By Mr. Sudhir Sethi
Director, Walden-India & Member of SEBI Committee on Venture Capital Reform
E-mail: ssethi@wiig.com

Venture Capital (VC) Funds, both domestic and offshore, have been around in India for some years now. However, it is only in the past 12 to 18 months that we have seen intense activity amongst entrepreneurs proactively seeking out venture capital funds. It is interesting to note that for every one investment which is funded by a VC, anywhere upto one hundred ventures are not funded by the same VC. As such, understanding the dynamics behind VC funding is important while seeking funds.

VC funds are broadly of two kinds; generalists or specialists. From the investee company perspective it is critical that the funding be obtained from those who understand the business. This backing of smart money for a growing company can prove to be invaluable as focused/specialized funds open doors, assist in follow on round of funding and act as an excellent sounding board on strategy. In a sense the investee company choosing a Venture Capitalist applies as much as does a VC fund's choice of the investee company.

Venture Capitalists are driven by the profit motive. In effect the VC and the entrepreneur are really on the same side, since VCs do not seek to profit through arbitrage. VC funds invest in the company, with a view to build and facilitate growth. At the time of exit, leaving behind an ongoing concern painstakingly built over 3 to 4 years is a matter of pride for a VC fund. Apart from ensuring returns for its investors such a company serves as an example of the caliber of the VC fund also; a reference of sorts of a good track record. Hence, with a view to derisking the investment most VC's tend to follow a similar set of guidelines, written or otherwise.

As such, while qualifying a potentially winning investee company, venture capital funds look at a select band of generic parameters.

A. The Management Team

First amongst such parameters is the quality of the management team, consisting of the entrepreneur as well as professionals in the team. Success or failure of the venture is fundamentally a people game - the best ideas, backed by a great business plan, well funded, cannot be a winner without a winning team.

It is important to distinguish the entrepreneur clearly from the professional management team. In the field of Information Technology, where, in India the average entrepreneur is around 30 to 35 years of age and reducing, he or she may not possess adequate experience or a track record in the chosen area. The value of the idea, the vision, putting the team together, getting the funding in place, are, amongst others, some key aspects of the role of the entrepreneur. VCs will insist on a professional team coming in, including a CEO to operationalize the idea in the absence of a complete team.

In the overall team, VCs will look for positive reinforcement on personal integrity, transparency as well as leadership, from the team, and more specifically from the entrepreneur.

Many Venture Capitalists tend to be hands on in a strategic sense and will be with the entrepreneur on the board of the company. In such cases the VC fund manager will seek personal chemistry with the entrepreneurs; a meeting of the minds facilitates the ability to listen to each other out of respect and nothing else, thus facilitating working together to build the company.

In India, since the regulatory framework of transparency and disclosure have a long way to go, strong entrepreneur's also practice and highlight self-imposed high standards of governance.

B. The Idea

The second key factor venture capital funds look at is obviously the idea and the potential of the idea to be monetized resulting in growth in valuations and profit. In effect the business model. Here key factors include:

1. Scalebility: Venture funds look for scaleable markets enabling the investee company to also be scaleable in terms of the business model. The scaleability potential, at a country level or a regional/global level is critical in building valuations, revenues and profits. In a scaleable model the presence of $ revenues provides a hedge against potential rupee depreciation.

2. Competitive Entry Barriers: Does the business model allow for adequate entry barriers to competition? Entry barriers in the form of technology, products, and now in terms of speed of entering and securing markets/customers.

3. Creation of Value: Does the business model allow for creation of intellectual property, patents, methodologies, processes and Brands, which will add to increased valuations? Increasingly the value of building brands is becoming critical to valuation increase in a company. In this day of the Internet it is entirely possible for an Indian entrepreneur to think of and build a global company, with speed as a key entry barrier and brand as a major asset. In essence, the importance from a valuation perspective, of softer assets, are increasingly becoming critical for a VC fund.

C. Valuation

The third key factor is valuations. VC funds are sensitive to valuations whether for a start up or an ongoing concern. Valuations typically are drawn from parallels in the stock market, business projections and experience. Expectations of valuations by investee companies vis VC funds will differ. However, the prime driver is not only the state of the business today but also expected returns by the VC fund in the future. In India, while calculating returns, VC funds will take into account issues like rupee depreciation, political instability - such issues tend to suppress valuations today. Presence of intellectual property, brands or predictability of future revenues and profits enhance valuations.

Linked to valuations is of course the stake or percentage share of the company, which a VC funds takes. In a seed stage company, where the entrepreneurs bring to the table a great idea in combination with a world class management team and no capital, the VC fund will typically take a stake of above 50% and even upto 70% depending on the funds required, e.g. if the pre-money valuation agreed upon is Rs.5 crores and the fund requirement is Rs.8 crores then the share of the VC ownership will be 61%. In the U.S. markets, this is normal; Indian entrepreneurs are still uncomfortable with the VC "taking control" in a seed stage project. It is critical to understand that the VC is owning stock commensurate with the financial risk being taken

In early stage or expansion stage companies VC funds tend to take lesser ownership based on valuations determined on factors mentioned earlier.

D. Exits

A fourth key factor is the issue of exits. For the VC fund to earn it must exit. Exit can be in the form of a trade sale or an IPO. Here structuring for tax optimization while existing is essential as well as the time frame of the holding. For the investee company and the entrepreneur, life after exit is critical; in the event of an IPO, the VC and the entrepreneur are really creating an ongoing concern with fiduciary responsibility to a larger set of investors. VC funds will discuss exit options at the time of investment.

E. Multiple Rounds of Funding

While investing, VC funds look for investee companies, which have got Angel funding already. Angel funding is smart funding at the start up stage. Angel funding also means that the angel has spent time to grow the company. Angel funding is specialist funding giving very high value add. Typically for an early stage, expansion stage or a seed stage investment, co-investments by Venture funds is a practice increasingly being followed. VC funds with complementary strengths e.g. one focused on a given sector and the other say a geography/markets, are the ones most likely to get together.

While investing, VC funds look for investee companies, which have got Angel funding already. Angel funding is smart funding at the start up stage. Angel funding also means that the angel has spent time to grow the company. Angel funding is specialist funding giving very high value add. Typically for an early stage, expansion stage or a seed stage investment, co-investments by Venture funds is a practice increasingly being followed. VC funds with complementary strengths e.g. one focused on a given sector and the other say a geography/markets, are the ones most likely to get together.

One of the key internal requirements of VC funds in deciding upon investments is portfolio balancing. Most Venture Capital funds invest in companies at seed stage, early stage and at the expansion stage, in the life cycle of a company. However, if for example a VC has invested in a portfolio of companies predominantly at seed stage, VCs will focus on expansion stage projects for future investments to balance the investment portfolio.

G. Conclusion

In summary, VC funds go through a certain due diligence to select a good investment. The due diligence starts at the management team level and goes on to encompass the idea and the potential of the idea to be monetized as well as exit opportunity evaluations, for a seed company. For a running concern, the above set of due diligence parameters are supplemented by legal and accounting due diligence typically done by an external agency, e.g. one of the Big 5 audit concerns.

In the event of a seed stage opportunity, VCs tend to take upto 2 to 3 months to decide whether to back a project or not; for early stage or expansion stage projects being valuated in India; the legal and accounting due diligence cycle itself will add another two months to the final go ahead signal for a VC fund. Comparatively in a U.S. company the time cycle in far smaller at less than 30 days in many cases, or an average of 60 days in most cases.

In effect, next time you are going to raise Venture Capital Funding do keep 2 to 4 months from the time fund raising starts to final disbursement for Indian companies or upto 2 months for USA structured companies.