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Rise and shine

India has to foster innovation to compete at the global level, and it will need partners for that, writes Promod Haque.

india Updated: Nov 23, 2006 02:21 IST

India was considered a second-class country with a slow rising domestic market when I was a child growing up in Delhi. Now, 40 years later, India has developed into a world-class technology hub and a major destination for investment capital from across the globe.

A tremendous amount of venture money is flowing into India, all leading us to believe that the country is headed for great success. However, there are still many obstacles to overcome so as to move up the value chain and successfully navigate the world economy, of which early stage foreign investment is a component.

What are India’s key advantages and challenges? How important is innovation and what does the country need to do to compete in the global world and eventually become a tech superpower? As venture capitalists actively making investments in India today, my firm and I ask ourselves these questions every time we evaluate a new investment opportunity.

India’s triple dose

There are three segments in particular in which India can truly excel, and we are currently making investments in these areas: consumer internet, second generation services and product companies.

There are tremendous opportunities in the local consumer markets (both internet and mobile) in India.  Business models for the internet have been well proven in the US, and we have also seen these models succeed in China. In fact, as penetration of broadband and wireless increases, the Indian market will mimic China.

While wireless penetration has increased in the last few years, broadband penetration has increased at a slower rate. We predict that wireless and broadband penetration will continue to increase more rapidly in the future. The Telecom Regulatory Authority of India (Trai) announced recently that 1.3 million Indians have broadband connections today. The opportunity for additional broadband penetration combined with a sizeable middle-class with tremendous spending power (approximately $ 420 billion) makes today’s investment landscape in India extremely attractive.

We are also beginning to see the maturity of the second generation services market. This sector is not solely focused on information technology companies. It also includes attractive investment opportunities in the areas of embedded systems, semiconductors, pharmaceuticals, medical devices and other knowledge-based outsourcing.

Although we are still in the early stages of seeing products germinate in India, this will rapidly accelerate in the coming years. When looking at investing in product companies today, the markets and early adopters of technology (when it comes to large enterprise customers) are based in the US. Therefore, the smart companies in India that want to aggressively target global markets choose to work with VC firms that can help expand their markets globally. As such, we have made more than 20 ‘hybrid’ or ‘cross-border’ investments in companies headquartered in the US but have extensive operations in India. By locating the headquarters of these ‘hybrid’ companies in the US, we can help them reach US customers (early adopters) more efficiently.

Give and tech

However, we envision a tremendous shift taking place in India during the next five years. Innovation of new technology is always done in collaboration with early adopters. As the country continues to open up, Indian enterprises will rely on technology as a key differentiator to compete globally. The rapidly increasing salaries in India will also force the country to rely more heavily on technology. The only way to offset rising wages is to use technology more aggressively to increase productivity gains. You will begin to see this happen in India, and it will force the country to become an early adopter of technology. Once India has early adopters, it will be a more competitive global player.

Investing in India seems obvious based on these numbers and promising opportunities. But investing in early-stage start-up companies here is not as easy as it sounds. Research on ‘Early-Stage Risk Capital in India’ by Rafiq Dossani, senior research scholar at Shorenstein Aparc (Asia-Pacific Research Centre), recently indicated that although the flow of venture capital in India has increased substantially since 2000, over 90 per cent of the money is invested in later-stage initiatives that are mostly replicating proven business models. Very few innovative start-up companies are actually being funded in India. This could negatively impact future innovation in the country.

Some of the causes identified for the shortage of early stage venture capital in India include the fact that the Indian business environment discourages sophisticated standards of corporate governance, university-industry collaboration and intellectual property (IP) protection and creation. There are also many bureaucratic, regulatory, legal and tax hurdles that make foreign investment difficult, as well as limitations on an investor’s ability to achieve liquidity. Costly creation of tax-efficient structures for overseas investors and security restrictions on investment under Sebi rules are just a few areas that are adding to the shortage of early stage venture capital in India.

Clarity begins at home

If India wants to compete at a global level, it first needs to concentrate on fostering innovation within its own borders. In addition to investing in India’s infrastructure, it must also have a mix of appropriate policies and regulations to increase the flow of early stage venture investing. To start, it needs to replicate open business practices (implemented in the US) in all sectors such as telecom, media and financial services. For example, there should be no restriction on the ownership held in Indian companies by foreign venture capitalists or foreign companies.

Until investors’ rights are enhanced, this will be a huge challenge for Indian start-ups and the growth of early stage venture capital investing in India. Progress is being made in this area, but it must continue.

Generation Next R&D

India should also play a more significant role in sponsoring and developing next-generation, strategic technologies that will create future growth — a model that has worked well in Israel and China. It is critical that the interests of industry, governments and universities are completely aligned. Instead of exploiting universities for only research capabilities, more emphasis should be placed on the development of next-generation technologies. Influence of institutions of higher education in cities like Chennai, Pune and Hyderabad must continue to encourage and sponsor entrepreneurship as Stanford University has done in the Silicon Valley. (Cisco Systems, Google, Hewlett Packard, Sun Microsystems and Yahoo all came out of Stanford).

Also, the demand for technical talent in India far outweighs the supply of available talent today. There simply aren’t enough engineers, and the growing demand for them continues to drive up wages in India. There needs to be a more focused effort on building additional schools and post- graduate institutions.

Making manufacture

Something else to consider is manufacturing. When it comes to hardware manufacturing, Taiwan and China have been regarded as the top destinations. However, customers are justifiably concerned about single source supply and are beginning to look for alternatives to China and Taiwan. India is well poised to be an alternate hardware manufacturing destination. Building a silicon foundry must be a preferred project of the government — sponsored, but not an equity participation project. This could be another huge growth opportunity for India.

Finally, India’s initial appeal has been lower labour costs and the availability of human capital. However, the long-term appeal rests on ‘knowledge arbitrage’ rather than pure ‘cost arbitrage’. The next layers of technology need to be knowledge intensive vs purely cost arbitrage. To move up the value chain, India must focus on offering high-value, high-impact differentiated services that require deep domain expertise and provide significant barriers to entry.

The bottom line is this: anyone can make an investment in today’s market, but how does one build a sustainable business from halfway across the globe for the long term that will truly benefit the entrepreneurs, investors, and the customers? The answer: through partnerships. In addition to providing financial capital, global venture capitalists should work closely with entrepreneurs to ensure they are building a culture that works for them and provide the right set of tools to set them up for success.

Promod Haque is Managing Partner, Norwest Venture Partners.