Rise of India presents challenges and opportunities

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 around the globe.

A tremendous amount of venture money is flowing into India and every day we read headlines about the “rise of India,” leading us to believe that India is headed for great success. However, there are still many obstacles the country must overcome 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 in India 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 both the U.S. and in India today, my firm and I ask ourselves these questions every time we evaluate a new investment opportunity. Although there are challenges associated with investing in India, we continue to put money into a variety of new sectors, and we are extremely optimistic about what we’ve seen to date.

There are three segments in which we believe 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 U.S., and we have also seen these models succeed in China. As penetration of broadband and wireless increases, we think the Indian market will mimic China.

More bandwidth

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 fact, the Telecom Regulatory Authority of India announced recently that 1.3 million Indians today have broadband connections.

The opportunity for additional broadband penetration combined with a sizeable middle class with tremendous spending power (India’s booming middle class has approximately $420 billion to spend) makes today’s investment landscape in India extremely attractive. We’ve seen this through our investments last year in such companies as Yatra.com, the first online and centralized travel services company for the India market, and Sulekha.com, the first and largest online social media and local commerce destination for Indians to interact and transact with their peers and businesses.

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

Promod Haque, Managing Partner, Norwest Venture Partners

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, we believe this will rapidly accelerate in the coming years.

Think hybrid

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 U.S. Therefore, we’ve found that 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’ve made more than 20 “hybrid” or “cross border” investments in companies that are headquartered in the U.S. but have extensive operations in India. By locating the headquarters of these hybrid companies in the U.S., we can help them reach U.S. customers (early adopters) more efficiently.

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 to increase productivity.

Investing in India seems obvious based on these numbers and promising opportunities, but investing in early stage startup companies in India is not as easy as it sounds. Research on “Early Stage Risk Capital in India” by Rafiq Dossani, senior research scholar at Shorenstein APARC, recently indicated that although the flow of venture capital in India has increased substantially since 2000, over 90% of the money is invested in later stage initiatives that are mostly replicating proven business models. Very few innovative startup companies are actually being funded in India, and 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 IP protection and creation. There are also many bureaucratic, regulatory, legal and tax hurdles that make foreign investment difficult, and limit 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.

If India wants to compete at a global level, it first needs to concentrate on fostering innovation within its own country. In addition to investing in infrastructure, such as roads and railways, India must also have a mix of appropriate policies and regulations to increase the flow of early stage venture investing.

Open standards

Very few innovative startup companies are actually being funded in India, and this could negatively impact future innovation in the country.”

Promod Haque, Managing Partner, Norwest Venture Partners

For India to attract venture capital for early stage, groundbreaking ideas, it needs to replicate open business practices (that are implemented in the U.S.) in all sectors, such as telecommunications, 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, I see this being a huge challenge for Indian startups and the growth of early stage venture capital investing in India.

India should also play a more significant role in sponsoring and developing next-generation, strategic technologies that will create future growth for the country. Instead of exploiting universities for only research capabilities, more emphasis should be placed on the development of next-generation technologies. India’s education system is one of the finest in the world, and there is no doubt that India can and will in due time produce successful technology companies. However, influence of nearby 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.

Also, 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.

We believe India is well positioned to be an alternative hardware manufacturing destination: High level committees are already being established to achieve this goal. Building a silicon foundry must be a preferred project of the government—sponsored, but not an equity participation project. Customers are justifiably concerned about single source supply and are beginning to look for alternatives to China and Taiwan.

Know-how

Finally, India’s initial appeal has been lower labor costs and the availability of human capital. However, the long-term appeal rests on “knowledge arbitrage” rather than pure “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. We have invested in two such Indian companies: Persistent Systems, an outsourced software product development, and Adventity, a provider of knowledge process outsourcing solutions to the financial services industry.

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 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 tools for success. Smart entrepreneurs in India today who want to aggressively target global markets choose to work with VC firms that have operational experience, can open doors for them to customers and partners, and expand their markets globally.

If India wants to eventually become a tech superpower, it needs to concentrate on fostering innovation within its own country. This can be achieved by opening business practices, collaborating with universities, building more graduate institutions, enhancing investors’ rights and continuing to shift its focus on high-impact differentiated services. This would help increase the flow of early stage investing in India and make it more competitive at a global level.

This is an edited version of a column that Promod Haque wrote for the Hindustan Times. Haque is managing partner of Norwest Venture Partners. He may be reached at promod.haque@nvp.com.