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Understanding venture capital


It's a book form compilation of a series of blog entries that tries to break down into very simple terms - how VCs work.

It's a book form compilation of a series of blog entries that tries to break down into very simple terms - how VCs work.

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  • 2. TABLE OF CONTENTSAbout ............................................................................................................................................................................................ 3How is a VC Firm set up and how does it work? ......................................................................................................... 4What does it take for a VC to return 10% to their Investors? ............................................................................... 5Company Valuations, How VCs Exit and Return Their Money to Limited Partners .................................... 7Fast Growth Companies Vs Lifestyle Companies - When are you a good candidate for VC Money? .... 9Venture Capital in India ...................................................................................................................................................... 10The Indian VC Landscape, What they have Funded and What they seem to be funding now ............... 11How do I Identify that Jackpot Business Plan suitable for VCs with the potential Hockey Curve or JCurve growth? ......................................................................................................................................................................... 13How to Identify the Right Kind of Venture Capital Company and the Partner Likely to Fund You..... 14The Coming Global Freeze in Venture Capital and Implications for Indian VC Monies ........................... 16Why does VCs Think Like Sheep, Whats up with the Fad Waves of Investing? .......................................... 18Why does VCs Think Like Sheep, Whats up with the Fad Waves of Investing? - Part II ........................ 19Fostering Innovation and New Startups During Tough Times ........................................................................... 21VC Valuations and Exits - The Reason Why a VC would Give you Money ...................................................... 23VCs, Angels and Control of Company ............................................................................................................................ 25Comments By Aditya ............................................................................................................................................................ 26Another Case Study Hot off the Press! .......................................................................................................................... 28What does having a lot of Mid-Market VCs really Mean? ...................................................................................... 29The Prosperity Supply Chain ............................................................................................................................................ 30One Invaluable Tool in the Entrepreneurs Corner .................................................................................................. 32 2
  • 3. ABOUTThere seems to be a lot of misunderstanding about Venture Capital - that they are holding backinnovation, they fund only companies that dont need the money, etc. Understanding how venturecapital is set up, when and why they invest all will enable an entrepreneur predict whether VC is suitablefor them and can avoid wasting time trying to raise VC money?This does not mean VC firms don’t screw up. Some even have their Missed Opportunities page with agreat sense of humor! Checkout this page about Bessemer Venture Partners Anti-portfolio - This listscompanies that they turned down for a Venture Investment and still went to become huge, hugecompanies - Like Google, Apple, HP, Cisco!!!!http://www.bvp.com/Portfolio/AntiPortfolio.aspxIdeally this should be done by VCs who are in this forum but hopefully they should jump in and correctme when I get some facts wrong! 3
  • 4. HOW IS A VC FIRM SET UP AND HOW DOES IT WORK?This is the key in understanding the motivations behind VCs and the kinds of companies that they willfund.Very large pension funds around the globe, very wealthy investors all have percentages of money thatthey can spend on "Gambling Money" or money that they set aside usually (5 to 10% or all the moneythey have, I am guessing) to invest in High Risk, High Return investments. This is what goes into VentureCapital. These are called Limited Partners.Two or three people usually with lots of experience doing this in another VC firm start a partnership thatis called say XYZ Venture Capital. They are the founders and managing directors of these VC firms. Theythen go out and raise a round of Capital from the Limited Partners after selling them on their experienceand focus - They would do it for Technology, Life Sciences, etc. They also need to define their investmentobjectives - Seed Stage, Early Stage, Middle Market, Late Stage, etc. They can take out a 2 to 3 %management fee out of this for their salaries expenses, etc every year out of this money.So they will raise say XYZ Venture Capital Fund I to be invested in say Early Stage TechnologyInvestments in Software and Services companies only. This fund has a life of say 10 years. This meansthat if they raise this fund I in 2009, they will have to return the money to the Limited Partners in 2019.So VCs have their own bosses - Limited Partners. If they raise $100, they can return $150 or $80 back in2019. That would mean a gain of 50% over 10 years or -20% over 10 years. The VC fund can also take aCarry if they return more money than they rose that is a cut from the gains that they caused in those tenyears.So the first thing to understand is that everyone has a boss - Entrepreneurs bosses may be VCs, VCsbosses are Limited Partners. They will not be able to raise a second fund if their first fund or their trackrecord is not that good in returning the money. The lesson for entrepreneurs here is that VCs have aperformance goal just as entrepreneurs do. Thats what motivates them to bet on certain things and noton certain things. 4
  • 5. WHAT DOES IT TAKE FOR A VC TO RETURN 10% TO THEIRINVESTORS?Lets assume that XYZ Venture Capital raises a fund called Software Products Early Stage Fund I with$100 in 2009. If the limited partners put their money in the bank in the US they can get only 2 to 3%. InIndia they might be able to get more but to get a decent return of 10% per annum they need turn this$100 to $200! If they need to return a spectacular (In VC world) 20% they will have to turn the $100 to$300 in 10 years!This is not like putting the $100 in the bank and earning interest! The $100 needs to be invested in veryrisky investments. Only a small percentage of startups make it beyond even the first one or two years.So if they make 20 investments of $5 each, many of this $5 goes away without a trace. So they need tohit that one Twitter or Google or Face Book jackpot that turns that $5 into 50 times - $250 to getanywhere near their 20% goal!But wait a minute! Not all this $100 will be invested right away. They will invest $5 in a company andthen they need to reserve 4 or 5 times that money - $20 to $25 for subsequent rounds! So for every $5invested, $20 is reserved. So they can do only 4 companies in $100!!!Now you are getting the picture! Thats the reason VCs go through many business plans looking for thatone Jackpot that can make up for all the other duds that will lose all of the money! Nothing personal -the growth you need to show is that of a hockey stick to get that $5 to be worth 20 times or 30 timesthe investment: Some examples of Hockey Stick Growth: 5
  • 6. More in the next note on Company Valuations, How VCs get their money out, etc 6
  • 7. COMPANY VALUATIONS, HOW VCS EXIT AND RETURN THEIRMONEY TO LIMITED PARTNERSWith startup companies, the valuation of the company is more of an Art than a Science. Twitter now isvalued at $1B plus and they are not sure how they are going to make money! Valuation at this stage ispurely a function of what someone is willing to pay for it. When some investors are willing to put in$100M into Twitter at a valuation of $1B plus, then today thats the valuation of that company.When a VC puts in Seed or Early Stage money they do it at a valuation based on general norms thatparticular month. When times are good and lots of VC money is chasing very few companies thevaluation shoots up and when it is not, it goes down. After the first round, it is in the VCs interest tospread the risk of that company - so they bring in additional VCs to share the risk. They put in additionalmonies from the money they have reserved for subsequent rounds for this company.Every round the valuation is bumped up like in the Twitter case above. If that sector is not hot,subsequent valuations can also be down-rounds or the valuation can also go down. So it can go eitherway. VC funds may not wait till the 10 years or up. They may exit their investment in the company bygoing public and selling their shares in the company in the open market. Or they could get that moneyback when this company is acquired by another company.These sound like stupid mumbo-jumbo but these are very smart, highly educated individuals. If thewhole system does not make logical sense over a long period of time, VC firms would have been historylong time ago! Many are history already since the Dot com boom because they defied the laws of VCgravity with many stupid investments and not too many Google’s.Why should some company acquire another company? If they have Intellectual Property, that cannot bedone quickly enough or if they have customers.Microsoft paid Sabeer Bhatia and Hotmail, $400M to acquire an instant customer base of 9 Millionpeople who had hotmail accounts (Rumor has it that a majority of them were in India opening accountsso that they send resumes out!. But thats another story!). Oracle paid billions of $ to PeopleSoft so thatthey can get their customer base and convert them to Oracle solutions over a long period of time.So its a question of the value of time! Oracle would rather set up a group inside their company anddevelop your best-of-breed solution that your startup company has from scratch. But if you already have25 customers and growing fast, it is better for them to buy you rather than develop it from scratch. Soits a Make Vs Buy decision for them. 7
  • 8. So XYZ Early Stage fund I during the ten years of its life, sells companies it funded or get to IPO and taketheir money out. That money minus the carry goes into the account of that fund. At the end of tenyears, this fund returns the money back to the Limited Partners. Could be $200 if they started with $100or $80 depending upon whether they made one or two good investments that turned 20 to 30 timesover! Thats where their returns are calculated. The VC firm or General Partners as they are calledcannot raise the next fund if their track record with previous funds were not good! They may dissolvethe VC firm as many have done recently. 8
  • 9. FAST GROWTH COMPANIES VS LIFESTYLE COMPANIES - WHENARE YOU A GOOD CANDIDATE FOR VC MONEY?Not all companies are good candidates for VC money. Are you a Fast Growth (Hockey Stick Growth)company or a Lifestyle Company?Some very large companies in IT never took a dime in venture capital - Oracle is a good example. In Indianone of the large IT companies have been started with Venture Capital. In fact more large companieshave been started without VC money!This is no reflection on VC firms but it is just the nature of how they raise their money and how they getout and how valuations are done in between. They are designed to fund risky, new ideas that have highrates of failure but the one o two that succeed changes the game for everyone forever.Lifestyle companies are companies that have growth but not the Hockey Stick style growth. It is morelike 10 to 15% per annum. There is nothing wrong with these companies. If you bootstrap them and theyare providing a steadily increasing cash flow you can still build a good company, pay yourself a goodsalary and have the entire company to yourself when you sell it!For the Hockey Stick growth, you may or may not need to look at Global markets! Mobile wireless inIndia has been growing at such a pace, that the Indian market is more than adequate to qualify for adeep hockey stick as the graph shows!In other cases, you may need to look to global customers for growth. There are Indian startupcompanies that have developed web 2.0 companies for Local Sports Leagues. There are local sportsleagues in India but they may grow much much faster if they look to the global market instead! So it alldepends.Why do VC firms need a Hockey Stick growth pattern? That goes back to the valuations of the companyin subsequent rounds. If a company grows to $50M within 5 years in revenues, their valuations also willmake sense in round after round and they can have that Jackpot exit. Other investors will not jump inuntil this rapid growth is shown. This rapid growth need not be in current revenues but also in potentialrevenues. Google was not making too much revenue when they went public but subsequently realizedbillions of dollars in revenues. So it is not all stupid!So before you complain about VC money, understanding whether your company is a candidate for VCmoney or not is key. Are you a Fast Growth company or a Lifestyle company? 9
  • 10. VC Firms need to report back to their Limited Partners on new companies they have checked out everyweek, month or quarter. So they will waste your time, taking meetings and putting them on theirreports. It is up to the entrepreneur to make sure that they spend their time wisely chasing VC money inthe first place. If you dont need it and you can grow slower comfortably, things are actually better foryou!The funny thing is that EVERY MAJOR VC in Palo Alto has offices in India, dedicated funds in India orwork through an Indian VC like Helion Ventures by becoming limited partners with them. Checkout thisarticle by Sramana Mitra that is somewhat old:Venture Capital in IndiaSramana lists almost all of the top VCs in Palo Alto - Matrix Partners, Kleiner, Sequoia, NEA, Battery, andBessermer Venture Partners and so on.... If anything, 90% of all VC in India are really Palo Alto VC firms.Europe and Middle East venture capital is more on less risky, very large Private Equity people ratherthan Venture Capital! They dont know or dont want to take risks like the Palo Alto VC firms.So make no mistake - the rules, approach, the pressures are all the same! 10
  • 11. THE INDIAN VC LANDSCAPE, WHAT THEY HAVE FUNDED ANDWHAT THEY SEEM TO BE FUNDING NOWThe Indian VC landscape gets the majority of money from US VC funds that set up offices in India (almostall the major ones - locate the US VC directory and look up their website to see where the Indian repsare) and have been and are funding many companies that provide the hockey stick growth or at leastfast growth companies at the time they were funded.Initially it was the time of IT Outsourcing and BPO Boom around 2004 to 2007 when a lot of theinvestment money found homes in Indian BPO companies - like ICICI One Source, now First Source, etc.At the same time they started funding many Mobile related startups - Mobile Banking, Mobile Ads, etc -given the hockey stick growth they saw with Rural Growth of Mobiles in India and among the urban,high income consumers. They also funded Travel Sites, Bus Ticket sites, etc where they saw fast growthjust given the paucity of such facilities in India - Clear Trip, RedBus, TicketVala, etc where they sawrightly so, fast growth.It is my guess that then they started seeing many ME-TOO websites - Oh - we are jinglee.com, just likeLinkedIn, we crowster - just like Twitter, etc and were sufficiently dismayed but see many manyopportunities in unexplored places - like what Mohanjit Jolly writes here eloquently:Will India Produce A Google?India has a vibrant VC scene and a lot of them also present. You just need to go find them, understandwhat makes them tick or not and see if your business is a fit for what they want to do. The best places tostart are the Us VC firm websites. They will lead you to the local offices and contacts. After the initialfew startups were funded, the Indian VCs seem to have hit a wall not finding enough early stage startupsto fund. Or they needed the rest of their $100M India fund to be reserved for their follow on rounds.Whatever the reason, right now these VCs in India also seem to have moved away from the early stagestartups preferring only later stage ones! So as of now, the situation with Indian VCs is not that good! 11
  • 12. I think many of the India funds may not have reached maturity yet for them to return monies to theirLimited Partners. So it will be very hard to come by any total Fund Return Stats. In fact look at theseStats for August 2009:India Venture Capital Stats: August 2009They are not even disclosing the investment size. I think it will be difficult to calculate even company bycompany Return X! The first half of 2009 shows a sharp fall compared to first half of 2008:Venture Capital firms invest $117-M in India during H1 2009From $413M for the first half of 2008, it has fallen to $117M in the first half of 2009. I hope this is notdisillusionment with the availability of enough plans in India with the J curve of growth! This does notmean that good companies in India cannot be grown to be good, profitable companies. It just meansthat the kinds of companies with the J Curve of growth are not found in enough numbers in India.Not surprised that many of the VC funds that came in looking for Early Stage deals quietly went intoother areas like real estate and other later stage deals. If you cannot find enough high growthcompanies, you could invest the bulk of the money in a few large deals and make at least a respectable5 to 10% on the whole. Beats making minus 20% at the end of the fund!Understanding how and when VC capital works makes us understand what VCs in India do also. Not thatit helps the entrepreneur any, but at least you can understand it as a rational business decision and notsome genetic defect with the VCs! 12
  • 13. HOW DO I IDENTIFY THAT JACKPOT BUSINESS PLAN SUITABLEFOR VCS WITH THE POTENTIAL HOCKEY CURVE OR J CURVEGROWTH?There are companies in India that are getting funded by VCs even now; a few of them in Early Stage butall of them seem to promise a steep growth curve.Mobile Payments that rely upon Rural adoption of phones where farmers can easily transact where theyare using SMS without having to travel to the nearest State Bank in the nearest town. Or Mobile Gamesstartups that show increasing adoption of slightly more capable phones beyond the Urban Professionalsin Tier 1 cities to tier 2 and tier cities. Here also the growth rate seems promising.Travel sites in India rapidly converted a lot of people to book tickets online (starting with Indian Railways- The Pioneer!) instead of dealing with paper. This rapid growth in millions and millions of customersattracted a lot of VCs to companies like Clear Trip, makeMyTrip, etc.Or Rural Solar Generation projects that have the potential of adoption in the rest of India, in villageswhere India lives. Anywhere, where you have a potential population is waiting for a solution and is inmillions and millions in numbers and the adoption is expected to be rapid, VC money, even early stagemay be easy to line up.Enterprise Software if SaaS based and you show rapid growth as an alternative to traditional licensedsoftware with Small and Medium sized businesses, you could line up venture funding. The key here isnot to talk about potential but to show the past 6 months customer wins. If they show a hockey stickgrowth, you have a story!Of course, if your business can really look to the whole world as a potential market rather than India andyou are showing fast growth in the initial stages of your company, again you may be a good candidate.This applies only to early stage venture capital. If you are midstage or late stage and you are showingsteady growth, you could line up venture capital again.This is not to say that you are a bad business or you cannot build a profitable business slowly,bootstrapping your operation. It just means you may not fit the profile of a VC investment! 13
  • 14. HOW TO IDENTIFY THE RIGHT KIND OF VENTURE CAPITALCOMPANY AND THE PARTNER LIKELY TO FUND YOUAs outlined in the previous entries, Venture Capital companies and their General Partners (The peoplewho run the VC firm) are beholden to the Limited Partners, the very very wealthy individuals and hugePension Funds that take a small portion of their monies and give them to VC firms to invest in high risk,high return investments.As such, every month they need to show how many business proposals they generated, how many theyturned down to earn their 2 to 3% Management Fee that they pay themselves every year out of thetotal money raised. This means that VCs will give you meetings - lots of meetings. Many of them aregood and will not waste your time but a lot of them will so that you can become part of weekly statistic.It is up to you, the entrepreneur to make sure that you approach only the RIGHT VC FIRM for you andthe right PARTNER within that VC firm that is dealing with companies like yours. If you want to waste alot of time feeling good about talking to many, many VCs, you should go ahead. But unless many planetsand stars are lined up correctly, you will just be wasting your time.You can do a lot of short listing by going to the VC firms web site and learning a lot about the kinds ofinvestments that are interested in and more importantly the kinds of investments they are doingCURRENTLY! If all they are interested currently are fast growing Travel or Mobile businesses, pitching anenterprise software company to them is a waste of time!First, narrow down by stage. If you are looking for Seed or First Round Capital for a technology company,make sure that the objectives of the VC firm clearly say that they are interested in Early Stage. Also lookfor amounts that they say they invest in the first round - $30K to $2M in the Indian context may signalan early stage investor. If they say that they are looking to invest from $5M to $25M they are clearly latestage, no matter what their web site says.Also, look through their Portfolio and see if they have funded companies similar to yours. Too similar,you will be wasting a lot of time only to be told that they already have a similar company they haveinvested in. Remember that no VC firm ever signs an NDA. So you will be sharing your business planentirely at your own risk!Look at the different partners and their backgrounds- Select partners that have some operationalbackground - either high positions in related companies or an entrepreneurial background. People whoare fresh off the MBA school or Investment Banking experiences only, I will shy away from. They may 14
  • 15. not know what it takes to start a company and run it! They will get in your way rather than help youeven if you land VC money!Dont waste your time with VC companies that clearly say they are interested in Consumer IT, notSoftware, if you have an Enterprise Software company. Similarly even if their web site says somethinglike Early Stage Information Technology company and their last three investments were Real Estate inMumbai, you want to shy away from them. This is true of Indian VC firms (branches of US firms) that arebecoming desperate as their funds are getting older and nearer their end and they need to invest andshow some returns.You can also attend industry and networking events, meet some of these VCs and ask them specificquestions about what they are interested in and whether they would be interested in some companylike yours. Then do the research any way and make sure that there is a fit between what you do andwhat they are looking for. Look at the last three or four investments they have made. Are they similar instage and industry as yours? Are they early or late stage companies?Find out how old their current fund is. If they are already 5 years old, they will most likely invest the restof the money they have in their current companies. If they are one year old, they are looking foryounger companies. You can do a lot of due diligence before you even approach any VC.Just remember that the VC is not there to build an Indian Ecosystem or to prove that India can come upwith innovative companies or to provide you with risk money so that you can find out if your idea isgood or not. They are there simply to invest the money they took from their limited partners andreturn back 10X or 20X that money. The rest may be your own assumptions and dont be disappointed ifthey dont meet your wrong expectations.And believe me, there are no big Asian VC funds of European VC Funds or Middle East VC funds that doEarly stage investing. There are only major US Funds and they are mostly the only ones that invest inearly stage in India through their own offices or giving it to Indian VC firms they trust. In India, even theywait for a lot of risks to be taken away before they invest. 15
  • 16. THE COMING GLOBAL FREEZE IN VENTURE CAPITAL ANDIMPLICATIONS FOR INDIAN VC MONIESEarlier this year, around January, Forbes magazine published this article entitled:Venture Capitals Coming CollapseIt quoted that many VC firms, especially the US VC firms that raised record amounts of money duringand immediately after the Dot Com boom had invested willy nilly in all kinds of stupid investments andhave a net return of -1%. Thats what this article talked about.Not surprising! VC had lost their minds around the Dot com boom and has not gained it back even now,in my opinion. This is the reason they are not paying attention to things SaaS and investing actively inthem. There was a time when new Hardware, Software advances were closely followed by ventureinvestments, but after the dot com boom, it has been dumb Dot com investments or You Tube, Twitter,Face Book look alike. If anything Mobile Payment companies in India are actually very ground breakingtypes of investments.So we are seeing the result of this prediction already. Add to the poor returns, the recent GlobalEconomic downturn and many pension funds have shrunk in size since. The IPO market and Acquisitionsmarkets have been lack luster around the globe for the past three or four years. The result is this:Venture capital funding plummets 81% in quarterYear ago, third quarter ending September, US VC firms raised $8.5B. This year same quarter -$1.6B. Adrop of 81%!! Globally non US VC firms would have had a similar outlook also given the global economicweakness!What does this mean for Indian VC firms?Indian VC firms usually got the overflow money - they set apart like $100M out of say $600M they rosefor the firm and sent a similar amount to their own Israel offices to invest. Now with smaller funds, a lotof the Indian VC money may be scaled back. Indian VCs may become tighter with their existing funds,saving them to invest in their own current companies for follow on financing. Things are bound to gettighter in the next couple of years.It could go the other way if something like Twitter or Google emerges out of India and growsdomestically or internationally at phenomenal rates. Then they could put more money to work in India. 16
  • 17. But it also involves some level of Angel capital available. This is all the more reason that something likeNASSCOM should create an Angel Fund and provide the catalyst for new and exciting growth companiesto sprout! 17
  • 18. WHY DOES VCS THINK LIKE SHEEP, WHATS UP WITH THE FADWAVES OF INVESTING?As entrepreneurs, we are often frustrated with why VCs are not able to see the Gem of a startup wehave, appreciate the hard work we have put in and invest?The problem is that for VCs it pays to think like sheep! If anything thats the only way they are going tosurvive in their own VC Ecosystem!As described in the beginning few chapters of this VC saga (It is turning out to be a veritable Ramayana,although I intended it to be a few chapters ), VC investments is all about taking risks and making surethat your continued livelihood is assured by spreading the risks that you take among the others in yourecosystem!This happens by making sure that if you as a VC invest $1M in round one, you want to bring in two moreVCs and put in $2M each, instead of you chipping in all of the $6M yourself. That also happens, if thecompany is growing like Google and you just want to keep it all within your firm. Except for rare cases,most investments, multiple VC firms are brought in to invest.Helps you spread your risk, take some of the money you did not invest and put it some other companythat may hit the 20X jackpot! This is where thinking like sheep helps! If everybody is interested in SocialNetworking and you are here investing in a SaaS software company, you may not find the others toshare the risks with you! Putting money in a company that is not part of your current fad is risky for youwhen you go for subsequent rounds. You may not find others willing to jump in!Thats why Green Energy, anything Green are all the rage in VC circles now. Even Social Networking isout. Smartphone apps are in! Even there iPhone silly $1.99 apps are passe. IPhone enterpriseapplications are the hot thing now! Long time ago, VCs were pure technology buffs and they tookinformed risks in many different types of companies - Intel, Cisco, Fairchild Semiconductor, Sybase,Informix, etc.The Dot com boom brought a lot of VCs who had no business being VCs - fresh MBAs, InvestmentBankers, etc who spoiled the entire ecosystem for all of us, unfortunately! If you want VC money youshould not be swimming upstream. You will swimming against a lot of this sheep like thinking and thereare perfectly rational reasons for it! 18
  • 19. WHY DOES VCS THINK LIKE SHEEP, WHATS UP WITH THE FADWAVES OF INVESTING? - PART IIIf you ever get a chance please read this Harvard Business Review article - How Venture Capital Works? .I was listening to a panel of VCs online discuss the state of Venture Capital as of August 2009. They had avery good insight into why VCs tend to invest in the same kinds of startups at any time. It is this:At any time, certain technologies, approaches come of age because of the penetration of MobilePhones, Broadband, Laptops, desktops, RFID chips or other enabling technologies. This gives rise to tensmart people around the world suddenly finding the same solution to any problem and doessomething about it with a startup company.Unlike what we imagine at any time, ideas are dime a dozen. Please be assured that about 100 peoplehave the same bright idea as you at any time and ten of them have done something about it with astartup company. Those ten are the ones that graduate from the bootstrapped stage or Angel Investedstage to one of VC funding. 19
  • 20. Indian Travel sites, Mobile Payments companies in India, KPOs, BPOs, every one of them in India orGlobally have all found themselves in the growth pattern above. Thats when they get funded. Theabove graph also shows the importance of Angel Investors in India. They are the engine that gets therest of the investments, innovations, going! 20
  • 21. FOSTERING INNOVATION AND NEW STARTUPS DURING TOUGHTIMESAs seen in my previous entry, there is a gap between an Idea and Venture Capital. That is bridged byAngel Investments and Bootstrapping money. For services companies this is no big deal since you mayhave cash flow from Day 1 after spending minimally on starting small, incorporating and may be evenproviding services yourselves.However, product companies have this gap as a huge insurmountable trench sometimes that cannot becrossed easily.Thats where True Angel Investments are a crucial and indispensable part of fostering a ProductEcosystem in India. This does not mean Private Equity masquerading as Angel Investing, askingentrepreneurs where they have already crossed the Technology Risk in terms of "Do You already have aproduct you can sell?" or the Business Risk as in "How many customers do you already have?".Angel Investments should be Pre-Technology Risk and Pre-Business Risk and this means not only justsomeone to give you money but more importantly, their wisdom and experience in building similarcompanies themselves. "Similar" is very important since Services and Product companies are twodifferent kinds of beasts. Lessons learned in one may not easily translate into another and may misleadyou sometimes!In The Indian Context, Incubators like YCombinator and TechStars are good role models. Both areincubators that provide much needed Angel Capital just based on your idea, space, meeting rooms andmost importantly, a whole network of Mentors made up of Entrepreneurs, Angel Investors and Venturecapitalists.TechStars was cofounded by Brad Feld, one of the more successful VCs consistently and operates out ofBoulder, Co and now Boston, MA. They are very open with how it is done if you read their details page.They accept only 20 companies at a time and only during specific periods in a year. They provide $6000per founder per three months or so, maximum of $18,000 per start up for 6% of the company.Most importantly they provide a lot of mentoring during the three months or so you develop yourproduct, provide you a demo day where you can demonstrate the products, they invite and in factsponsored by VCs. They have about 60 to 70% of their startups either not needing any more money orraising the next round of VC money. This is a model that can be very useful if NASSCOM could organizeor at least facilitate the organization of such incubators! 21
  • 22. The large IT service companies, their founders could all be interested in something like this. You needideas and the seed capital to sprout 1000 startups if you need five Google like successes! But it will beworth it and will truly build a product ecosystem! It does not have to be Google like businesses. It can bebusinesses that exploit SaaS, a brand new market like India or some sector of India thats growing fastlike Mobiles. But the key is that they need to show a convincing Growth Curve!If it does not have a growth curve like that, it can still make a comfortable, profitable business for youthat are growing at a more sedate pace. That does not mean it is not worth going after, it just means itdoes not fit THIS model of funding, growth and faster exits! We have seen companies like Bharti, TataTelecom, Reliance Telecom and others grow into huge, huge businesses on the back of enormousgrowth. There will be hundreds of others also! 22
  • 23. VC VALUATIONS AND EXITS - THE REASON WHY A VC WOULD GIVEYOU MONEYAshim Bose referring to the company Hubspot and their continued Venture Funding is a classic casestudy that makes my points about Why and How Venture Capital Funding and Exits Work in the idealcase, recession or no recession, global slowdown or no slowdown. First, Hubspot is a SaaS MarketingAutomation company focused on what they call VSB - Very Small Business as opposed to SalesForce.comwhich is focused on non-VSBs!They get started in 2006 with a $500,000 Seed funding round.http://www.hubspot.com/blog/bid/1331/Press-Release-HubSpot-Announces-Seed-Round-FundingThis was raised from Private Investors. Then in September 2007 they raised a Series A fund of $5M. TheVC this time is General Catalyst Partners.http://www.masshightech.com/stories/2007/09/10/daily39-HubSpot-spotted-5M-in-first-funding.htmlThen in May 2008 they raise a Series B of $12M. The VCs this time are General Catalyst Partners andMatrix Partners.http://www.masshightech.com/stories/2008/05/12/weekly12-HubSpot-grows-grabs-a-12M-round-two.htmlThen in October 2009 they raise a Series C of $16M.http://www.masshightech.com/stories/2009/10/19/daily5-HubSpot-hauls-in-16M-in-Series-C.htmlThe VCs this time are General Catalyst Partners, Matrix Partners and Scale Venture Partners ofCalifornia.The above case study is a good case study in which everything goes right simply because they end uplining up customers in a J curve or a hockey stick pattern. This shows a couple of things:VCs like spreading risk, bringing in more VCs in future rounds. But increasing valuations will happen onlywhen the new investors feel that the growth is fast and genuine. Otherwise they would not put theirmoney that they need to return back to their limited partners in a10X or 20X multiple. 23
  • 24. I am sure that the $33M or so raised so far will be gotten back in a decent multiple when the company issold for $200M or $300M to someone like Oracle, SAP or IBM. The IPO market in the US is also showingsigns of returning and that would make sure that the returns are even more than an acquisition.In India, VCs may invest $50K, $2M, $5M and $10M in seed, A, B and C rounds if a company like Hubspotfocuses on the Indian market with the same kind of business model. But the key is showing consistentgrowth so that subsequent rounds are easy and safe for other investors to jump in.Hubspot is an unusual example. 80% of VC funded companies may not go this way. They may go theother way where future rounds of funding may be Down-Rounds where a new round is at a valuationlower than the previous ones. In those cases, the valuations may not go in the positive direction all thetime. But thats the risk VCs take sometimes.Valuation is more an Art than a Science. Sometimes there is no explaining the fact that some companywhich has no business model and no revenues, like Twitter having a valuation of $1.3B. A valuation iswhat some new comer is willing to put in new monies at. 24
  • 25. VCS, ANGELS AND CONTROL OF COMPANYIf you really like controlling your company, the pace, the direction, vision, mission of the company, stayaway from VCs and certain types of Angels! Venture Capital is fundamentally structured in ways thatwith each subsequent round of funding, you lose significant chunks of company control. You own lessand less of the company, the Board of Directors is getting loaded with more and more of the VCs boardmembers. They could bring in a CEO and replace you anytime!He who owns the Gold, makes the rules!Angels come in all colors and flavors. There are angels who write a check and never bother you. Thereare angels who write a small check and call you on Saturday evening 10 p.m to tell you about a change indirection your company should take, just because they thought of it at that time after a few drinks!This is also where you selecting a VC who has operational experience themselves or have beenentrepreneurs is very important. VCs with no operational experience will have wild and wooly ideas thatwill make your skin crawl and you may feel that you are under the mercy of a pack of wild boars that arerunning in many different directions with your company in tow!If the company is growing at a significant fast pace and subsequent valuations are increasing fast, youhold the reins. You can tell the VC to go sit in a corner. If that hockey stick growth is not there, then theVC may push down your companys throat all kinds of corrective actions, even drastic changes in whatthey funded. I know of a VC funded company that was a Dot com shop selling consumer goods that wasreborn as a Business to Business startup in Insurance!!There are always people like Sergei Brin and Larry Page of Google who made sure that held control ofthings that they cared most about - the technology and some key aspects of culture while theyacquiesced to VCs and other investors in bringing in an able CEO, Erik Schmidt to manage things theydidnt want to deal with. If you take VC money, you need to make sure that you have enough control todo the things you care about, the way you want them done. VC Money equals Control and take it if youknow what and how much control you want to relinquish! 25
  • 26. COMMENTS BY ADITYALet me add a few bits from my experience of being on the investment side for a few years and then afew years of interaction with VCs the world over and startups as well.It’s the high growth, large market opportunity businesses that get VC funding. That is probably 1 - 2% ofall businesses being started. The rest of 98% are probably medium - low growth or niche market orlifestyle business. A lifestyle business is one which maintains a good lifestyle for the entrepreneurs anddoesnt require a lot of work (read 9 to 6). Most of the businesses fall into one of these categories. WhileVCs are glamorized as the funding agencies they are not the only source. The rest of 98% can turn to thefollowing in India:1. Government: Govt usually has grants or subsidy schemes for different kinds of businesses that theywant to support in line with their policy. One example that is probably relevant for this forum is theTePP (Technoentrepreneurship Program) under Department of Science and Technology. Under thisprogram, a grant is given for developing an innovative product. Do note that this is a grant and not aloan or an investment.2. Banks: Banks offer loans under various schemes again as a part of Govt policy. Under one suchscheme which is not very well known, one can get a loan upto Rs 1 cr without any collateral.Government of India becomes the guarantor and pays the bank if the loan is not repaid. One needs toget registered as an SME and then chase the bank officials a lot to get this done. I know a startup whichgot this fund. They had to work hard at it - visiting multiple offices and meeting multiple people. In theend they realized that talking to anyone less than a DGM doesnt help. Btw, they didnt have to pay abribe.3. Angels: Angels are friends and family who take a leap of faith with you. Another set of angels are HighNetworth Individuals who are looking for high returns in unfamiliar businesses. Again not glamorized,but this is the most frequent form of funding. A lot of large businesses today used this when they weregrowing up. Eg - Startbucks. Indiabulls. India today has two large organized angel groups - Indian Angelsand Mumbai Angels. Both have been investing quite actively and have even funded just ideas. Also theyinvest in all kinds of sectors.4. Customer: This is the most ignored one but Im sure that a lot of people on this forum have used thissource. What I do not see very frequently in India is the entrepreneur collecting money from thecustomer for the product development. The customer typically does this as it’s a burning problem for 26
  • 27. him/her and also because they are the leaders in their space. The payment serves as an advance interms of accounting. While rare in India, Ive seen at least one entrepreneur use it in Mumbai.5. Incubators: Incubators provide support of infrastructure, advice and their network in exchange forfees. However, some of them also offer cash assistance again for equity. For eg the incubator at my almamater IIM Bangalore has an arrangement with NSR where an incubate becomes qualified for cashinvestment upto Rs 25 Lacs. The iAccelerator program at IIM A is modeled after the Y Combinator andagain the startups get a stipend while theyre in the program. Its entering its third edition now andwould be in Bangalore this time.6. Corporate: Large corporations are always keen on entering new markets. They find it difficult to dothat with their structure, processes etc. Therefore, several of them fund startups in-house. The goodpart is the support and the bad part is that youre probably not far enough from the corporate. Ive donethis twice and my advice is to do it only if youre a separate company from day 0. A similar option is acorporate VC. They may relax the financial parameters a bit (and only a bit!) if there is alignment withthe strategic goal. A great example in Intel Capital. They are the largest VC on earth in terms of moneydeployed and in terms of live portfolio (400+ the last time I checked). They tend to invest more in areasthat helps Intels businesses.All the options above give an entrepreneur capital upto max of Rs 2 - 2.5 Cr or $ 0.5 million (exceptoption 6). Hopefully this gets them to the next stage where 3 - 5 million is required and a no of VCsoperate in that segment. There also have been talks of 3 - 4 funds coming in at $ 1 - 2 Million as well butthat is still to be seen.In general the VCs in India face a unique challenge. They find difficult to put in the usual silicon valleykind of money in a similar startup in India because it doesnt need that much cash. But they need to lookat that size because the entire model and even LPs are a copy paste of the US one. One the other hand,there are companies in India in growth stage where risk is lower and returns good. So they end upinvesting there rather than the classic startup. Similarly PE funds find it difficult to get deals. If the dealsare there then valuation is too high due to competition. So they have moved to PIPE deals. In all, sincethe investors raised money abroad and used the same model, the VCs have been forced to become PEswhile the PEs have been forced to become stock market investors leaving large gap in early stagefunding. It’s getting addressed but not fast enough. 27
  • 28. ANOTHER CASE STUDY HOT OFF THE PRESS!Google Pays $750M (yes, thats seven hundred and fifty million dollars!!) in stock to buy AdMob, astartup company that serves ads on Smart Phones just as Double Click serves ads to Web Pages!Heres why they paid this princely sum! The key is very fast growth - They served 2.6 billion mobile adson iPhone and iPodTouches in September 2009 as compared to 130million ads in September 2008. Theyraised about $50 Million in a number of rounds, and grew to a 142 people company. Google could havedone this themselves (this is questionable since Google is already a big company with a big beauracracy!)but decided to buy the company instead of doing it from scratch. Double-click for Web pages and nowthey will incorporate Ad Sense for mobile ads also.Lessons from a VC angle - This need not have come from the US. There are some startups here in Indiaalso that does the same thing. This is a 15X return for VCs. No wonder they shelled out $50M in hurry.the only slide they may have seen is the growth slide.Indian companies can also do this as long as they keep close tabs on whats happening and moreimportantly be capable of taking informed bets with nothing but their own guts telling them where theworld is going! Think Smart Phones! Laptops are about to be displaced by Handheld devices (notnecessarily just Smart Phones - iPodTouches are really small handheld computers with wifi connectivitywithout the voice part alone - lots of adopters - it works at home with wifi , it works at work with wifi.There is no need to sign up for expensive data plans! 28
  • 29. WHAT DOES HAVING A LOT OF MID-MARKET VCS REALLY MEAN?I was checking out an Indian VC conference list of attendees. Majority of the VCs were Mid-MarketVCs! Mid-Market VCs are those that provide expansion capital. They come way after Seed and EarlyStage, Series A, even sometimes, Series B capital. And the majority of them were Indian and Middle EastVenture Capitalists. What struck me was that almost ALL of the Early Stage VCs were American VCsthat put their money to work directly through their Indian branches or work through a VC that set up shopin India after spending a lot of years in the US as a VC.What does this really mean?We hear endless talk about "Going up the value chain" and "Building an IP base instead or a services basein India". Unfortunately, none of these things will happen if every Indian VC is a mid-market VC!! Youneed people to take some bold risks to make any of the above happen! If every VC waits for everytechnical and business risk to be gone, they could as well be bankers, not VCs. This is not to be takenlightly or brushed off. Risk taking VCs are the lifeblood of IP creation and creation of "googles" and"oracles" in India.Hope ten years from now, the ratio of Mid-market VCs to Early Stage VCs is reversed!As someone who has lived in the Boston area and then Colorado and now in Silicon Valley, believe mewhen I say that just waiting around and hoping we have a vibrant ecosystem is just whistling in the wind!I have seen firsthand, why the Boston/New England area gets only the number 2 or 3 position in ventureand angel funding and Colorado a distant third, when Silicon Valley significantly outperforms all theother regions, year after year, through big busts like the dotcom bust and still manages to power on!I had posted this in the China Vs India discussion. It is worth thinking about in this context also. This isthe Prosperity Supply Chain that seems to be needed to build a powerful venture ecosystem. If any link inthe whole chain is missing, it does not fully form and bear fruits. For example, Boston has all the otheringredients like Research, Very Talented people but does not have that many risk taking Angels and VCs.Colorado lags in many of these ingredients and so lags behind even Boston. 29
  • 30. THE PROSPERITY SUPPLY CHAINArvinds note instigated this entry I have been meaning to write for a long time. This is one of those sixblind men and the elephant story deal! Its entrepreneurs, its the government, its research, its theeducation system, etc.The thing is that all of these are right and if you look at how it works successfully in other countries likethe US (Or used to!), it appears to be a proper Prosperity Supply Chain and all components in the supplychain needs different people, different supports but all of them make the elephant!Research - Huge amounts of money going after national topics of importance, defense, technology,scientific topics that could be strategic to the country. Unless we have many places like IISC, IndianSpace Research Institute, TIFR, etc that get money to do research in many interesting topics likeelectronics, computer science, biotechnology, aerospace, rocketry, medicine, agriculture, that thegovernment deems is of strategic importance to the country. Masters and PHD students interested in puresciences are key here and you need to have goals to produce so many of these every year focusing only onpure science for its own sake! Entrepreneurs talking about local innovation is meaningless without thislarge factory of ideas from which to choose from.Advanced Development - This is to take fruitful research ideas and do the first baby steps towardsproduct development but not quite. This is where Small Business Innovation Research (SBIR) grants thatArvind mentions could come in very handy. The US government identifies Advanced ProductDevelopment topics that it deems of national strategic interest. If you are an entrepreneur you get moneyto propose taking a research idea in one of these topics and develop a product out of it. Yes. You getmoney to experiment whether a research idea can be turned into a product. The entrepreneur ownseverything at the end of the project - they just owe a report to the funding agency!Early and Seed Stage Venture Capital - This is where many countries develop an investing, risk takingmindset and money to back up 20 crazy ideas so that one of them is a blockbuster. We can name anythingVenture capital but unless it does the above it is just glorified banking. India needs to do a lot in this area.Growth Ecosystem - This is where growth capital, Central and State government supports, incentives,entrepreneurs mentoring individual state governments towards these come in. Large workforce educatedin specific skills needed for these growth stage companies also need to be part of the supply chain at thisstage. 30
  • 31. Global Competitiveness and Export - Huge internal consumption without being competitive globally willnot save your industry in the long run - witness the US automotive industry and how it could not competewith Japanese automakers paving their downfall over a fifty year period. This is a great example if exportand global competitiveness is ignored in the long run!Floundering around and addressing individual items in parts of this supply chain may not do much exceptpromote protectionism which does not do good in the long run anyway, China or India. Its a long termproject and all aspects needs to be addressed systematically. Addressing individual things withoutaddressing others will just result in unintended consequences, unfortunately!When I was in India, I was so thrilled and impressed by Mr.Narayana Murthys article - Securing Indiasscience future.The nice thing about Mr.Narayana Murthy is that he seems to be doing something about it all by himself -Infosys Prize 2009 Laureates Awarded at Grand CeremonyThese are what needs to happen in the beginning of the supply chain if very innovative companies,Googles and Oracles were expected of India, ten years from now! So the picture is not all that bleak, butthe other things need to fall in place also! Of course, the Government needs to do its part, set up all theright incentives and get out of the way. No give away, no direct investment, but just act as a catalyst in achemical reaction and make the reaction happen. 31
  • 32. ONE INVALUABLE TOOL IN THE ENTREPRENEURS CORNERIf you are an entrepreneur or founder or CEO or President of a company, you can become a memberof www.thefunded.com . It is meant for entrepreneurs to rate Venture capital firms and partners withinthose firms.Check it out! It can be very valuable when you are considering VC firms A, B and C. What can youexpect from which one? They do cover a lot of Indian VC firms also.Much more valuable than you think! 32