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
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”.