Venture capital investing at the IDCIn this article we’ll try to answer the question of whether your business is the kind of business thatwe are looking to fund at the Venture Capital unit of the Industrial Development Corporation (IDC),taking into account the mandate within which we must operate.Keep this thought in mind and then let’s work backwards from here: We’re looking for a businesswhere globally unique technology creates a long term sustainable competitive advantage that allowscash to be generated and returned to the investor in excess of 30% of the amount invested, eachyear, for the life of the investment, in other words a real after tax internal rate of return of at least30%, or ca 4x the initial investment returned to the investor in 4 years!Well that sounds simple enough, but in reality it’s not. Let’s assume you can tick the box that saysyou have proprietary technology. You’re half way there! Wrong. You’ve got proprietary technology,but is that technology driving a long term and sustainable competitive advantage, or could yourcompetitor replicate or slightly improve on your offering thereby negating your advantage? Now Ihear you saying that technology is not the only means of creating and protecting a competitiveadvantage. You’re right, but for the time being our mandate is restrictive in this sense, and for goodreasons.What about the stage of growth that the technology or business is going through? In a nutshell, wedon’t invest in an idea. We need the team to have progressed to the point of a working prototype.This way, when we invest, there is some value on the entrepreneur’s side to balance against ourcash contribution. If we invested merely in an idea, then we could only ascribe a tiny fraction ofvalue to the entrepreneur’s contribution, and accordingly we’d end up with control of the company,which we not only don’t want, but aren’t mandated to do.We invest up to R15m in the first round, for an equity position of between 25% plus one share and50% less one share. We’re then able to invest up to R25m in follow-on equity capital in subsequentrounds. We’d prefer your business not to be incorporated when you come to us, but if it is, that’salso fine. We’re an open fund, in the sense that our money is a balance sheet allocation and doesnot have a specific time period attached to it, meaning that if your business will only make economicsense after a number of years, and you’re not the star investment, we have the capacity to carry onfunding you with the purpose of creating sustainable businesses. Closed funds may not have thisluxury and your investment could be sidelined to free capacity to invest in the fund’s stars.
OK, so you’ve ticked the mandate boxes and you’re getting pretty excited. We now turn ourattention to the financials, which although being discussed now, are not a starting point, but ratherthe end point. Your income statement and balance sheet are prepared showing monthly figures forthe first couple of years, and thereafter quarterly. You’ve run the numbers through a discountedcash flow analysis, assumed a weighted average cost of capital of ca 35%, played with the equity tothe investor and calculated the real after tax IRR, and it’s in excess of 30%. Well done! Now we’reinterested, but not convinced. This is where your face to face discussion with us, as well as thesupporting business plan becomes important. Essentially you need to support your financial claimswith sound business logic and defendable assumptions. There are 3 main categories of assumptionsthat you need to focus on. I’ll tackle them each separately.Team: The cash that an investment returns is really a function of revenue and expenses. Can youconvince us that the team standing before us is intelligent, driven, committed and ultimately capableof managing the start-up business and driving meaningful revenue from sales? This may soundsimple enough, but dig a little deeper into the less obvious management issues that support successin these two areas, and you’ll unearth a multitude of other questions that we would like answered.For example: Is the CEO the right person for the job? What is the depth of his/her network? Has s/heconvinced top quality peers to join in the venture? Has s/he convinced quality advisors to associatetheir name and experience to the company? Has s/he amongst other attributes the qualities toinspire, lead, motivate, manage, sell, relate, and empathise? Is the management team trustworthy?Have they identified their weaknesses and put a plan in place to address them? Will thetechnologists, the brains behind the proprietary intellectual property and associated unfaircompetitive advantage be involved in the business on a full time basis and remain exclusivelycommitted to the success of the business? Who’s the go-to person on technical matters? Who’sgoing to be held accountable for sales? Does this person have real and meaningful sales experience?Have they sold a new product into the market before, from the relatively weak position of a start-up? Who can we call on with regard to monthly management reports and monthly financialstatements? What experience does the CFO bring to the table and do we feel comfortable that theCFO will be managing the cash appropriately? Are salary expectations for the management teamreasonable and justifiable? At the IDC we don’t ask for any personal surety from the entrepreneurs,so commitment is shown to some degree by salary expectations, as well as previous cashcontributions from the entrepreneurs to get the company to the point where we can look to invest.Finally is the management team adequately incentivised with equity or profit sharing? Thesequestions, when answered in a face to face sitting with the entrepreneur, should give us a gut feel asto whether this is a team that can make our money work. If however we see notable gaps thathaven’t been addressed by the entrepreneur, it doesn’t mean that we won’t look further. On thecontrary, we’ll try to assist the entrepreneur in addressing these shortcomings.Technical: Here we look at two aspects of commercialising the business, namely what is theunderlying technology and how much capital is required to take the product to the point where thebusiness no longer needs cash injections from us? On the technology side we need to understand ifits uniqueness is defendable and whether, if applicable, it can scale. On the cost side, along with
comfort around the accuracy of the budgets, we need to be convinced that potential technical risksand mitigations have been identified. I suggest keeping your budgets as granular as possible, with aseparate line item for every expense, and monthly for 36 months, or at least until 12 months aftercash flow break even. It’s also a good idea to overlay the technical milestones with the technicalbudget and to articulate funding milestones against which cash can be injected. It simply shows usthat you understand and endeavour to minimise our investment risk.Sales & Marketing: This is where most start-up businesses struggle. It is very seldom that thebusiness fails to develop the product to the market’s specification. It is far more likely that thebusiness has no idea how to transition from product development to sales. Accordingly, aninordinate amount of effort needs to be put towards planning this phase of growth and painting abelievable picture of the market and how you intend to address it. The end answer to this analysis isthe revenue line and marketing expense section of the income statement, but once again it’s thebelievability of these lines that is under our scrutiny. Begin by explaining the need being addressed.Where is the pain? It is this key thought that drives everything! Is what you are producing of anybenefit to anyone? If the answer to this is no, then stop. If it’s yes, then what is the benefit, to whomand how much will they pay for it? If you struggle to articulate this on paper in a business plan or in aroom with focused investors, then how are you going to convince your customers in the short spaceof time they afford you? Next study the existing value chain, its key contributors and theirincentives, then assess the market size, identify your competitors and the competitive forces at play,segment the market and identify your target, set your price, identify possible seasonality, identifyyour distribution channels and the economics thereof, elaborate on how you intend to promote yourproduct, and lastly anticipate your competitors’ response. Then work from first principles to build upyour sales budget. Determine where you anticipate your first sale to come from, then your next saleand so on. It’s easy to think big once you’ve sold your millionth unit, but you need to convince usthat you can sell your first unit, and we’ll then take it from there. Finally, ensure that you areallocating enough resources to support the enablement of your marketing strategy.Now you’re sitting with financials that are established from first principles, and the assumptionsdriving your financials are believable and documented in your business plan. You’re ready to look forfunding!In the case of the IDC, give us a call or email through your business plan. Your executive summaryshould show us that you’ve read our mandate and that your investment proposal meets ourconditions. We’ll follow up on your request and assuming there are no mandate issues, we’ll meetface to face or discuss the application over the phone. We’ll then undertake and initial assessmentof the proposal and if the team agrees that it fits our mandate we’ll propose a due diligence. It’s atthis stage that we really dig deeply into the assumptions driving your financials. A believablebusiness plan will shorten this process.
We hope this article serves as a starting point for further discussion on start-up equity investment inSouth Africa. We’d like to conclude with a disclaimer that this is a high level overview of how we doit in the VC business unit at the IDC. It is certainly not the only approach taken by equity investors inSouth Africa.About the AuthorPeter van der Zee is a venture capitalist at the Industrial Development Corporation (IDC) where theventure capital team make significant early stage equity investments into promising technologycompanies with global aspirations. Peter holds a B.Bus.Sci (Information Systems) from UCT as well asan MBA (cum laude) from GIBS. To talk to us about your investment opportunity, please contact theIDC Venture Capital unit on +27 11 269 3730.