Tuesday, May 8, 2007

How venture capital funding works

May 08, 2007, www.rediff.com, Co-author-Puneet Bambha

It is popularly believed that venture capitalists fund only established players and proven products. There is a lot of cynicism amongst many about all the hype that private equity and venture capital is getting in India of late.
However, the truth is that, in recent times in India, the VCs have actually provided capital to relatively new, start-up companies that have a reasonable, though not certain, prospects to develop into highly profitable ventures. Travelguru.com is a case in point, funded by Sequoia Capital and Battery Ventures.
The advent of firms like Helion Ventures with a $140 million corpus is helping the VC scenario to improve in the country. The three key people behind Helion Ventures, Ashish Gupta, Sanjeev Aggarwal and Kanwaljit Singh, all carry with them a successful track record across various companies in the international arena.
What is interesting is that for first time in India, venture capital will be backed by successful entrepreneurs who themselves have a hands-on experience in handling and developing businesses.
The National Venture Capital Association defines venture capital as: "Money provided by professionals who invest alongside management in young, rapidly growing companies that have the potential to develop into significant economic contributors."
Innovation is the key driver of competitiveness within organisations as well as within countries. It has been well said: "Nothing is more powerful than an idea whose time has come." However, innovative ideas need more than research and knowledge to succeed.
They need not only financial, but also, managerial (technical, marketing and HR), support to achieve success. This support is lent in many forms by private funding and incubation organisations such as venture capitalists.
Akhil Gupta, JMD & CFO of? Bharti Airtel, once remarked, "While we could have raised funding from other sources, Warburg Pincus' involvement helped us in scaling up significantly." Almost identical has been the findings of a research conducted recently by Venture Intelligence (founded by Arun Natarajan, a leading provider of information and networking services to the private equity and venture capital ecosystem in India) with the guidance of Prof. Amit Bubna of Indian School of Business, Hyderabad, to study the economic impact of PE and VCs on the Indian businesses.
The following are some of the interesting observations of this study:
The study shows that the PE and VC backed companies grew faster compared to the non-PE backed peers and even better than the benchmark indices like the NSE Nifty. They found that the sales of listed PE-backed companies grew at 22.9% as compared to 10% for non-PE-backed listed firms.
PE backed firms added more jobs to the economy and even the wages at listed PE financed firms grew at around 32% as compared to 6% for non-PE-backed firms.
An astonishing finding was that almost 96% of the top executives felt that without the support and the backing of private equity these companies would not have existed or would have grown at a slower rate, while only about 4% felt that they would have developed the same way even without PE funding.
The study also shows that the biggest support of the PE investors were provided in the area of strategic direction followed by the financial advice and then recruitment and the marketing activities.
Thus venture capital has become an important source of finance for innovative ideas that are risky and have a potential for high returns over a long-term horizon. Venture capitalist investment is driven by the expectation that the start-ups invested in could give them a higher rate of return than other firms.
In the process venture capitalists have created some of the best known companies in the world. Without VCs we might not have seen companies such as Apple, Compaq, Sun Microsystems, and Intel to name a few.
Some of the unique features of a VC firm are:
Investment in high-risk, high-returns ventures: As VCs invest in untested, innovative ideas the investments entail high risks. In return, they expect a much higher return than usual. (Internal Rate of return expected is generally in the range of 25 per cent to 40 per cent).
Participation in management: Besides providing finance, venture capitalists may also provide technical, marketing and strategic support. To safeguard their investment, they may also at times expect participation in management.
Expertise in managing funds: VCs generally invest in particular type of industries or some of them invest in particular type of businesses and hence have a prior experience and contacts in the specific industry which gives them an expertise in better management of the funds deployed.
Raises funds from several sources: A misconception among people is that venture capitalists are rich individuals who come together in a partnership. In fact, VCs are not necessarily rich and almost always deal with funds raised mainly from others. The various sources of funds are rich individuals, other investment funds, pension funds, endowment funds, et cetera, in addition to their own funds, if any.
Diversification of the portfolio: VCs reduce the risk of venture investing by developing a portfolio of companies and the norm followed by them is same as the portfolio managers, that is, not to put all the eggs in the same basket.
Exit after specified time: VCs are generally interested in exiting from a business after a pre-specified period. This period may usually range from 3 to 7 years.
Buyouts and second-stage financing are the most popular stages of venture capital financing. Globally, according to a report by PricewaterhouseCoopers, around 80 per cent of the total private equity investment is done at these stages.
However, in spite of the venture capital scenario improving, several specific VC funds are setting up shop in India, with the year 2006 having been a landmark year for VC funding in India.
Sumir Chadha, MD of Sequoia Capital India, feels that a slowdown could be on the cards for the year 2007 as the companies and investors may try to give some time and test the investment decisions made by them over the last year.
The first quarter of the calendar year 2007 is already over. There is no sign of the VC story slowing down. This is a good sign for all the entrepreneurs out there with an idea! If you have an idea, this is the time to tell it. You never know, someone might be listening round the corner!

Thursday, May 3, 2007

Valuation, Structuring & Monitoring Of The Deals By Vcs

3rd May 2007, www.indiainfoline.com, Co-author-Puneet Bambha

During the late 1990s, as the internet boom was at its peak so was the Venture Capital
(VC) and Private Equity (PE) activity. Led by the huge expectations of the Y2K coupled
with the soaring success of the large number of software startups, various VC firms were
enticed to promote and fund such kind of businesses. It is pertinent to note that ripple
effect of private funding was felt not only in US but across the globe including emerging
markets like India.
But what followed was nothing short of disaster. Firstly, there was the dotcom bust which
badly affected the fortunes of several leading firms including ChrysCapital, eVentures
India, Draper International and ConnectCapital etc. The damage was further accentuated
by the 9/11 attacks in the US followed by the general US economic slowdown. The US
being the largest source of private funding in the Indian markets, these events resulted in
premature death of private funding in India.
However what is interesting to note is that once again the VCs and PE players have
staged a comeback not only in developed markets but also in emerging markets like India
and China. The tide started turning again from 2003 and since then there has been no
looking back. See Graph 1 for the VC and PE investments in India since the year 2003.

The combined total investment of the PE and VC firms for the year 2003-2005 has been
close to $505 billion globally. Notably the share of VC firms has been close to $100
billion out of the total pie. For India, although the year 2006 saw record investments
which were far ahead of the expected $6bn for the year, the Indian share of the global pie
is still just close to 6-7%. While China still takes the lion’s share of the pie in the Asia
Pacific region.

An interesting observation is that slowly other emerging markets like South America,
Middle East and Asia Pacific have been increasing their respective shares over the last
few years. Also, over the past few years it has been noted that the various PE/VC firms
have been globalizing their investment base so as to diversify the risks and as well gain
from the world wide opportunities.
With so much of improvement in the VC scenario globally, and especially in India, and
with so much scope for improvement of the market share for India, understanding the
various aspects related to VC investments become pertinent for Indian businesses. In this
article, we look at the various approaches used by the VCs for valuation of a deal.
Valuation is one of the most important factors when obtaining VC funding. It gives rise
to maximum conflicts at the time of negotiation between the management & VCs. This is
because valuation is not an absolute but a relative factor, which may change from one
situation to another.
The Cost Based approach to business valuation is based on the premise that the
economic value of an asset can be determined by the cost of an asset. However, there is
usually controversy over definition of cost and the usage of different types of cost
(historical or current). Also, estimating the cost of Intangibles can be very judgmental.
The Market Based approach assumes that the value of the business can be assessed by
observing the value at which comparable business ownership interests presently are being
exchanged in either the public or private markets. But obtaining data in case of private
market deals can be difficult and there can be arguments over what is comparable.
Income Approach to business valuation estimate the value of the expected economic
benefits of ownership of the business as equal to the present value of expected future
income streams. The problems with this approach are that income forecasts are uncertain
and based on assumptions. Also, the process of estimating an appropriate discounting rate
for future earnings can become controversial.
Amongst the above three approaches, the Income approach is the one which is considered
to be the better one. The discount rate used in the calculation of the present value of
future earnings is generally very high if the VC is providing the funding at the start-up
stage (it can be as high as 70-80%). However, this approach may not work when it comes
to valuation of the early stage of enterprises where there is no certainty in case of future
cash flows or some tangible assets.
In early-stage investing, valuation is simpler. Valuation has little to do with the
company’s worth at that point of time. Valuation is derived from how much capital the
company needs and the percentage of the company the VCs would like to own, given the
high-risk nature of the investment. Except for a vague sense that the market being
addressed is adequately large, there is no pretense of knowing future revenues or
profitability. In fact, most VCs in this situation ignore all future earning forecasts after 18
to 24 months.

At the other extreme, valuation of large publicly-listed companies is much simpler.
Besides the traded stock price, these companies have dozens of equity analysts figuring
out what the stock is worth and which way it will move. The true value of these stocks is
as much a function of supply-demand and investor preferences, as they are of cash flows
and discount rates. Analyst estimates and the actual stock price typically fall within a
reasonable band.
This leaves the companies which are somewhere between the above two extremes. In
India, most investment opportunities are in such cases. These are often privately-held and
almost always project rapid growth (that’s why they need the funds in the first place).
The valuation process may get messy, as these are neither here nor there. Given the small
size and relatively early stage in their lifecycle, their future performance is subject to a
high level of variability.
The Valuation in such cases is a lot more about the softer factors – supply-demand for
deals, relationships, competitive dynamics, bull or bear nature of the investing
environment. The actual projections and valuation techniques may at times tend to be
more distracting than helpful.
Once a value is agreed upon by both the VC and the company, the next challenge is to
structure the deal. The objective is to choose an instrument (or a mix of instruments)
which would protect the interests of both the parties involved, that is, VCs and the
entrepreneur. The various instruments commonly used are Equity Shares, Convertible
and Non-Convertible Preference Shares, and Convertible and Non-Convertible
Debentures.
Investments made by VCs in early stages are usually in the form of debt or debt related
instruments, which allow them to keep their principal safe to guard against failure of an
enterprise. In case of later stage investments, they are usually made in the form of equity
or similar instruments. This is because during this stage, there is lesser uncertainty and
more chances of success of the enterprise. Thus, the deals are generally structured in a
way that would involve safety of principle and a chance to participate in the super profits
(if they occur). Thus, the usual deal structuring is that about 2/3rd of the investment is in
the form of debt related instruments and one third is in the form of pre-decided
proportion of equity.
Once a deal has been made, Monitoring the Project becomes of utmost importance to
the VCs. It has been well said that "A venture is most prone to failure during its first
three years of operation - the so-called 'valley of death'. A key to getting through these
early years is to avoid the obvious mistakes." – ‘Devising Venture Strategies' by Invest-
Tech Ltd.
Hence to safeguard their interest and to ensure the success of the project VCs usually
monitor the project on an ongoing basis. Their involvement in the venture can range from
sitting on the board of the company (in general about 30-60% board seats may be held by
the VCs) to providing consultancy services to reviewing the internal documents and
reports of the company on a regular basis. Seats on the board of the company are
generally a point of contention between the company’s management and the VCs. The
company management usually prefers to share less number of seats with the VCs.

Apart from Valuation, Structuring of the deal and Monitoring the Project, the Exit Route
is one of the most important factors in the VCs evaluation process. The VCs normally
invest for a range of 3-7 years and if the smooth exit route is not available then the VCs
might not like to commit funds no matter how attractive the project is. The various exit
options used by the VCs range from IPO’s, Secondary Offering, Acquisitions, Buy-Back,
and Third Party Sale.
It has been seen in the past that IPO’s and Acquisitions provide the maximum gain to the
VCs, averaging approximately 300% of the initial investment. Hence, they are also the
most commonly used exit routes. An IPO is also a preferred option by the company’s
management and/or the entrepreneur. IPO allows the original management to stay in
place and retain control of the company and also allows management who hold shares to
realize their value in the business or retain a share and benefit from the future growth of
the company. Example: SHAREKHAN, an Indian stock broking firm provided exit route
to three of its VCs (HSBC, Intel and Carlyl) holding 49% stake in the company in 2002
through an IPO.
Apart from the above, it is pertinent to note that the period 2003 – 04 onwards when the
private investors staged a comeback in the Indian Territory, the stock markets were at the
lower level and the valuations of the companies were not stretched. But now with such
high valuations, the private investors would be skeptical about investing liberally and
would be all the more choosy in making their investment decision in future. However,
investment bankers feel that even though now private investors would have to be choosy
but still there are several opportunities available in the Indian markets. To quote Mr.
Nandakumar Ranganathan, Head, Investment Banking, DBS Bank, “Going ahead, the
challenge for PE players will be to go beyond the obvious opportunities and mine out
undiscovered sectors. Companies need to be convinced about the value proposition,
which companies bring to the table, in addition to the funding”.

Wednesday, April 11, 2007

What VCs look for while funding a business

April 11, 2007, www.rediff.com, Co-author-Puneet Bambha

"In the world today, there's plenty of technology, plenty of entrepreneurs, plenty of money, plenty of venture capital. What's in short supply are great teams." -- John Doerr, Partner, KPCB.
Early investors in amazon.com, Apple Computers and the Body Shop got returns of 260, 1,692 and 10,500 times their initial investments, respectively. That's mind boggling. Now let's look at some other numbers.
According to http://www.1000ventures.com/, only six out of 1,000 business plans get funded on an average. Only about 5 per cent of the business plans are read beyond the executive summary and 10 per cent of proposals pass initial screening. Only and only 10 per cent of these screened proposals pass due diligence and receive funding.
The investor, at whichever stage of the venture he might be investing, as per a report by Lehman Brothers, makes detailed evaluation of the quality of people, quality of business and the quality of investment involved. A decision to invest is reached after several rounds of presentations and negotiations.
The most difficult to assess is however the quality of people. As John Doerr rightly put it, 'What's in short supply are great teams.'
So given a great idea, a great business plan, and plenty of money, will the people involved be able to pull the project through to make great returns possible for the investors?
Before deciding to invest in a project, venture capitalists (for the purpose of ease, we are using venture capitalists as the term representative of incubators, angel investors, private equity investors and mezzanine financiers) undertake a series of steps to evaluate the project.
The following paragraphs broadly explain the various steps of the evaluation process.
Initial Screening: VCs are in the business of making more than the average returns and only the proposals which can match or exceed the VCs expectation will get an attention from them. Thus initial screening is a step in which the venture capitalist reaches an initial decision to investigate further the investment (or not).
The initial screen is a cursory glance at the business plan to determine whether or not the proposal fits within the investor's areas of expertise. VCs carry out initial screening of all projects on the basis of some broad criteria.
For example, the screening process may limit projects to areas with which the venture capitalist is familiar in terms of product, technology or market scope. The size of investment, stage of financing and geographical location could also be used as the broad screening criteria.
Detailed Business Plan: If the plan manages to clear the initial screening round then the VCs call for the detailed business plan from the entrepreneur. The business plan is the main tool with the help of which VC would make up his mind. Thus the entrepreneur should present clarity of thinking about the business in the plan as the "Surprises can be great for parties, but potentially could be fatal for businesses."
Due Diligence: In the next and the most important phase, due diligence is conducted by the VC to verify the accuracy of the statements made by the entrepreneur. The two main types of due diligence conducted are Business and Legal.
The legal due diligence involves verification of the documents by the lawyers of the VC. These documents include Memorandum and Articles of the Association, important contracts, patents, copyrights, et cetera.
Business due diligence involves looking at the quality of people, quality of business and the quality of investment. Quality of people is one of the most important criteria. There is unanimity among theorists that venture capitalists prefer a Grade A team with a Grade B idea to a Grade B team with a Grade A idea. However, how the quality of team is evaluated is a source of controversy.
Many feel that the integrity of the team members is the most important criterion. Past research shows that trustworthiness, enthusiasm and expertise of the entrepreneur are the most important factors considered by the VCs. It has also been seen that about 50-60 per cent of the projects which are seriously considered for financing but are ultimately rejected is due to the factors related to the entrepreneur.
The other major consideration is quality of business. Some VCs, especially the early stage ones, may not give a lot of importance to details; however, the idea must necessarily and clearly signify a distinct and unique competitive advantage.
Generally, market potential and attractiveness are an integral part of a marketing plan.
Though visibility and transparency in a business may not necessarily increase its attractiveness, it is more of a necessity. One of the most important considerations for VCs while judging an investment proposal is clarity of the exit mode and the expected return from the project, which is quality of the investment. This is because the VC is ultimately a fund and they (like mutual fund managers) need to manage their portfolio to get maximum return.
Dr A K Mishra of IIM Lucknow, conducted a detailed study in the year 2001 on the investment evaluation criteria used by the Indian venture capitalists. Even though the study was conducted six years back, its findings are still relevant and confirm the findings of researchers globally.
Mishra found the entrepreneurs' personality (integrity, attention to detail, long term vision, etc.) to be the most important criteria for the VC, followed by growth prospects of the business.
Finally, if the VC is positive after the due diligence, he will issue a term sheet which is an indication that he is seriously looking at the proposal. It is pertinent to note that the term sheet is not the final document, but only a basis for further negotiations.
So, behind those mind boggling returns lies serious evaluation. Apart from luck and being in the right business at the right time, venture capitalists must also be given due credit for the detailed evaluation that they carry out before deciding to invest.

Wednesday, February 14, 2007

The world is waking up to a New India


February 14, 2007, http://www.rediff.com/, Co-author-Puneet Bhamba


With the third wave sweeping the globe, the concept of business has changed. During the second wave, that is the industrial revolution, scale of operations, economies of scale, plants and equipments were the buzzwords.
Machinery and automation were keys to success. Any need for financing an expansion by an established company or starting a new company were met by banks, financial institutions etc. These traditional providers of funds evaluate an investment option based on tangible assets, regularity and certainty of cash flows and past history of a business or the past history of promoters.
With the advent of Knowledge Based Enterprises, which is a direct consequence of the third wave, that is the information technology revolution, the rules of doing business have changed.
Now, technology and intellectual capital have become the buzzwords. Innovation and ideas, the courage to nurture them, and then take them to their logical conclusion are the things that the fund providers look for in such enterprises.
In KBEs, the business idea is untested, the promoters are relatively unknown, tangible assets form very small part of the entire investment, cash flows cannot be predicted with certainty and human beings and their knowledge are considered the most valuable assets.
Sunrise sectors like information technology, IT enabled services, biotechnology, are especially the kind of businesses which can be called KBEs. This is where the alternative modes of raising funds come in and have gained importance.
However, it is pertinent to note that even these players providing specialised funding can also be classified into various types depending upon the stage at which they invest in an enterprise and the kind of support provided by the incubators, angel investors, venture capitalists and private equity players.
Incubators: These provide infrastructure and advisory services to the startups at a very early stage. They encourage entrepreneurship and facilitate growth of new businesses, particularly for high technology firms, by housing in one facility a number of young enterprises, which share range of services.
These shared services may include meeting areas, research library, secretarial services, accounting services, on-site professional and management counseling, and computer word processing facilities.
For example, the Beijing Zhongguancun International Incubator Inc assists companies introduced by the Nanyang Technological University, Singapore, to set up or expand their businesses in China and helps attract talents from Chinese universities for these business ventures.
Angel investors: Angel investors are rich individuals funding risky/uncertain ventures at very initial phase. They are usually interested in the field in which an entrepreneur is working and are conversant with the operational aspects. Thus the benefits of angel investors are: experience of funding such ventures and contacts.
They are generally less formal and less public in their approach to investing. This is a common form of funding tech ventures, especially in the US.
Ram Shriram of Sherpalo Ventures was one of the primary financers (read 'angel') of Google in its early phase. Some of the successful Angel Deals include an investment of $100,000 by Thomas Alberg in the online bookshop, www.amazon.com.
At exit, the value of his investment was $26million, a whopping 260 times the original investment. Even better are the stories of the angel investors of Apple Computers and the Body Shop. The returns at exit for both the companies were 1,692 and 10,500 times of the original investment respectively.
Venture capitalists: Venture capitalists are professional money managers (in fact they usually manage something like a mutual fund with much larger investments made by investors), who provide risk capital to businesses at a stage advanced than the angel investors.
In the year 2006, more than $200 million has been invested by various foreign venture capital firms in Indian companies like travelguru.com and AppLabs Technologies.
VCs may be found in many different forms, but all share the common trait of making investments at an early stage in privately held companies that have the potential to provide them a very high rate of return on their investment.
It is pertinent to note that generally funds for venture capitalists are obtained from number of sources while for the angel investors it's generally one source. Further the return expectations of the Angel investors are more moderate as compared to the VCs, which target a higher return.
Private equity players: Private equity (PE) investments are essentially investments in relatively more matured companies at their expansion stage. They usually invest in proven and established businesses.
Private equity firms look for greater control in the company and often take a lot of interest in the activities of the management, usually also guiding them. In practice, most of the VCs often act as PEs and vice versa. The actual difference between a VC and PE is in the stage at which finance is provided and not the actual investors.
PE has recently become the buzzword in India, especially after some of the private equity funds struck gold here.
One such deal was the $300 million investment made by private equity fund Warburg Pincus LLC in Bharati Televentures of India between the years 1999 to 2001. It later sold off two thirds of its investment for $1.1 billion in 2005.
Corporate ventures: These funds are promoted by the large established corporations such as Intel and Motorola, usually in the hope of funding small companies that have technology or resources that larger companies want or need.
Corporate venture capital revolves around the company's goal to incubate future acquisitions, obtain intellectual property licenses and gain access into newer technologies and newer markets.
Cisco and General Electric are two companies known to invest billions annually in hundreds of such companies, then later acquiring them or exiting them.India Shining and India Poised may just be the slogans created by the media, but the fact is that the world is taking note of the New India and is eager to have a piece of the pie in some way or the other. So angel investors or private equity funds, they are all swarming India right now and we shall make hay while it lasts.