Bombay’s Butterfly Effect

Venture investment in India skyrocketed in 2006, leading some sanguine pundits to opine that U.S. firms had finally woken up to the subcontinents economic potential.

But the $1.7 billion invested by VCs into 125 Indian companies during 2006–up from $1.1 billion invested into 70 companies during 2005–has less to do with the regions innate opportunity, and more to do with regulations governing the exit environment (numbers from Thomson Financial, publisher of PEHub.com).

India was in 2006 much the same as it was in 2005 or even in 2004: a great place to find technical expertise at low prices and a great market to sell certain products and services into.

The big change over the last two years has been in the performance of the regions stock exchanges.

The Bombay Stock Exchange Sensex, that markets version of the Dow Jones Industrial Average, closed at 14,014.92, its highest level ever thanks to optimistic third-quarter earnings expectations and the expectation of higher levels of foreign investment. The Sensex is now at double its 2000 peak. The index shot up more than 46% in 2006. Compare that to the DJIA, which went up a mere 16% in 2006.

The strength of the Bombay Exchange is causing more companies to consider listing there. Its relatively easy for an Indian company to go public on the exchange. The minimum market capitalization is a little over $1.1 million with revenue of more than $600,000 in the past year and more than 1,000 investors after the offering.

But foreign companies have a much tougher time. The BSE requires foreign companies to average $500 million in revenue for the three years prior to offering, five years of profitability and that 10% of profits be paid out in dividends each year, according to Fenwick & West. Id pick Sarbanes-Oxley over that any day!

VCs and entrepreneurs are responding to this by both locating their startups in India. Theyre effectively deep-sixing the old head-and-shoulders model of company formation, where a startups management and headquarters are in the United States and its operations are abroad. The idea behind this model is that the majority of the startups sales will be to U.S. companies. It was also touted as a way of helping ensure the startup would remain attractive to U.S. acquirers.

A year ago I spoke to Jai Rawat, an early employee at security startup AirTight Networks about trying to get funding. “VCs wanted a valley-based CEO,” he said. When the company, which had developed its technology in Pune, tapped David King, the former CEO of Proxim and a Valley native, the companys Series A was immediately oversubscribed Rawat said.

But that type of thinking is changing thanks to the success of the BSE and its regulations around foreign companies. We shouldnt be surprised when companies that would once have been based in the U.S. and operated out of India now keep their headquarters there as well. No doubt VCs are waking up to the potential of India as a place to invest, but the chance to exit on a booming exchange may be the main driver of increased investment there.