UNIT- 3

VENTURE CAPITAL

Introduction (Financial Markets and Financial Services by Vasant Desai, Page no: 428-432)

Venture capital is a new financial service, the emergence of which went towards developing
strategies to help a new class of new entrepreneurs to translate their business ideas into realities.
As the name suggests it implies capital provided to start a new venture. The capital provided to
start a venture is known as venture capital. In particular, for a small entrepreneur with zeal and
dynamism but inadequate or lack of finance, venture capital or seed capital is a boom making it a
launching pad for financial growth.

Venture capital broadly implies an investment of long-term, equity finance in high risk projects
with high reward possibilities. It is equity finance based on the principle that a partnership can be
formed between the entrepreneur and the investors and thus represents an attempt to
institutionalize entrepreneurship particularly associated with innovations.

Definition

 Venture capital is “equity support to fund new concepts that involve a higher risk and at
the same time, have high growth and profit potential”.
 Venture capital investment is defined as an activity by which investors support
entrepreneurial talent with and business skills to exploit market opportunities and thus
obtain long-term capital gains.
 Start-up companies with a potential to grow need a certain amount of investment.
Wealthy investors like to invest their capital in such businesses with a long-term growth
perspective. This capital is known as venture capital and the investors are called venture
capitalists.
 Venture capital is an investment in the form of equity, quasi-equity and sometimes debt –
straight or conditional, made in new or untried concepts, promoted by a technically or
professionally qualified entrepreneur.

Features of Venture Capital investments

 It is High Risk
 It finances high-tech and innovative projects
 The gestation period is long.
 Lack of Liquidity
 It is an equity or quasi-equity form of investment
 It is a long term investment
 Returns are in the form of capital gains
 It is an active form of investment (High degree of management involvement)

A.L.I.E.T 1 FINANCIAL MARKETS AND SERVICES

Aims of venture capital/ Objectives of Venture Capital (Financial Markets and Financial
Services by Vasant Desai, Page no: 434-435)

 To adopt and modify the applications of implemented technology

 Setting up of pilot project
 For technological innovations and modernization
 For developing appropriate technology
 For meeting the cost of marketing surveys and market promotion programmes.
 Fuels ambitious and dreams
 Charts the course of incisive business ideas
 Helps in building enterprise vision

Advantages of Venture Capital

 Economic oriented
- Helps in the industrialization of the country
- Helps in the technological development of the country
- Generates employment
- Helps in developing entrepreneurial skills
 Investor oriented
- Benefit to the investor is that they are invited to invest only after the company start
earning profits, so the risk is less and the healthy growth of capital market is entrusted
- Profit to venture capital companies/ venture capital funds
 Entrepreneurial oriented
- Helps small and medium first generation entrepreneurs to translate their ideas into a
reality
- Promotes and fosters entrepreneurship in the country

Limitations of Venture Capital

 As the investors become part owners, the autonomy and control of the founder is lost
 It is a lengthy and complex process
 It is an uncertain form of financing
 Benefit from such financing can be realized in long run only

GROWTH OF VENTURE CAPITAL IN INDIA (Financial Markets and Financial Services

by Vasant Desai, Page no: 429-430)

The development of the organized venture capital industry in India, as is in existence today, was
slow and belabored, circumscribed by resource constraints resulting from the overall framework
of the socialistic economic paradigms. Although funding for new businesses was available from
banks and government-owned development financial institutions, it was provided as a collateral-
based money on project-financing basis, which made it difficult for the most new entrepreneurs,
especially those who were technology and services based, to raise money for their ideas and
businesses. Most entrepreneurs had to rely on their own financial resources, and those of their
families and well wishers or private financiers to realize their entrepreneurial dreams.

A.L.I.E.T 2 FINANCIAL MARKETS AND SERVICES

In 1972, a committee on Development of Small and Medium Enterprises highlighted the need to
foster venture capital as a source of funding new entrepreneurs and technology. This resulted in a
few incremental steps being taken over the next decade-and-a-half to facilitate venture capital
funds into needy technologically oriented small and medium Enterprises (SMEs), namely:

National financial institutions

 Industrial Finance Corporation of India Ltd (IFCI-1948) provides medium and long term
finance to industries. Risk Capital Foundation, sponsored by IFCI, was set-up in 1975 to
pro-mote and support new technologies and businesses.
 Industrial Credit and Investment Corporation of India Ltd (ICICI-1955) the primary
objective is to meet the foreign exchange requirements of industrial concerns and for
promoting medium and large industries in the private sector. Programme for
Advancement of Commercial Technology (PACT) Scheme was introduced by ICICI in
1985 in 1988; ICICI emerged as a venture capital provider with Unit Trust of India. As
now, there are a number of venture capital institutions in India. Financial banks like
ICICI have stepped in to this and have their own venture capital subsidiaries.
 Industrial Development Bank of India (IDBI-1964) coordinates the activities of other
financial institutions, supplements their resources to plan and promote the medium and
the large industries, the Seed Capital Scheme and the National Equity Scheme was set up
by IDBI in 1976. The idea of venture capital gained momentum in the budget of 1986-
87. A 5% cess was levied on all know-how imports to create the corpus of the venture
fund floated by IDBI in 1987. Later, a study was undertaken by the World Bank to
examine the possibility of developing venture capital in the private sector, based on
which the Government of India took a policy initiative and announced guidelines for
venture capital funds (VCFs) in India in 1988.
 Industrial Reconstruction Bank of India (IRBI-1985) functions both as a lending and a
reconstruction agency and provides finance in term loans, in the form of term loans
underwriting guarantees etc.
 Small Industries Development Bank of India (SIDBI-1990) for developing and financing
small scale industries.

Specialized institutions

 Risk Capital and Technology Finance Corporation Ltd (RCTC-1988) Provides risk
capital and technology finance for the project envisaging promotion, transfer and
adaption of new technologies.
 Technology Development and Information Company of India Ltd (TDICI-1988) the
TDICI was set up jointly with the ICICI and UTI to provide assistance in the form of
project loan etc, to small and medium industries conceived by technocrat entrepreneurs.
 Tourism Finance Corporation of India Ltd (TFCI-1989) Provides assistance in the form
of rupee loans, underwriting securities, equipment leasing for developing tourism
industry including holiday report, hotels, amusement parks and entertainment complex.

State level financial institutions

A.L.I.E.T 3 FINANCIAL MARKETS AND SERVICES

  State Finance Corporation (SFCs-1951) provides assistance to medium and small scale
industries in their respective states.
 State Industrial Development Corporations (SIDCs) provide assistance in the form of
term loans, underwriting securities and direct subscription. Some of them engage in
preparation of feasibility reports, conducting surveys, and in developing industrial
estates. The financial investment process has evolved a lot with time in India. Earlier
there were only commercial banks and some financial institution but now with venture
capital investment institution in India has grown a lot. Business forms now focus on
expansion because they can get financial support with venture capital. The scale and
quality of the business enterprises have increased in India now with international
competition, there have been a number of growth oriented business firms that have
invested in venture capital.

The venture capital finance in India can be categorized in to following three groups.

 Central government : The power and authority is vested in the hands of government of
India, some of the examples of venture capital finance promoted by the Central
Government controlled development finance institutions are as follows SIDBI Venture
Capital Limited (SVCL) IFCI Venture Capital Funds Limited (IVCF)
 State Government: The power and authority is vested in the hands of state government,
some of the examples of venture capital finance promoted by the State Government
controlled development finance institutions are as follows Gujarat Venture Finance
Limited (GVFL), Kerala Venture Capital Fund Private limited, Punjab Infotech Venture
Fund, Hyderabad Information Technology Venture Enterprises Limited (HITVEL).
 Private sector companies: The power and authority is vested in the hands of private
sector companies, some of the examples of venture capital finance promoted by the
private sector controlled are as follows IL&FS Trust Company Limited and Infinity
Venture India Fund.

The paradigm shift in venture capital

The Old The New

Seed and start-up  Conditional loan  Conditional loan

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 capital  Equity support from financial  Equity support from
institutions financial institutions
 Social development funds  Social development funds
 Informal sources  Informal sources
 Venture Leasing

Expansion  Term loans  Equity support from

financial institutions
 Private equity
 Convertible debentures
 Cumulative Preference
shares

Bridge Financing  Bank Loans

 Special Purpose Vehicles

FINANCING PATTERNS UNDER VENTURE CAPITAL/ FORMS OF VENTURE

CAPITAL (Financial Markets and Financial Services by Vasant Desai, Page no: 432-432)

Based on the four stages of development of a business, the venture capital financing may be
classified as seed finance, start-up finance, beginner’s finance and establishment finance. During
the first stage of starting a business, i.e., at the formulation of an idea stage, the risk associated is
very high. Here an idea needs to be translated into a business proposition. So the finance required
at this stage is the seed finance from the venture capital fund. The second stage being the
implementation phase, start-up finance from venture capital is required for the purpose of
implementing the appropriate production process. In the third stage, commercial production is to
be started and beginners finance is required to develop the marketing and other infrastructures. In
the fourth and the last stage, when the business is fully established, it requires finance for growth
and expansion so as to reap the economies of the scale

There are typically six stages of financing offered in Venture Capital that correspond to these
stages of a company’s development.

Venture capital- Stages of financing

 Seed Money stage: Small amount of financing needed to prove a concept or develop a
product. Marketing is not included in this stage.
 Start-up: Early stage firms that need funding for expenses associated with marketing and
product development
 First-Round Financing: Additional money to begin sales and manufacturing after a firm
has spent its start-up capital.
 Second-Round Financing: Funds earmarked for working capital for a firm that is selling
its product, but is still losing money.

A.L.I.E.T 5 FINANCIAL MARKETS AND SERVICES

  Third-Round Financing: Financing for a firm that is breaking even and is
contemplating an expansion project.
 Fourth-Round Financing: Also called bridge financing, Money provided for firms that
are likely to go public soon. Fourth round is intended to finance the “going public”
process.

METHODS OF VENTURE FINANCING

Venture capital is typically available in three forms in India, they are:

 Equity: All VCFs in India provide equity but generally their contribution does not
exceed 49 percent of the total equity capital. Thus, the effective control and majority
ownership of the firm remains with the entrepreneur. They buy shares of an enterprise
with an intention to ultimately sell them off to make capital gains.
 Conditional Loan: It is repayable in the form of a royalty after the venture is able to
generate sales. No interest is paid on such loans. In India, VCFs charge royalty ranging
between 2 to 15 percent; actual rate depends on other factors of the venture such as
gestation period, cost-flow patterns, riskiness and other factors of the enterprise.
 Income Note: It is a hybrid security which combines the features of both conventional
loan and conditional loan. The entrepreneur has to pay both interest and royalty on sales,
but at substantially low rates.
 Other Financing Methods: A few venture capitalists, particularly in the private sector,
have started introducing innovative financial securities like participating debentures,
introduced by TCFC is an example.

VENTURE CAPITALISTS INVESTING IN INDIA/ MAJOR PLAYERS (Financial Markets

and Financial Services by Vasant Desai, Page no: 436-436)

For a very long time, Silicon Valley venture capitalists only invested locally. However,
throughout the years, they expanded their investments worldwide. Most recently, Matrix
Partners, a leading American venture capitalist firm, had announced a $150 million India fund,
where they will provide internet, mobile, media, entertainment, leisure, and travel services to
customers in Mumbai. Sequoia Capital, a Silicon Valley-based VC firm, wanted to take
advantage of investing in start-up companies and had acquired West bridge Capital, an Indian
firm, for $350 million. It is no wonder that venture capitalist investments in India have risen
dramatically within the past few years. From 2005 to 2007, VC investments in India grew from
$320 million to about $777 million, respectively.

Some important Venture Capital Funds in India:

 APIDC Venture Capital Limited , 1102, Babukhan Estate, Hyderabad 500 001
 Canbank Venture Capital Fund Limited, IInd Floor, Kareem Towers, Bangalore
 Gujarat Venture Capital Fund 1997, Ashram Road, Ahmedabad 380 009

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  Industrial Venture Capital Limited, Thyagaraya Road, Chennai 600 017
 Auto Ancillary Fund Opp. Signals Enclave, New Delhi 110 010
 Gujarat Venture Capital Fund 1995 Ashram Road Ahmedabad 380 009
 Karnataka Information Technology Venture Capital Fund Cunningham Rd Bangalore
 India Auto Ancillary Fund Nariman Point, Mumbai 400 021
 Information Technology Fund, Nariman Point, Mumbai 400 021
 Tamilnadu Infotech Fund Nariman Point, Mumbai 400 021
 Orissa Venture Capital Fund Nariman Point Mumbai 400 021
 Uttar Pradesh Venture Capital Fund Nariman Point, Mumbai 400 021
 SICOM Venture Capital Fund Nariman Point Mumbai 400 021
 Punjab Infotech Venture Fund 18 Himalaya Marg, Chandigarh 160 017
 National venture fund for software and information technology industry Nariman.

VENTURE CAPITAL FUNDING PROCESS

Approaching a Venture Capital for funding as a Company. The venture capital funding process
typically involves four phases in the company’s development:

 Step 1: Idea generation and submission of the Business Plan: The initial step in
approaching a Venture Capital is to submit a business plan. The plan should include the
below points:

- There should be an executive summary of the business proposal

- Description of the opportunity and the market potential and size
- Review on the existing and expected competitive scenario
- Detailed financial projections
- Details of the management of the company

There is detailed analysis done of the submitted plan, by the Venture Capital to decide
whether to take up the project or no.

 Step 2: Introductory Meeting (Start-up): Once the preliminary study is done by the
VC and they find the project as per their preferences, there is a one-to-one meeting that is
called for discussing the project in detail. After the meeting the VC finally decides
whether or not to move forward to the due diligence stage of the process.

 Step 3: Due Diligence (Ramp up): The due diligence phase varies depending upon the
nature of the business proposal. This process involves solving of queries related to
customer references, product and business strategy evaluations, management interviews,
and other such exchanges of information during this time period.

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  Step 4: Term Sheets and Funding (Exit): If the due diligence phase is satisfactory, the
VC offers a term sheet, which is a non-binding document explaining the basic terms and
conditions of the investment agreement. The term sheet is generally negotiable and must
be agreed upon by all parties, after which on completion of legal documents and legal due
diligence, funds are made available.

CHALLENGES OF VENTURE CAPITAL INDUSTRY (Financial Markets and Financial

Services by Vasant Desai, Page no: 439-439)

The venture capital industry in India, started in mid eighties is still in a growing stage. Venture
capital funds particularly the domestic funds which have relatively small corpus, are engaged in
financing small and medium enterprises which form the hub of the industrial sector of the nation.
However, the venture capital industry has not been able to make noticeable impact as compared
to the countries in the West. Venture capital funds, particularly the domestic ones are suffering
on the following counts.

 Lack of regulatory framework: There is no regulatory framework for structuring the

funds. Most of the domestic VCFs have been set up under the Indian trust Act which was
enacted in 1982 and since then has never been changed. Offshore funds are set up
through the Mauritius route. While the domestic VCFs have to follow SEBI guidelines,
offshore funds are required to follow the RBI guideline. However, all over the world,
funs are settled under the Limited Partnership Act.
 Anomaly in Taxation: There is a great anomaly in tax treatment among VCFs and
offshore funds. While offshore funds which cater mainly to the existing large companies

A.L.I.E.T 8 FINANCIAL MARKETS AND SERVICES

 do not pay any tax, domestic VCFs which provide equity assistance to small and medium
enterprises pay maximum marginal tax. Even among the domestic funds, funds settled by
UTI are totally exempted from tax.
 Difficulty in Fund Raising: In absence of any incentive, it is extremely difficult for
domestic VCFs to raise money. Initially the funds were raised either from multilateral
agencies like the World Bank or all India Financial Institutions. In the U.S. and other
developed countries, pension funds and insurance companies invest in the VCFs. During
1997-199, the corpus mobilized by the VCFs with proven track records. This will go a
long way in giving a boost to domestic venture capital industry which would ultimately
help small and medium scale companies.
 Exit: All the early investments were made by the VCFs in small companies. As OTC
Exchange could not take off, these investments are largely liquid. This is one of the major
reasons for domestic VCFs not taking off. At present CBDT guidelines permit investment
of 80% of the funds only in the equity of unlisted companies. This makes it all the more
difficult for the VCFs to exit.

WHERE ARE VC’S INVESTING IN INDIA

 IT and IT-enabled services

 Software Products (Mainly Enterprise-focused)
 Wireless/Telecom/Semiconductor
 Banking
 PSU Disinvestments
 Media/Entertainment
 Bio Technology/Bio Informatics
 Pharmaceuticals
 Electronic Manufacturing
 Retail

LEGAL ASPECTS AND GUIDELINES OF VENTURE CAPITAL (Financial Markets and

Financial Services by Vasant Desai, Page no: 441-442)

Venture capital companies/funds which want to avail of concessional treatment of capital gains
referred to in the budget speech of 1988-89, would be required to comply with the following
guidelines.

 Establishment:
 Funds, companies or scheme wishing to undertake venture capital finance
activities may be established using the term ‘Venture Capital’ if they come
within, and agree t abide by, these guidelines.
 Approvals would be given for the establishment of the venture capital
companies/funds by the department of Economic Affairs, Ministry of Finance, or

A.L.I.E.T 9 FINANCIAL MARKETS AND SERVICES

 such authority as may be nominated by the government and applications for such
approvals and addressed to Joint Secretary (Investments) in Department of
Economic Affairs.
 Application for issue of capital by companies should be made as per SEBI
guidelines. Composite applications for approval to establish the fund and for the
issue of capital can also be made.
 All India public sector financial institutions, SBI and other scheduled banks,
including foreign banks operating in India, and the subsidiaries of the above
would be eligible to start venture capital funds/companies, subject to such
approval as may be required from the RBI in respect of banking companies.
 Management:
 It is required that the venture capital funds/ companies are managed by
professional such as bankers, managers and administrators and persons with
adequate experience of industry, finance, accounts, etc.
 No person would be permitted to be a full-time Chairman/ President, Chief
Executive, M.D. or Executive M.D. or Executive Director or a whole time
director of venture capital company/ venture capital fund if they holds any of the
above positions in any other company, except that he may hold such a position in
an assisted company by virtue of his position in the venture capital companies/
venture capital fund.

 Venture Capital Assistance: Venture capital should cover those enterprises which fulfill
the following parameters.
 Size: Total investment not to exceed Rs.10 crores.
 Technology: New or relatively untried or very closely held or being taken from
pilot to commercial stage, or which incorporates some significant improvement
over the existing ones in India.
 Promoters/ Entrepreneurs: Relatively new, professionally or technically
qualified, with inadequate resources or backing to finance the project. Investment
in enterprise engaged in trading, broking, investment or financial services, agency
or liaison work, shall not be permitted.
 The venture capital company invests at least 75 % of its funds into venture capital
activity.
 During the first 12 months, any permissible investments may be made (including
leasing up to 16 percent of the funds), but a level of 30 percent should be reached
for venture capital activity by the end of the second year, and 60 percent by the
end of the third year, and 75 percent by the end of the fifth year or operations
 The balance amounts may be invested in any new issue, by an existing or a new
company, or equity, CCP debentures, bonds or other securities approved for this
purpose by CCI
 Size: The minimum size of a venture capital company/ venture capital fund would be Rs.
10 crore. If it desires to raise funds from the public, the promoters’ share shall not be less
than 40 percent.

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  Capital issue:
 Funds may be raised through public issues and/ or private placements to finance
Venture Capital Company/ venture capital funds.
 Foreign equity up to 25 percent by multilateral/ international financial
organizations, development finance institutes, reputed mutual funds, etc., would
be permitted, provided these are management-neutral and re for medium to long-
term investments.
 NRI investment would be permitted up to 74 percent on a non-repatriable basis
and up to 25 percent/40 percent on repatriable basis.
 An application should be addressed to the Ministry of Finance, Investment
Division, with a copy to Chairman, Securities Exchange Board of India for
foreign/ NRI participation in capital issue.
 Debt-Equity Ratio: Debt-Equity ratio may be a maximum of 1: 1.5
 Underwriting/ Listing:
 The venture capital company/ venture capital fund may be listed according to the
prescribed norms. Its issue may be underwritten at the discretion of the promoters.
 For assisted units also, listing, guidelines would apply. Investments by a widely
held VCF would be treated as public participation for this purpose.
 Exit: Pricing of shares at the time of disinvestments by a public issue of general offer of
sale by the venture capital company/ venture capital fund, may be done by them, subject
to this being calculated on objective criteria like book value, profit-earning capacity, etc.,
and the basis is adequately disclosed to the public.
 Eligibility for Tax Concession: The preferential tax treatment would be available to the
approved venture capital company/ venture capital fund only in respect of financing of
such assisted units as are eligible to be treated as venture capitalists. For this purpose, the
unit seeking equity support from the Venture Capital Company/Venture Capital Fund
should obtain a letter of eligibility from IDBI, ICICI or any such agency that may be
nominated by the government.

FACTORING (Financial Services and System by Dr. S.Gurusamy, Page no: 158-158)

The word factor is derived from the Latin word ‘facere’, which means to make or do or to get
things done. Factoring originated in countries like USA, U.K, France, etc where specialized
financial institutions were established to assist firms in meeting their working capital
requirements by purchasing their receivables. A financial service, whereby an institution called
the ‘Factor’ undertakes the ask of realizing accounts receivables such as book debts, bills
receivables, and managing sundry debts and sales registers of commercial and trading firms in
the capacity of an agent, for a commission, is known as ‘ Factoring’. Factoring as a fund based
financial service, provides resources to finance receivables, besides facilitating the collection of
receivables.

Meaning

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  Factoring is a debt-collection service where the factor- usually a financial institution –
buys out a client’s (supplier’s) book debts (accounts receivables).
 Factoring basically means purchase of book-debts of clients. If working capital funds
could be recycled with greater velocity through better management of credit extended to
buyers and collection of their dues, industrial units can improve their profitability
considerably.
 A continuing arrangement under which a financing institution assumes the credit and
collection functions for its client, purchases receivables as they arise, maintains the sales
ledger, attends to other book-keeping duties relating to such accounts, and performs other
auxiliary functions.

Functions of Factoring (Financial Markets and Institutions by E,Gordon and K.Natarajan, Page no:
234-235)

As stated earlier, the term ‘factoring’ simply refers to the process of selling trade debts of a
company to a financial institution. But, in practice, it is more than that. Factoring involves the
following functions.

 Purchase and collection of debt: Factoring envisages the sale of trade debts to the factor
by the company, i.e., the client. It is where factoring differs from discounting. Under
discounting, the financier simply discounts the debts backed by account receivables of
the client.
 Sales ledger management: Sales ledger management function is an important one in
factoring. Once the factoring relationship is established, it becomes the factor’s
responsibility to take care of all the functions relating to the maintenance of sales ledger.
The factor has to credit the customer’s account whenever payment is received, send
monthly statements to the customers and to maintain liaison with the client and the
customer to resolve all possible disputes.
 Credit investigation and undertaking of credit risk: The factor has to monitor the
financial position of the customer carefully, since; he assumes the risk of default in
payment by customers due to their financial inability to pay.
 Provision of finance: After the finalization of the agreement and sale of goods by the
client, the factor provides 80% of the credit sales as prepayment to the client. Hence, the
client can go ahead with his business plans or production schedule without any
interruption.
 Rendering consultancy services: Apart from the above, the factor also provides
management services to the client. He informs the client about the additional business
opportunities available, the changing business and financial profile of the customers, the
likelihood of coming recession, etc.

TYPES OF FACTORING ARRANGEMENTS (Financial Markets and Institutions by E,Gordon

and K.Natarajan, Page no: 235-237)

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Domestic Factoring

Factoring can be both domestic and for exports. In domestic Factoring, the client sells goods and
services to the customer and delivers the invoices, order, etc., to the Factor and informs the
customer of the same. In return, the Factor makes a cash advance and forwards a statement to the
client. The Factor then sends a copy of all the statements of accounts, remittances, receipts, etc.,
to the customer. On receiving them the customer sends the payment to the Factor.

Different types of Domestic Factoring are as follows

 Full service Factoring or without recourse factoring: This is also known as "Without
Recourse Factoring ". It is the most comprehensive type of facility offering all types of
services namely finance sales ledger administration, collection, debt protection and
customer information.
 With Recourse Factoring: The Factoring provides all types of facilities except debt
protection. This type of service is offered in India. As discussed earlier, under Recourse
Factoring, the client's liability to Factor is not discharged until the customer pays in full.
 Maturity Factoring: It is also known as "Collection Factoring ". Under this
arrangement, except providing finance, all other basic characteristics of Factoring are
present. The payment is effected to the client at the end of collection period or the day of
collecting accounts whichever is earlier.
 Bulk Factoring: Bulk Factoring: Under bulk factoring, the factor first discloses the fact
of assignment of debt by the client to the debtor. This type of factoring is useful when he
is not fully satisfied with the condition of the client. This type of factoring is also known
as 'Notified Factoring' or 'Disclosed Factoring'
 Invoice Discounting: In this arrangement, the only facility provided by the Factor is
finance. In this method the client is a reputed company who would like to deal with its
customers directly, including collection, and keep this Factoring arrangement
confidential. The client collects payments from customer and hands it over to Factor. The
risk involved in invoice discounting is much higher than in any other methods. The
Factor has liberty to convert the facility by notifying all the clients to protect his interest.
This service is becoming quite popular in Europe and nearly one third of Factoring
business comprises this facility.
 Agency Factoring: Under this arrangement, the facilities of finance and protection
against bad debts are provided by the Factor whereas the sales ledger administration and
collection of debts are carried out by the client.
 Bank participation factoring: Under this arrangement, a bank participates in
factoring by providing an advance to the client against the reserves maintained by the
factor. For example, assume that a factor has advanced 80 percent of the value of
factored receivables and the commercial bank provides an advance limited to 50 percent
of the factor reserves. The client is required to fund only 10 percent of the investment in
receivables, the balance 90 percent being provided by the factor and the commercial
bank.

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International Factoring

International factoring is an ingenious and relatively simple concept. Factoring serves as export
insurance. Factors, usually working for a factoring company, guarantee the import price of goods
to the exporter. It is the exporter who hires the factor. The factor is totally responsible for the
cash flow from the importer to the exporter. In essence, credit is outsourced to the factor
company.
FACTORING MECHANISM (Financial Markets and Financial Services by Vasant Desai, Page no:
479-480)

A.L.I.E.T 14 FINANCIAL MARKETS AND SERVICES

Steps involved in the factoring are enumerated below

Step 1: The customer places an order with the seller (the Client)

Step 2: The factor and the seller enter into a factoring agreement about the various terms
of factoring.

Step 3: Sale contract is entered into with the buyer and the goods are delivered. The
invoice with the notice to pay the factor is along with.

Step 4: The copy of invoice covering the above sale is to the factor, who maintains the
sale ledger.

Step 5: The factor prepays 80% of the invoice value

Step 6 & 7: Monthly statements are sent by the factor to the buyer. If there are any unpaid
invoices, follow up action is initiated.

Step 8: The buyer settles the invoices on expiry of credit period allowed.

Step 9: The balance 20% less the cost of factoring is paid by the factor to the client.

COST OF FACTORING (Financial Markets and Institutions by E,Gordon and K.Natarajan, Page
no: 238-239)

The cost of factoring comprises of two aspects namely finance charges and service fees. Since
the factor provides 80 percent of the invoice as credit, he levies finance charges. This charge is
normally the same interest rates which are in vogue in the banking system. Factoring is a cheap
source because the interest is charged by only on the amount actually provided to the client as
repayment of his supplies. Apart from this financial charge, a service charge is also levied. This
service fees is charged in proportion to the gross value of the invoice factored based on sales
volume, number of invoices, work involved in collections, etc. generally, the factor charges a
service fee on the total turnover of the bills. It is around 1 percent. If the bills get paid earlier,
service charges could be reduced depending upon the volume of work involved.

Pricing of factoring services: While pricing factoring services, the following components
should be taken into account

 Factoring fees or administrative charges

 Discount charges
Factoring fees: This is charged mainly as administrative expenses for providing various services
to the clients namely.
 Sales ledger administration
 Credit control administration
 Bad debts administration

A.L.I.E.T 15 FINANCIAL MARKETS AND SERVICES

Discounting charges: For providing instant credit to the client by way of repayment, some
charges have to be levied and they are called discount charges. This charge is normally linked
with the base rate.

FACTORING IN THE INDIAN CONTEXT (Financial Markets and Institutions by E,Gordon and
K.Natarajan, Page no: 244-246)

Factoring service in India is of recent origin. It owes its genesis to the recommendations of the
Kalyanasundaram Study Group appointed by the RBI in 1989. Pursuant to the acceptance of
these recommendations, the RBI issued guidelines for factoring services in 1990. The first
factoring company-SBI Factors and Commercial Ltd (SBI FACS) started operation in April
1991.

The main recommendations of the Committee/Group are listed as follows

 Taking all the relevant facts into account, there is sufficient scope for introduction
factoring services in India which would be complementary to the services provided by
banks.
 The introduction of export factoring services would provide additional facility to
exporters.
 While quantification of the demand for factoring services has not been possible, it is
assessed that it would grow sufficiently so as to make factoring business a commercially
viable proposition within a period of two/three years.
 On the export front, there would be a fairly good availment of various services offered by
export factors.
 With a view to attaining a balanced dispersal of risks, factors should offer their services
to all industries and all sectors in the economy.
 The pricing of various services by factors would essentially depend upon the cost of
funds. Factors should attempt a mix from among the various sources of funds to keep the
cost of funds as low as possible, in any case not exceeding 13.5 percent per annum, so
that a reasonable spread is available.
 The RBI could consider allowing factoring organizations to raise funds from the Discount
and Finance House of India Ltd, as also from other approved financial institutions,
against their usance promissory notes covering receivables factored by them, on the liens
of revised procedure under bills discounting scheme.
 The price for financing services would be around 16 per cent per annum and the
aggregate price for all other services may not exceed 2.5 percent to 3 percent of the debts
services.
 In the beginning only select promoter institutions/groups of individuals with good track
record in financial services and competent management should be permitted to meter into
this new field.
 Initially the organizations may be promoted on a zonal basis.
 There are distinct advantages in the banks being associated with handling of factoring
business. The subsidiaries or associates of banks are ideally suited for undertaking this

A.L.I.E.T 16 FINANCIAL MARKETS AND SERVICES

 business; initially, it would be desirable to have only four or five organizations which
could be promoted either individually by the leading banks or jointly by a few major
banks having a large network of branches.
 Factoring activities could perhaps be taken up by the Small Industries Development
Bank of India, preferably in association with one or more commercial banks.
 The business community should first be educated through bank branches about the nature
and scope of these services and the benefits accruing there from.
 Factors cannot extend their services efficiently, effectively and economically without the
support of computers, as quick and dependable means of communication. Concurrent
with consideration of various aspects relating to commencement of factoring operations
the promoters should initiate measures for organizing network of computers /dedicated
lines the branches/agents in different parts of the country for accounting follow up
remittance and other activities involved in factoring business.
 The Central Government ad RBI should initiate appropriate measures immediately for
setting up specialized agencies for credit investigations; until such agencies become fully
operative, factors may have to rely on such information about clients/customers as could
be collected through banks or other sources.
 Since the suppliers would be able to obtain financial services from both banks and
factors, it is necessary to provide for proper linkage between banks and factoring
organizations.
 The factoring of Small Scale Industrial (SSI) units could to be mutually beneficial to both
factors and SSI units and the factors should make every effort to orient their strategy to
crystallize, the potential demand for this sector.

FORFAITING (Financial Markets and Institutions by E,Gordon and K.Natarajan, Page no: 253-256)
(Financial Markets and Financial Services by Vasant Desai, Page no: 485-490)

Forfaiting is another source of financing against receivables. Forfaiting is a financial tool to

exporters enabling them to convert their credit sales into cash sales by discounting their
receivables with an agency called a Forfaiter. It is not only a financing tool but also an important
risk management tool to exporters, because by selling the export receivables to the forfaitor, the
exporter is relieved of the inherent political and commercial risks involved in international trade

The term ‘forfaiting’ is derived from the French word ‘forfait’ which means surrender of rights.
In the export financing context, forfeiting is an arrangement by which the exporter surrenders
export receivables to the forfaiting agency and receives the full value of the export before
realization.

Definition
 Forfaiting is a method of trade finance that allows exporters to obtain cash by selling
their medium and long-term foreign accounts receivable at a discount on a “without
recourse” basis. ... “Without recourse” or “non-recourse” means that the forfaiter assumes
and accepts the risk of non-payment.

A.L.I.E.T 17 FINANCIAL MARKETS AND SERVICES

  Forfeiting has been defined as ‘the non-recourse purchases by a bank or any other
financial institution, of receivables arising from an export of goods and services.
 Simply put, forfeiting is the non-recourse discounting of export receivables.

Benefits of forfeiting
 Profitable and liquid:
 Simple and flexible:
 Avoids export credit risk:
 Avoids export credit insurance:
 Confidential and speedy:
 Suitable to all kinds of export deal:
 Cent percent finance:
 Fixed rate finance:

Drawbacks
 Non-availability for short and long periods:
 Non availability for financially weak countries:
 Dominance of western currencies:
 Difficulty in procuring international bank’s guarantee:

Difference between Factoring and Forfaiting

Basis for
Factoring Forfaiting
comparison

Meaning Factoring is an arrangement that converts Forfaiting implies a transaction in

your receivables into ready cash and you which the forfaiter purchases
don't need to wait for the payment of claims from the exporter in return
receivables at a future date. for cash payment.

Maturity of Involves account receivables of short Involves account receivables of

receivables maturities. medium to long term maturities.

Goods Trade receivables on ordinary goods. Trade receivables on capital

goods.

Finance up to 80-90% 100%

Type Recourse or Non-recourse Non-recourse

Cost Cost of factoring borne by the seller Cost of forfaiting borne by the
(client). overseas buyer.

Negotiable Does not deals in negotiable instrument. Involves dealing in negotiable

Instrument instrument.

A.L.I.E.T 18 FINANCIAL MARKETS AND SERVICES

 Basis for
Factoring Forfaiting
comparison

Secondary No Yes
market

BILL DISCOUNTING/ INVOICE DISCOUNTING (Financial Services and System by Dr.S

Gurusamy, Page no: 107-114)

The terms ‘invoice discounting’ or ‘bills discounting’ or ‘purchase of bills’ are all same. Invoice
discounting is a source of working capital finance for the seller of goods on credit. Bill
discounting is an arrangement whereby the seller recovers an amount of sales bill from the
financial intermediaries before it is due. Such intermediaries charge a fee for the service. From
the other side, it is a business vertical for all types of financial intermediaries such as banks,
financial institutions, NBFCs, etc.

Meaning

 Invoice discounting can be technically defined as the selling of bill to invoice discounting
company before the due date of payment at a value which is less than the invoice amount.
The difference between the bill amount and the amount paid is the fee of the invoice
discounting to the company. The fee will depend on the period left before payment date,
amount and the perceived risk.
 The bills or invoices under bill discounting are legally the ‘bill of exchange’. A bill of
exchange is a negotiable instrument which is negotiable mere by endorsing the name. For
example our currency is an example of bill of exchange. Currency provides value written
over it to the bearer of the instrument. In the case of bill discounting, such bills can be
either payable to the bearer or payable to order. Therefore, after discounting a bill, a bank
can further get the bill discounted from other banks in case of cash flow requirement.

Features of bill discounting

 Maturity: Normally maturity periods are 30, 60, 90 or 120 days. However, bills
maturing within 90 days are the most popular.
 Discount charges: Calculated on the maturity value at rate a certain percentage per
annum.
 Ready finance: Bank discount and purchase the bills of their customers so that the
customers get immediate finance from the bank.

Advantages

 Easy access:

A.L.I.E.T 19 FINANCIAL MARKETS AND SERVICES

  Safety of funds:
 Certainty of payment:
 Profitability:
 Smooth liquidity:
 Higher yield:
 Ideal investment:
 Facility of refinancing:
 Relative stability of prices:

Bill Discounting Procedure

The process of bill discounting is simple and logical.

 The seller sells the goods on credit and raises invoice on the buyer.
 The buyer accepts the invoice. By accepting, the buyer acknowledges paying on the due
date.
 Seller approaches the financing company to discount it.
 The financing company assures itself of the legitimacy of the bill and creditworthiness of
the buyer.
 The financing company avails the fund to the seller after deducting appropriate margin,
discount and fee as per the norms.
 The seller gets the funds and uses it for further business.
 On the due date of payment, the financial intermediary or the seller collects the money
from the buyer. ‘Who will collect the money’ depends on the agreement between the
seller and financing company.

In invoice discounting, the process is confidential and customers are usually unaware the
business is using a financial provider. In invoice factoring, the customer pays the factor-
company directly. In invoice discounting, the customer pays the company as normal.

A.L.I.E.T 20 FINANCIAL MARKETS AND SERVICES