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The Saraf Foods Investment (A)

Cornell University
Johnson Graduate School of Management
NBA 593 International Entrepreneurship

Auke Cnosssen, MBA ‘04 prepared this case study under the guidance of and with Professor Melvin
Goldman as the basis for class discussion rather than to illustrate either effective or ineffective handling
of a business situation.1

The Saraf Foods Investment (A)

In August 1999, Vishnu Varshney, head of Gujarat Venture Finance Ltd. (GVFL), a venture
capital firm in the state of Gujarat, India, was assessing the investment of GVFL in Saraf Foods
Ltd. Saraf Foods was a producer of freeze dried vegetables for export. The latest monitoring
report showed the financial projections for Saraf Foods for FY 1999-2000. 1998 had been a
particularly bad year as a huge increase in the price of raw materials and restrictions on exports
had increased costs and limited the ability to deliver products to customers. Sales volume for
1999 would be significantly below the break even volume. As a result, Saraf was now facing
serious liquidity problems and needed additional funding.

It had been seven years since GVFL had first put money into the venture and Varshney now had
to decide whether to write off the Saraf Foods investment or to keep backing the entrepreneur
and his company. Writing off the investment would mean that the return on the investment
would be very low, if the assets could be sold. On the other hand, Saraf had turned out to be an
honest and hard working businessman that had built up a strong relationship with his buyers.
Continuing would mean a heavy time allocation by the staff of GVFL and Varshney in particular.
And how would he exit?

Entrepreneurship and Venture Capital in India


The Indian Government as well as state level administrations had provided various incentives
and financing schemes to promote and finance small and medium enterprises (SMEs). SMEs
proliferated in India, but Gujarat with its tradition of business and entrepreneurship produced
many companies and two relatively successful state level financing organizations. However,
these financing organizations were conservative and rarely financed companies with new or
untried technologies and /or markets.

1
The authors acknowledge the enormous support provided by GVFL and the company and particularly Messrs
Varshney and Saraf. Both opened their files and gave enormous time.

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The Saraf Foods Investment (A)

Venture Capital (VC) was just being experimented with by a development financial organization
(DFI) when the World Bank was developing a scheme to promote technology development in the
private sector. It identified VC as having enormous potential in India and identified organizations
to spearhead the effort including the Gujarat Industrial Investment Corporation. The Government
of India announced guidelines for VC funds in India in 1988.

With the help of the World Bank the VC industry did eventually gain momentum in the late
1980s and early 90s. The program involved setting up VC firms and recruiting and educating
people with proper backgrounds. Internship programs for 18 ‘would-be’ venture capitalists were
set up with US firms in order to introduce the required knowledge and develop the man power.
In total nine funds were set up with total capital of $180 million for 350 investments.

India generally is considered entrepreneurial. However, industry was very much dominated by
the public sector and several family-led large industrial conglomerates like Tata and Mahindra.
Entrepreneurs tended to start as traders and build their businesses up based on retained earnings.
They needed to learn to deal with inadequate financing and infrastructure and a difficult
regulatory environment. For new entrepreneurs, it was particularly difficult to obtain bank
finance and there was no services industry to support new entrepreneurs with few resources. The
problem was far worse for those starting a business based on new technology and new markets.

Gujarat Venture Finance Ltd.


GVFL, started in July 1990, was one of the first VC funds set up under the World Bank initiative.
Mr. Vishnu Varshney, who had a background in equity investment, project planning and
implementation, and turn-around was selected by the parent company Gujarat Industrial
Investment Corporation (GIIC) to run GVFL. Mr. Varshney, a senior project manager with GIIC
helped set up GVFL. He was joined and assisted early on by a very competent deputy, J M
Trivedi another GIIC project manager. After a year of putting together GFVL and initiating the
work, Varshney was the first venture capitalist in India to be selected to undergo the World Bank
sponsored eighteen-week internship in the US. He worked at Hambro International Equity
Partners in Boston in the US and attended a training program in 1991 organized by the National
Venture Capital association in the US. Later on, he was one of the founding members of the
Indian Venture Capital Association (IVCA) and served as Secretary and Chairman of the
Association. Trivedi also was an early intern in a New York early stage VC partnership—
Lawrence, Smith and Horey.

Key investors in GVFL’s funds were GIIC, the Industrial Development Bank of India, the
Commonwealth Development Corporation, the Small Industries Development Bank of India, and
a few private and public sector Gujarati companies, many of whom had close relationships to
GIIC. Even in the late 1990s, when many VC firms shifted towards later stage investments and
private equity, GVFL remained loyal to its initial goal of stimulating entrepreneurship by
investing in seed stage innovative start-ups. GVFL adopted a ‘hands on’ approach believing it

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The Saraf Foods Investment (A)

should work hand-in-hand with the entrepreneur. GVFL was pioneering in a number of ways. It
convinced the parents and lead investors to invest all over India as well as across industries.

The first fund (Gujarat Venture Capital Fund – 1990) was targeted at start-up companies based
on new and untried or closely held technologies, innovative products or processes and services.
Since there was no experience in India to build on, GVFL took extra time to invest the funds.
The broad based fund was invested in over 25 companies. The total fund size was 240 million Rs.
and the fund had an intended life span of 15 years. Exhibit 1 shows the details of the fund. As of
1999, the fund was fully invested and pay-outs to investors had started.

Following the success of GVCF-1990, in terms of identifying promising VC investment


opportunities, GVCF-1995 was launched. Investors included many of the investors of the earlier
fund. The second fund was invested nationwide and shifted in focus towards funding new as well
as small to medium sized companies with a sustainable competitive edge. Total fund size was
600 million Rs. and the life span was 12 years. By the end of 1998, 240 million Rs. had been
invested in 15 companies.

The third fund (GVCF – 1997) was started in 1997 with an emphasis on the IT industry. The
fund had a size of 400 million Rs. and a life span of 12 years. The fund focused on Software and
Information Technology- an area where India has established strong core competencies on a
global level. Four investments totaling 71 million Rs. had been made by the end of 1998.

The Indian banking system


The mainly government owned banking system in India had been dominated by two kinds of
institutions; the commercial banks and the DFIs. DFIs traditionally provided project finance
while commercial banks lent money to companies primarily to finance working capital.

Project finance by DFIs was related to industrial development or expansion projects. The DFI
would provide either term finance or equity financing. In the case of term financing, the DFI
would get a board seat in the company. Equity financing would involve a much more active role
in the company. Although the board seat would allow the DFI to stay informed on the company,
it would generally not be very involved in the decision making within the company. In case of
default, a DFI would normally restructure the loan and convert the defaulted interest into a term
loan.

Term finance loans would typically be six to eight years and would have a maximum grace
period of two years. There were three key national DFIs that concentrated on the large industrial
companies and projects. Other national DFIs were built for lending to agriculture and to
infrastructure. DFIs for SMEs were left to the States to develop. GIIC was among the most
successful regional DFIs to provide project lending and investment for SMEs.

The GIIC guidelines prescribed that the maximum project cost would have to be less than Rs 50
million (in 1990 that was approximately $3.3 million, while in 1999 it was about $1.25 million)

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The Saraf Foods Investment (A)

and 30 to 35% of equity would have to be brought in by the promoter of the project. Interest rates
in 1991 were on the order of 21%. (inflation was in the double digits). DFIs were focused on
industrial projects with significant collateral in the form of assets. Service companies, and
software companies in particular, had a hard time securing loans for starting or expanding a
business.

Since the late 1990s there has been a trend in India of mergers between DFIs and banks. This
trend was accompanied by these institutions going public and has led to innovation and to one
stop financing of enterprises.

Another characteristic of the lending industry in India was that loans were based on a pari pasu
agreement, meaning that there was no seniority of debt. All parties involved in investing in a
company had the same rights on the assets of the company. In case of financial problems, all
parties thus had to agree with each other on the action to be taken.

Given the nature of the financial system in India, entrepreneurs faced many difficulties financing
new ventures. High tech, service oriented, and high growth companies had very different
characteristics than the traditional industrial clients of the DFIs. If financing could not be secured
through DFIs or banks, the only remaining source would be family, friends and some rare seed
funds for “first generation entrepreneurs.”

Venture capital challenges


As expected, VC initially was not well understood by entrepreneurs, investors, and government
agencies and needed nurturing. Businesses were traditionally closely held family operations and
the concept of selling out a company to a strategic investor or rival was foreign. The concept of a
financing organization becoming a partner and having veto power over certain decisions would
take time to be grasped. Merger and acquisition activity started only slowly in the mid 1990s.
Buying and selling companies was not common and the concept of writing off an investment
took many years to get accepted and be understood. Bankruptcy remains a long and involved
process needing reform.

Stock markets in India dated from the late nineteenth century, but trading was relatively thin with
only the larger companies being freely traded. While IPOs were not uncommon, prices of shares
at the IPO stage were highly regulated and not market determined until the early-mid nineties.
Periodic scandals rock the market. When serious, they can chase away many investors
depressing stock prices and activity for many years.

To overcome these constraints and gain the trust of entrepreneurs, VC in India needed
experienced ex-entrepreneurs and businessmen who could nurture companies. VC in India,
however, was dominated by people with DFI experience and by inexperienced young MBAs.
Few (former) entrepreneurs were found in VC firms. While those who worked at a DFI have
good company and industrial experience and a mindset that is frequently helpful to borrowers, it
is insufficient. An MBA is also quite useful, but senior entrepreneurs and businessmen find it
difficult to accept a “youngster” as their equal partner.

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The Saraf Foods Investment (A)

In India, the typical J-curve for a start-up company was much longer term as growth tended to be
slower. The up-side for a VC was thus also more limited, requiring Indian VC investments to be
structured differently compared to US VC investments. Amounts invested in start-ups were
much smaller and investments were made in phases, because of the higher risks, lower burn-rates,
and longer time-frames to reach maturity. VCs needed to look for other ways of putting in
money and generating a return, besides equity investments. Examples were convertible stock,
debentures, and royalty payments. Royalties allowed the VC to get a significant up side, while
limiting the costs to the entrepreneur during economic downturns.

In the latter 1990’s, foreign VC groups, particularly angel investors and successful entrepreneurs
in the US and UK, began to take a serious interest in India. Most, however, quickly moved to
private equity where risks were fewer compared to seed stage VC. Most of the domestic VC
firms also changed from seed stage investing to private equity. Although a significant number of
seed stage investments had been made, few successful exits had been realized. The shift towards
private equity did help develop this industry and would in the long run provide more exit
opportunities for VC. However, seed stage investing still had a long way to go as of the late
1990s before being able to attract significant capital from investors.

90% of VC firms were institutional VC firms that were funded by one of the DFIs. Many VC
management companies were structured with a CEO with subordinates. The institutional
framework hindered the VCs; they were less agile for a dynamic VC industry. People with an
institutional background were used to doing larger deals than the typical VC deal. Because the
concept of partnership was not fully developed, the incentives for VCs were also not well
developed.

Cultural issues also complicated VC investments. Indian entrepreneurs were very individualistic,
preventing them from being able to let go of their company, hindering an exit in the form of an
acquisition or merger. The Indian entrepreneur, typically with an engineering and finance or
MBA degree, wanted to control all fields within a company himself. This caused problems when
companies grew and were in need of people with more specialized knowledge in for example
finance or marketing. The individualistic mindset was overcome by clauses in the term sheet that
required the entrepreneur to hire appropriate expertise when requested by the VC.

Entrepreneurs frequently came from wealthy and successful business families, the middle class,
or were managers from large corporations. Entrepreneurs typically had a high equity stake in
their companies as they had difficulties giving up part of their company. In addition, VCs wanted
to see a substantial commitment by the entrepreneur. Mr. Varshney commented on how a VC
would ensure control over an investment in which it had a minority stake:

The large equity stake held by the entrepreneur gives him less incentive to run off with
the money invested by the VC and gives him an incentive to work harder. We make sure
that we have enough control by making the entrepreneur realize that a VC investment is a
partnership and that we are on the same side of the table. A strong relationship with trust
is very important. The entrepreneur has to see the benefit of the relationship with the VC.

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The Saraf Foods Investment (A)

VCs generally had one or two board seats. However, few decisions were taken by the board.
Board meetings were a formality to inform people. Important decisions were made between the
entrepreneur and the head of the VC firm. Industries that were attractive for VC, like
telecommunications and IT were not well developed, and VCs thus had difficulties creating a
good management team and finding experienced board members. Obviously, this gradually
changed by the late nineties as IT and telecommunications grew rapidly.

Even though the upside of a VC investment in India was limited by slower growth rates and
difficulties getting ventures off the ground, many people felt that VC could work in India as the
number of companies that reached maturity tended to be higher compared to the Western World.
Indian companies were better able to survive a setback or economic down turn because:
- Indian entrepreneurs tended to be conservative about spending money;
- Burn rates in India were much lower and it was easier to reduce costs during a set back;
- Indian entrepreneurs often came from business families and managed to raise funds
within their own network/family when needed when they were in financial distress.
As a result, the India VC industry saw fewer companies that gave a return of 100x or 200% IRR,
but did show more companies returning a 30 to 40 % IRR compared to their Western
counterparts.

Saraf Foods Ltd.


Saraf Foods Pvt. Ltd. (Saraf Foods) was started by Mr. Suresh Saraf. After completion of his
studies in mechanical engineering and business administration, Saraf joined the family business,
which owned roller flour milling plants and warehouses. Not content with running an established
business, he decided to start his own business and began with trading in steel in 1986. Based in
Delhi, he was on the look out for a suitable project.

During this time, he came in contact with the Agricultural and Processed Food Products Export
Development Authority (APEDA). APEDA introduced him to the vast potential of the export of
fruits and vegetables. Specifically, APEDA believed that there was an opportunity to export
vacuum freeze dried foods. Vacuum freeze drying (VFD) was a relatively new technology in the
food industry and vacuum freeze dried products were high margin products in the Western
World. During 1988 and 1989, Saraf worked on this idea and developed insights in VFD and the
application of this technology to various fruits and vegetables. Saraf made enquiries with various
foreign suppliers of VFD machineries in Denmark, West Germany and the U.K.

During his research on the VFD equipment manufacturers he came across an Indian company,
IBP Company Ltd, which manufactured VFD plants for pharmaceutical applications. After
discussing the potential for using the machinery of IBP for drying of vegetables, trials were run
on the equipment for pharmaceuticals. Results were encouraging and samples were prepared and
sent to potential customers in the US, the U.K. and West Germany to assess the interest of
consumers in such products. The response was encouraging, which led to additional sample
production of various fruits and vegetables. In the mean time, IBP developed a VFD pilot plant
for fruits and vegetables to enable its clients to take trials and establish process parameters.

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The Saraf Foods Investment (A)

VFD technology for vegetables


India, gifted with a large variety of exotic fruits and vegetables, had a vast potential for exporting
these agricultural products to other countries according to APEDA. India’s distance from major
markets and the dispersion across India and short shelf life of these perishable products has
limited the ability to export. Various methods for preserving fruits and vegetables had been in
practice to increase their shelf life, among which air drying has been the most commonly used
method.

VFD of fruits and vegetables was sophisticated and a relatively new process which had several
advantages over traditional preservation methods. VFD involves freezing the substance to be
dried while simultaneously creating a vacuum so that the water content of the substance which is
frozen to ice directly sublimes into vapor. The major advantage is that the aromatic substances in
the fruits and vegetables are not lost in drying as is the case in most other processes. Thus,
original flavor, color, texture, as well as nutrients like proteins and vitamins are retained and
addition of preservatives is not required. The product has a longer shelf life and does not require
storage at low temperature. Whenever they are to be consumed, they can be re-hydrated to
achieve quick and complete re-constitution. VFD, however, is a very slow method of drying,
requires a high investment in drying equipment, and involves high energy costs.

According to APEDA, the health consciousness of users all over the world had spurred numbers
of uses of fresh fruits and vegetables. In the West, there was an increasing use of natural
ingredients in a wide variety of products such as ice creams, confectionaries, bakeries, soups,
sauces, yoghurts, cereal foods, baby foods, ready to make milk shakes, etc. Freeze dried fruits
and vegetables were an excellent substitute for fresh fruits and vegetables and had advantages in
longer shelf lives and simpler storage conditions.

While VFD technology had been known for quite some time and widely used in industrialized
countries for various applications including for fruits and vegetables, it had only been applied
until very recently in India to pharmaceuticals. A successful application of this technology
required Saraf to first develop the time temperature cycles for each product. Saraf approached
the Central Food and Technological Research Institute (CFTRI) in Mysore, which had
experience in drying of fruits and vegetables and had VFD equipment. Developing these cycles
was important in order to obtain the right product in terms of quality (odor and flavor), structure
of the product, texture after re-hydration, and to minimize the energy costs.

Financing the idea


Once the idea matured, Saraf moved to Gujarat in 1990 and started working towards setting up a
100% export oriented business in Vaghodia near Baroda. This location was chosen because of
the availability of a number of different raw materials. Setting up a VFD company would involve

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The Saraf Foods Investment (A)

significant investments in fixed assets. Besides investing family funds, Saraf needed additional
financing to get the venture started and therefore approached GIIC.

GIIC concluded that Saraf Foods was too risky: project cost particularly for the equipment was
high; there was no experience in India of VFD for fruits and vegetables and there was no
marketing experience in the area. In addition, it would take at least a couple of years before the
company could launch a product on the market, too long to service a traditional term loan. The
difficulty that GIIC saw was that it would be hard to secure any contracts without having built a
plant. The company would therefore have to invest much time and money into building the plant
and developing the product.

Mr. Saraf was found to be a very capable entrepreneur who was open-minded to input from
others regarding his business idea. Saraf initially had the ambition to develop a product for the
end-consumer. Plans were to launch the company’s own product on the shelves of food retailers.
It was clear to GIIC that this was too ambitious. GIIC did see the capability of drying tropical
fruits (which should be exported to the US) as the competitive edge compared to producers of
freeze dried food in the US and Europe. However, capital expenditures would have to be kept
low by development of machines in India. Another concern of GIIC was that power was
relatively expensive in India (at the time around 10 US cents per kWh). It was also unclear to
GIIC if there where any economies of scale. The variable costs, energy and raw materials, didn’t
decrease much in price if purchased in larger quantities. In addition, VFD drying units had a
maximum size and increasing the capacity would simply mean increasing the number of units.

The GIIC officers, however, neither rejected nor approved the idea. Through the VC network of
GIIC, the business proposal ended up on the desks of Mr. Varshney and his new deputy Trivedi
(who knew about the project from his recent work in GIIC) in January 1991. Both recognized
that the idea had potential as it involved a new technology, used indigenously sourced raw
materials, and was exported oriented. This was in line with the focus of the GVCF - 1990 fund.
The project promised a 25+ % IRR with the prices quoted by Saraf. In addition, Saraf came from
a trustworthy and successful business family.

GVFL put together a due diligence team for evaluating the technology and market prospects.
With Saraf, GVFL further developed the business proposal over the next couple of months.
GVFL did the required due diligence on Saraf and his family’s business and concluded that Saraf
was very knowledgeable in the area and had a good understanding of the technology, as initial
tests had been conducted at the CFTRI. Examination of the family businesses was satisfactory.

An appraisal report was written and sent to the World Bank for approval in April of 1991. After
a series of communications in May, the World Bank approved and suggested that the project be
divided into two phases. Phase one would involve additional testing at the CFTRI to further
develop the process and produce samples and a trip to Europe and the US for market research
and to gauge interest with potential buyers. Phase two would be initiated if the results of phase
one were satisfactory and involve project implementation during which the factory would be set
up.

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The Saraf Foods Investment (A)

The appraisal report2


According to the appraisal report, the annual production of fruits and vegetables produced in the
country in 1991 was estimated at 33 million tons and 40 million tons, respectively. The world
production was 326 million tons and 1000 million tons, respectively. India’s fruit production
included about 62% of the world’s mangoes and 11% of the world’s bananas.

The export of fruits and vegetables from India was less than 1% in 1983 – 1984 of the world
total exports. Total dollar value of these exports in 1983 – 1984 was 107.5 million USD, a
meager 0.45% of the 23.56 billion world total. The main reasons for this were the dispersed
Indian production without any quality control, the distance to market, the lack of a well
developed processing industry for fruits and vegetables, and a proper export marketing strategy.

In 1991, there was only one VFD plant being commissioned in India that was planning on
producing freeze dried vegetables and prawns (to be used in ready to eat noodle products). In
Kerala (South India) there was another plant that engaged in the drying of shrimps. No company
was exporting vacuum freeze dried products at the time. Most of the producers of VFD foods
were located in Germany, Denmark, Italy, Taiwan, and the US.

The major markets for Indian (fresh and processed) fruits and vegetables were found to be
Germany, UK, Netherlands, US, and Kuwait. Mangoes constitute the largest part of the fruit
export. The appraisal report identified Germany and the US as the likely main markets. Germany
imported 40% of its food requirements and had been a major importer of fruits and vegetables. In
1988, Germany imported 1 million tons of fruit and 788,000 tons of vegetables each valued at
1.7million USD. Forecasted annual growth rate for tropical fruits was estimated by the Indo-
German Chamber of Commerce at 15 to 20% per annum for the next five years.

The appraisal report concluded that:


- Many exotic tropical fruits available in India (Papaya and Mango) were quite popular in
Germany and their demand was growing substantially.
- Guava had also been introduced in Germany and its consumption was increasing.
- Sapota (a similar fruit to Kiwi) had been introduced in Germany.
- Germany imported large quantities of Capsicum, Coriander, and Ginger.
- Large quantities of banana and tomatoes were imported by Germany, but these were
among the low priced common fruits and vegetables.

Given the favorable conditions of the German market, Germany had been selected as a target
market for the proposed project. Although the size of the VFD market was not spelled out, the
appraisal report expected it to be high, well beyond India’s potential capabilities for the short
term. In 1991, VFD fruits and vegetables in Germany were mainly imported from the US,
Thailand, and Malaysia. The marketing companies in Germany for VFD products were known to
market their product all over Europe. German standards and regulation for food products were

2
In VC jargon, this is termed “due-diligence.” In India, however, many VCs initiated by DFIs retained the term used
for projects namely, “appraisal.”

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The Saraf Foods Investment (A)

the most stringent, thereby making it relatively easy to approach other European countries at a
later date, once the company had moved into Germany successfully.

Given the attractive fruit market compared to the vegetable market in Germany, the company
chose to devote 75% of total production to tropical fruits and 25% of production to vegetables.
The product mix had been chosen based on local availability, marketability, price
competitiveness and seasonal availability. Production would include Mango (75 production
days), Sapota (60 production days), Papaya (70 production days), Guava (20 production days),
Capsicum (30 production days), Ginger (30 production days), and Coriander (15 production
days). The pricing strategy would be based on quotations received from the German buyers
Prices quoted to Saraf Foods are shown in Exhibit 2.

Exhibit 3 shows the pro-forma income statement for Saraf Foods, as used in the appraisal report.
The prices of freeze dried vegetable and fruits were about 8 to 15 times higher than those of air
dried products. About 25% of the total costs were budgeted for energy, 20% for raw materials,
20% for labor, and 35% for fixed costs like financing, depreciation, and general expenses.

Phase one and phase two


The projected costs of the venture were estimated at Rs. 15.7 million. Of this, GVFL would
provide Rs. 2.5 million in equity (at Rs. 10 per share) and Rs. 7.5 million in income notes. The
project qualified for a Rs. 3 million subsidy from the government of Gujarat. The remaining Rs.
2.7 million would be brought in by Saraf. Of the budget, Rs. 500,000 was needed for phase one
(to be equally split between GVFL and Saraf) and the remainder for phase two. Interest on the
income notes was set at 10%. In addition, GVFL would receive a 5% royalty on sales.

Phase one was completed by December 1991. Saraf had visited France, Germany, Italy,
Switzerland, Denmark, and the UK, where he contacted 41 potential customers. At the
suggestion of GVFL, Saraf also visited the US. At the conclusion of phase one, GVFL appointed
a Monitoring and Project Implementation Committee. During phase two, orders for major
machinery was placed with IBP Ltd and work on land development and building construction
was started. GVFL started cash disbursements, took an active role in the negotiations with the
equipment manufacturers, and assisted in obtaining the required government approvals.

Project delay caused by late arrival and installation of the equipment led to cost overruns of Rs.
4.5 million by the end of 1992. Saraf and GVFL agreed to finance equally these additional costs.
The delay in project implementation also resulted in a delay in the receipt of the subsidy. Saraf
therefore requested GVFL to provide a bridge loan in the amount of Rs. 3 million against the
subsidy. GVFL also assisted in obtaining working capital facilities from the State Bank of India.

Commercial production

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On paper, the plant was declared ready in March 1993 in order to receive the subsidy. However,
problems were detected in the blast freeze drier supplied by equipment manufacturer Alfa Laval.
The defrosting system was not operating properly and the door of the freezer was leaking. Alfa
Laval was informed of this problem, however, it took them until July 1993 after intervention of
GVFL to rectify the problems. As a result, Saraf Foods suffered significant production losses.
Actual production was started in September 1993, eight months behind schedule. The costs
associated with the delay was put into expenses, but should have been capitalized.

In early 1994, Saraf Foods shipped its first consignments of banana, onion, and okra to the US.
The Food and Drug Administration (FDA) detained the load of okra after detecting residues of a
banned pesticide. As per the suggestion of GVFL, Saraf Foods subsequently entered into
contract farming agreements to minimize future risks regarding pesticides. Saraf Foods offered
the customer to destroy the shipment and replace the container free of charges.

As a result of all the delays, FY 1993/1994 ended with a loss of Rs. 3,645,000 on sales of Rs.
1,706,000. During 1993, as it became clear that additional financing was needed, GVFL started
to sell the venture as an investment opportunity to Canbank Venture Capital Fund (CVCF), a
Bangalore based World Bank supported VC. In April 1994, CVCF gave its sanction for funding
in the form of equity. CVCF would receive 210,000 shares at a premium of 2 Rs. per share,
providing Saraf with Rs 2,592,000 in cash. Exhibit 4 and Exhibit 5 show the balance sheets and
income statements of Saraf, respectively.

Marketing of Freeze Dried products


Once the company had sorted out all the equipment problems, Saraf strengthened the marketing
efforts of the company. Typically the process of market acceptance and securing contracts
involved the following steps. Samples were developed and sent to prospective buyers. Buyers
then tested the samples for quality and shelf life. The buyer would visit India to check facilities
and prices and contract terms would be negotiated. The entire process could take many months.

The initial samples produced at CFTRI had been taken on the tour to Europe and the US. It
turned out to be extremely difficult to get customer interest without having a product or a facility
yet. However, Saraf managed to secure a contract with a large buyer and producer of freeze dried
foods in the US in 1993. The tour through Europe was also used to explore what kinds of
products would be suitable for production in India. It turned out that demand was highest for
more commodity like products like onion, okra, and banana.

In 1994, Saraf approached the Center for Promotion and Imports from Developing Countries, a
Government of the Netherlands organization. This organization sponsored the company for a
three-day seminar on marketing in Europe. They also assisted in setting up a booth at the Food
Ingredient Europe (FIE) fair in London, which led to initial contracts with buyers.

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The increased marketing efforts led to the signing of a long term agreement with a German
marketer of freeze dried foods in 1995. The contract involved monthly dispatches of one
container load of onion and banana.

The growth phase


Once the company was receiving regular orders in 1995, additional equipment (a dicer and a
metal detector) were purchased in the amount of Rs. 1.2 million. These investments were needed
to ensure product uniformity and safety. As a result, the liquidity position of the company would
be tight and therefore Saraf requested GVFL to reschedule its Income Note dues. GVFL agreed
to this and deferred five quarterly principle installments and six interest installments for 18
months. FY 1994/1995 ended with a loss of Rs. 3,628,000 on a turnover of Rs. 2,806,000.

The delays and low utilization of the dryer forced the company to raise additional capital in order
to repay the bridge loan against the subsidy. GVFL approved Rs. 1,620,000 on the condition that
Saraf would bring in Rs. 1,690,000 and CVCF would also raise its share with Rs. 740,000.

By mid 1995, however, the company had booked its entire 1 ton capacity. The factory building
had been constructed for three dryers and capacity expansion would thus only involve adding
additional dryers. Adding a dryer gave significant economies of scale, as no additional man
power was needed and energy costs would only increase by 50%.

IBP, the supplier of the first dryer had closed this line of business and Saraf therefore decided to
undertake construction of the dryer himself. This decision was justified by the fact that imported
dryers where three times as costly as dryers manufactured in India. In addition, 70% of the parts
supplied by IBP were bought from suppliers and ex-employees of IBP were available for
technical consulting. Saraf had acquired substantial knowledge of the technical side of the dryer
operation. After discussing the issue with GVFL, it was decided to self-fabricate a second dryer.

GIIC was approached to finance the expansion of the plant. Even though GIIC had initially
rejected the project, Saraf Foods was now fully operational and GIIC was the appropriate
financing institution. A Rs. 9,400,000 term loan was approved by GIIC in August 1995. At the
time of the negotiations, the interest rate was 17%, which was used in the projections. However,
between the time of sanctioning and disbursement, the interest rate rose 5% to 22%. GVFL
approved additional equity in the amount of Rs. 2,280,000 in December of 1995 as their share of
the expansion. The expansion project was completed in November 1996 without any overrun.

Even though revenues increased, the financing costs were weighing heavily on the company’s
cash position. Saraf therefore approached GVFL again for loan restructuring. GVFL recognized
that the company had made good progress on the implementation of the expansion project and
that the company had built good relationships with its customers. GVFL therefore approved
rescheduling. The outstanding balance of Rs. 7,145,000 on the Income Note was to be paid in 14
quarterly installments starting from October 1st 1996 instead of 20 installments starting on April
1st 1994. Interest was revised from 10% to 13%. The royalty on revenues was revised from 5% to

12
The Saraf Foods Investment (A)

7% and GVFL reserved the right to convert an amount not exceeding Rs. 3,700,000 out of the
principal amount of the Income Note and / or royalty into equity shares.

In FY 1995/1996, the company’s sales increased to Rs. 9,870,000. The company also reported a
small profit of Rs. 145,000. FY 1996/1997 saw a further increase in revenues to Rs. 12,971,000.
Profits improved to Rs. 537,000. Since the second dryer was not in operation until December
1996, the 1996/1997 numbers only included several months of operation of the second dryer.

Although turnover had increased, profitability was still low. GVFL advised the company to
increase the proportion of exotic products in order to improve the margins. By 1997, most of the
production consisted of banana, onion, and okra, which was produced for two customers, one in
US and one in Germany. These products represented the largest market volume in the VFD
market and were the easiest products to market but they had low margins.

By the end of 1997 Saraf had made a proposal to produce freeze dried curries according to
traditional Indian recipes. After a pre-launch survey, four freeze dried curries were launched
under the ‘Fairies’ brand name in early 1998. Since this was an innovative product for Indian
consumers, the company decided to create awareness through point of sale demonstrations and
by deputing personnel in cities. The company also sent samples of these curries to its existing
customers abroad for market assessment. The products, however, could not reach projected
volumes as the price point was considered too high for the Indian market. As a result, a much
lower number of shops displayed the product than was anticipated.

In early 1998, the German customer informed Saraf that it could not purchase white onions on a
regular basis as they could not create a market for it. 1998 brought another breakdown in one of
the dryers, which lasted for a month and resulted in a delayed export consignment. The company
was also desperately in need of an in-house laboratory, as both major customers were facing
problems with high microbial counts. The laboratory would involve an expenditure of Rs.
600,000. GVFL was once again asked to defer one installment by six months. Even though FY
1997/1998 had shown several problems, the company showed an improvement in the financial
results. Turnover and profit increased to Rs. 21,205,000 and Rs. 1,928,000, respectively.

The onion crisis


Although turnover had increased, profitability was still low. During 1998, considerable rises in
prices of onions in India impacted Saraf’s main line of business. The onion crop was affected by
heavy rains in the onion growing areas which led to crop failure. Onions constituted the largest
portion of the company’s sales. The company had to supply against committed orders at the
originally quoted price even though prices had increased significantly. Besides, the company was
unable to take fresh orders and as a result sales dropped. Onion prices stabilized around
December 1998 but a delay in customs clearances prevented the company from dispatching
onions for export until March 1999. The delay was a result of a temporary export ban on onions,
implemented to guarantee that the domestic demand for onions would be filled.

13
The Saraf Foods Investment (A)

As a result of the onion crisis, Saraf Foods started to experience liquidity problems starting in
mid 1998. The company had difficulties servicing the GVFL and GIIC installments and once
again had to request GVFL to reschedule payments. In December 1998, GVFL approved the
rescheduling of four quarterly principle and interest installments on the Income Note and two
quarterly royalty installments. These dues were rescheduled to be paid in ten quarterly payments
starting April 1st 2000 and would carry an interest of 20%. GIIC decided in March 1999 to
extend the repayment schedule of Saraf Foods by three quarters.

The company encountered further liquidity problems when the US buyer did not purchase the
three containers of banana they had indicated they would buy. Saraf Foods had already processed
1.5 containers, valued at 2.1 million Rs. By mid April the working capital limit of 5 million Rs.
was fully used. Saraf requested GIIC to delay cashing a 425,000 Rs check made out to them.
GIIC did cash the check, however, resulting in an overdraft. The German buyer had placed an
order for one container of red onion (Rs. 1.4 million), scheduled for processing during April. The
State Bank of India agreed to give an additional overdraft facility of 1 million Rs. needed to
process this order. The overdraft would help sustain operations during April and May. However,
if the US buyer failed to buy the processed banana, Saraf’s position would further deteriorate.

GVFL officers prepared a detailed cash flow projection and a proposal for rescheduling of dues.
The company would need about 2.5 million Rs. for the first half of FY 1999-2000, over and
above the rescheduling of income notes. Projected sales for the first quarter of FY 1999-2000
were 3 million Rs., while break even sales were 5.5 million Rs. The resulting cash losses would
be around 500,000 Rs. In addition, the company needed between 1.5 million and 2 million Rs. to
pay overdue creditors and 425,000 for the GIIC installment.

As of mid 1999, the US buyer had placed an order for banana and Okra, totaling 1.7 million Rs.
The German buyer had placed an order for banana and white onion, totaling 800,000 Rs. The
company had earlier stopped ordering white onions on account of high microbial count.
Projected sales for the second quarter were still far below breakeven sales, however.
Domestically, the marketing of the curries was still going slow. Several marketing firms, one of
which was planning on selling this product in the US, had shown interest but had not given any
feedback or placed orders yet. Saraf had also started discussions with the Indian army for the
supply of VFD curries, however, there were no firm commitments as of august 1999.

It was clear that the company would need additional funding in order to survive. Saraf could
request GVFL for funding, but GVFL would demand that Saraf put in a similar about as they put
in. Saraf estimated the amount needed from GVFL to be around Rs. 3 million. In addition, Saraf
would have to request GIIC to defer an additional four installments on top of three installments
that were already deferred. While contemplating the additional investment, GVFL started
negotiations with GIIC and SBI to discuss the possibility of increasing the working capital limits.
GVFL was concerned that the attitude of the financiers would not be sympathetic, as the
company’s turnover for FY 1998/1999 had decreased to Rs. 19,352,000 with a profit of only Rs.
920,000.

Exhibit 6 shows the cash disbursements and payments received from Saraf. Saraf had made
interest payments to GVFL and paid off a portion of the income notes and the bridge loan. Even

14
The Saraf Foods Investment (A)

if the company would survive the current crises, it would take several more years before an exit
could even be considered.

15
The Saraf Foods Investment (A)

Questions

Group A: GVFL—Summarize the situation today from GVFL’s point of view. Discuss the
options available to GVFL (put in the requested money, write-off the investment, find other
sources of capital, etc). What should you do?

Group B. Suresh Saraf and family members—Summarize the situation as you see it today.
Discuss your options. What should you do?

Group C. GIIC and SBI. Summarize the situation from your standpoint. What should you do?

The following questions should be addressed by all groups:

1. What do you think of the way the investment was structured? Did GVFL function as a
true VC firm or were they acting more like a bank? Could GVFL and Saraf have done
things differently with regards to financing the venture?

2. What is there in the company that is of any value? How would you go about valuing the
company?

3. Looking back, was this a potential VC investment to begin with? What were the strengths
and weaknesses of the venture?

4. Does VC have an opportunity to succeed in this difficult environment?

16
The Saraf Foods Investment (A)

Exhibit 1. Gujarat Venture Capital Fund – 1990 (GVCF – 1990)


Date of establishment November 1990
Date of maturity November 2005

Authorized capital Rs. 240 million


Pay-outs to investors Rs. 96 million

Investment philosophy
Preferred stage of investment Start-up / early stage
Target return and period 25%, 15 years
Monitoring Hands-on
Syndications preferred Yes

Instruments of finance Instruments Rs. million


Equity shares 120,01
Convertible pref. shares 15.55
Convertible debt 12.90
Income note loan 52.05
Other (temp., bridge loan) 32.40
Total 232.91

Stages of investment Stages Number Rs. million


Seed stage 2 37.81
Start-up 13 115.61
Other early stage 2 12.85
Later stage 7 53.79
Turnaround financing 1 12.85
Total 25 232.91

Investment by industry Industry Number Rs. million


Biotechnology 1 5.00
Computer software, service 1 12.85
Consumer related 6 38.25
Food & food processing 2 21.65
Industrial products 1 3.75
Medical 2 25.88
Other electronics 2 13.45
Tel. & data communications 1 9.13
Other 9 102.95
Total 25 232.91
Source: Venture Activity Report – 1998. Indian Venture Capital Association.

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The Saraf Foods Investment (A)

Exhibit 2. Prices in US dollars per kilogram quoted to Saraf Foods in 1991 for VFD foods
Prices assumed by Prices quoted by Prices assumed by
GITCO1 German importers SFPL2

Mango 19 18.9 19
Papaya 12 11.7 11
Sapota - - 12
Guava 8 14.8 8
Capsicum 11 - 11
Coriander 12 - 10
Ginger 12 - 12
Source: Appraisal report
1
Technical consultancy agency 2 Saraf Foods Private Ltd.

Exhibit 3. Pro-forma forecasts for Saraf Foods at project inception


Year 1 2 3 4 5 6 7 8 9 10

Production
Capacity (metric ton / year) 61 61 61 61 61 61 61 61 61 61
Utilization (%) 60% 70% 80% 90% 90% 90% 90% 90% 90% 90%
Production (ton / year) 36.6 42.7 48.8 54.9 54.9 54.9 54.9 54.9 54.9 54.9

Costs
Raw materials 1,170 1,365 1,560 1,755 1,755 1,755 1,755 1,755 1,755 1,755
Power, fuel, water 840 980 1,120 1,260 1,260 1,260 1,260 1,260 1,260 1,260
Wages and salaries 850 935 1,029 1,132 1,245 1,370 1,507 1,658 1,824 2,006
Repairs and maintenance 429 433 437 441 441 441 441 441 441 441
Manufacturing overhead 362 412 462 512 512 512 512 512 512 507
Selling/General/Admin. 571 650 732 816 849 886 926 970 1,019 1,073
Royalty to GVFL 438 511 584 657 657 657 657 657 657 657

Total cost of production 5,593 6,348 7,118 7,901 8,080 8,279 8,496 8,735 8,999 9,279

Total sales realization 9,284 10,832 12,380 13,928 13,928 13,928 13,928 13,928 13,928 13,928

Gross Margin 3,691 4,484 5,262 6,027 5,848 5,649 5,432 5,193 4,929 4,649

Interest on term loan 752 752 694 544 394 244 94 0 0 0


Interest on working capital 84 97 109 122 122 122 122 122 122 122
Total interest 836 849 803 666 516 366 216 122 122 122
Depreciation 1,543 1,543 1,543 1,543 1,543 1,543 1,543 1,543 1,309 61

Profit before tax 1,312 2,092 2,916 3,818 3,789 3,740 3,673 3,528 3,498 4,466

Profit after tax 1,312 2,092 2,916 3,818 3,789 3,740 3,673 3,528 3,498 4,466

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The Saraf Foods Investment (A)

Exhibit 4. Saraf Foods Balance Sheet


(amounts in thousand rupees)
Fiscal year ending
31-03-92 31-03-93 31-03-94 31-03-95 31-03-96 31-03-97 31-03-98 31-03-99
Fixed Assets
Fixed Assets 1,221 17,662 17,952 17,986 19,854 30,638 35,028 36,731
Less: Depreciation 7 767 1,558 2,406 3,290 4,741 6,372
Net Fixed Assets 1,221 17,655 17,185 16,427 17,449 27,348 30,287 30,360

Current Assets, Loans and Advances


Inventory 2 1,586 3,145 4,686 5,238 6,633 10,930
Debtors 6 6 955 1,026 975 151 282
Cash & Bank Balance 183 122 22 13 382 27 24 29
Loans & Advances 2,897 675 205 3,382 1,229 770 589 461

Less: Current Liabilities 14 772 580 748 849 1,328 1,393 2,672
Net Current Assets 3,066 32 1,238 6,746 6,474 5,682 6,004 9,029

Total 4,287 17,687 18,423 23,173 23,923 33,030 36,291 39,389

Shareholders Funds
Saraf 2,600 4,950 4,950 4,950 6,640 10,060 10,060 10,060
GVFL 4,750 4,750 4,750 8,650 8,650 8,650 8,650
Canbank 2,160 2,900 2,900 2,900 2,900
Total share capital 2,600 9,700 9,700 11,860 18,780 21,610 21,610 21,610
Reserve & Surplus 3,404 3,404 3,404 3,404 3,404
Net Shareholders Funds 2,600 9,700 9,700 15,264 22,184 25,014 25,014 25,014

Loan Funds
Secured Funds 1,683 7,995 12,098 13,897 8,770 17,758 15,341 18,967
Unsecured Funds 16 16 292 1,307 245 642 626 5

Miscellaneous Expenditure
To the extent not written off (12) (11) (10) (8) (135) (3,770) (5) (4)
Profit & Loss Account (13) (3,658) (7,286) (7,142) (6,614) (4,686) (4,594)

Total 4,287 17,687 18,423 23,173 23,923 33,030 36,291 39,389

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The Saraf Foods Investment (A)

Exhibit 5. Saraf Foods Income Statement


(amounts in thousand Rupees)
Fiscal year ending
31-03-92 31-03-93 31-03-94 31-03-95 31-03-96 31-03-97 31-03-98 31-03-99
Sales
Sales 6 582 2,806 9,870 12,971 21,206 19,353
Other Income 0 8 3 36 12 3 1 2
Increase (decrease) in stock 0 0 1,121 1,534 1,540 591 1,327 4,263

Total Sales 0 14 1,706 4,376 11,422 13,565 22,534 23,618

Expenses
Raw Material 4 319 642 2,050 2,548 2,944 4,708
Manufacturing 2 1,649 2,586 4,021 5,016 8,179 9,684
Administrative 14 1,270 2,011 2,582 3,345 4,845 4,219
Bank charges 168
Loss on sale of assets 3 15 0

Total Expenses 0 20 3,238 5,239 8,653 10,912 15,983 18,779

EBITDA 0 (6) (1,532) (863) 2,769 2,653 6,551 4,839

Interest expenses 0 1,353 1,974 1,777 1,237 3,108 3,112

Depreciations 7 760 791 847 888 1,515 1,633

EBT 0 (13) (3,645) (3,628) 145 528 1,928 94

Cash Profit (loss) (6) (2,885) (2,837) 992 1,416 3,443 1,727

20
The Saraf Foods Investment (A)

Exhibit 6. Cash disbursements and payments received from Saraf Foods by GVFL
(amounts in Rupees) Total
Fiscal Year 91-92 92-93 93-94 94-95 95-96 96-97 97-98 98-99

Equity (2,500,000) (2,250,000) (1,620,000) (2,280,000) (8,650,000)


May Aug Mar Dec
Income Note
Disbursement (7,500,000) (7,500,000)
Interest 435,185 535,362 41,855 628,956 1,682,193 710,726 131,247 4,165,524
Repayment 375,000 1,125,000 2,000,000 500,000 4,000,000

Brigde Loan
Disbursement (3,000,000) (3,000,000)
Interest (25%) 210,548 37,743 1,379,040 93,493 1,720,824
Repayment 1,500,000 1,500,000 3,000,000

Soft Loan
Disbursement
Interest (10%)
Repayment

Fees and Upfront Charges 17,500 11,250 39,000 67,750


Interest on Funded Interest 135,960 486,867 27,332 650,159
Other Interest 5,849 12,393 56,663 74,905
Repayment of NCDs
Royalty 304 58,893 470,275 691,509 1,114,503 1,028,768 3,364,252

Net Annual Cash Flow (9,982,500) (1,803,565) (2,253,786) (1,339,700) 2,611,531 5,176,190 3,825,229 1,660,015

21

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