand for capital at early stages of development of start-ups by analyzing the growth trends in the micro and small scale enterprise sector. We also establish that there is a potential supply of informal risk capital providers in India in the form of high net-worth individuals and wealthy families. Lastly, we emphasize how an effective policy framework can be instrumental in making the two sides meet and result in the development of a vibrant informal market for risk capital in India.