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

1. UNDERSTANDING VENTURE CAPITAL -
WHEN AND WHY YOU CAN EXPECT VC?
By Nari Kannan
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2. TABLE OF CONTENTS
About ............................................................................................................................................................................................ 3
How is a VC Firm set up and how does it work? ......................................................................................................... 4
What does it take for a VC to return 10% to their Investors? ............................................................................... 5
Company Valuations, How VCs Exit and Return Their Money to Limited Partners .................................... 7
Fast Growth Companies Vs Lifestyle Companies - When are you a good candidate for VC Money? .... 9
Venture Capital in India ...................................................................................................................................................... 10
The Indian VC Landscape, What they have Funded and What they seem to be funding now ............... 11
How do I Identify that Jackpot Business Plan suitable for VCs with the potential Hockey Curve or J
Curve growth? ......................................................................................................................................................................... 13
How to Identify the Right Kind of Venture Capital Company and the Partner Likely to Fund You..... 14
The Coming Global Freeze in Venture Capital and Implications for Indian VC Monies ........................... 16
Why does VCs Think Like Sheep, What's up with the Fad Waves of Investing? .......................................... 18
Why does VCs Think Like Sheep, What's up with the Fad Waves of Investing? - Part II ........................ 19
Fostering Innovation and New Startups During Tough Times ........................................................................... 21
VC Valuations and Exits - The Reason Why a VC would Give you Money ...................................................... 23
VCs, Angels and Control of Company ............................................................................................................................ 25
Comments By Aditya ............................................................................................................................................................ 26
Another Case Study Hot off the Press! .......................................................................................................................... 28
What does having a lot of Mid-Market VCs really Mean? ...................................................................................... 29
The Prosperity Supply Chain ............................................................................................................................................ 30
One Invaluable Tool in the Entrepreneurs Corner .................................................................................................. 32
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3. ABOUT
There seems to be a lot of misunderstanding about Venture Capital - that they are holding back
innovation, they fund only companies that don't need the money, etc. Understanding how venture
capital is set up, when and why they invest all will enable an entrepreneur predict whether VC is suitable
for 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 a
great sense of humor! Checkout this page about Bessemer Venture Partners' Anti-portfolio - This lists
companies that they turned down for a Venture Investment and still went to become huge, huge
companies - Like Google, Apple, HP, Cisco!!!!
http://www.bvp.com/Portfolio/AntiPortfolio.aspx
Ideally this should be done by VCs who are in this forum but hopefully they should jump in and correct
me when I get some facts wrong!
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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 will
fund.
Very large pension funds around the globe, very wealthy investors all have percentages of money that
they can spend on "Gambling Money" or money that they set aside usually (5 to 10% or all the money
they have, I am guessing) to invest in High Risk, High Return investments. This is what goes into Venture
Capital. These are called Limited Partners.
Two or three people usually with lots of experience doing this in another VC firm start a partnership that
is called say XYZ Venture Capital. They are the founders and managing directors of these VC firms. They
then go out and raise a round of Capital from the Limited Partners after selling them on their experience
and focus - They would do it for Technology, Life Sciences, etc. They also need to define their investment
objectives - 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 Technology
Investments in Software and Services companies only. This fund has a life of say 10 years. This means
that 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 in
2019. That would mean a gain of 50% over 10 years or -20% over 10 years. The VC fund can also take a
Carry if they return more money than they rose that is a cut from the gains that they caused in those ten
years.
So the first thing to understand is that everyone has a boss - Entrepreneurs' bosses may be VCs, VCs'
bosses are Limited Partners. They will not be able to raise a second fund if their first fund or their track
record is not that good in returning the money. The lesson for entrepreneurs here is that VCs have a
performance goal just as entrepreneurs do. That's what motivates them to bet on certain things and not
on certain things.
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5. WHAT DOES IT TAKE FOR A VC TO RETURN 10% TO THEIR
INVESTORS?
Let's 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%. In
India 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 very
risky 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 to
hit that one Twitter or Google or Face Book jackpot that turns that $5 into 50 times - $250 to get
anywhere near their 20% goal!
But wait a minute! Not all this $100 will be invested right away. They will invest $5 in a company and
then they need to reserve 4 or 5 times that money - $20 to $25 for subsequent rounds! So for every $5
invested, $20 is reserved. So they can do only 4 companies in $100!!!
Now you are getting the picture! That's the reason VCs go through many business plans looking for that
one 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 times
the investment: Some examples of Hockey Stick Growth:
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6. More in the next note on Company Valuations, How VCs get their money out, etc
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7. COMPANY VALUATIONS, HOW VCS EXIT AND RETURN THEIR
MONEY TO LIMITED PARTNERS
With startup companies, the valuation of the company is more of an Art than a Science. Twitter now is
valued at $1B plus and they are not sure how they are going to make money! Valuation at this stage is
purely 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 that's 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 that
particular month. When times are good and lots of VC money is chasing very few companies the
valuation shoots up and when it is not, it goes down. After the first round, it is in the VC's interest to
spread the risk of that company - so they bring in additional VCs to share the risk. They put in additional
monies 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 either
way. VC funds may not wait till the 10 years or up. They may exit their investment in the company by
going public and selling their shares in the company in the open market. Or they could get that money
back when this company is acquired by another company.
These sound like stupid mumbo-jumbo but these are very smart, highly educated individuals. If the
whole system does not make logical sense over a long period of time, VC firms would have been history
long time ago! Many are history already since the Dot com boom because they defied the laws of VC
gravity with many stupid investments and not too many Google’s.
Why should some company acquire another company? If they have Intellectual Property, that cannot be
done quickly enough or if they have customers.
Microsoft paid Sabeer Bhatia and Hotmail, $400M to acquire an instant customer base of 9 Million
people who had hotmail accounts (Rumor has it that a majority of them were in India opening accounts
so that they send resumes out!. But that's another story!). Oracle paid billions of $ to PeopleSoft so that
they can get their customer base and convert them to Oracle solutions over a long period of time.
So it's a question of the value of time! Oracle would rather set up a group inside their company and
develop your best-of-breed solution that your startup company has from scratch. But if you already have
25 customers and growing fast, it is better for them to buy you rather than develop it from scratch. So
it's a Make Vs Buy decision for them.
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8. So XYZ Early Stage fund I during the ten years of its life, sells companies it funded or get to IPO and take
their money out. That money minus the carry goes into the account of that fund. At the end of ten
years, this fund returns the money back to the Limited Partners. Could be $200 if they started with $100
or $80 depending upon whether they made one or two good investments that turned 20 to 30 times
over! That's where their returns are calculated. The VC firm or General Partners as they are called
cannot raise the next fund if their track record with previous funds were not good! They may dissolve
the VC firm as many have done recently.
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9. FAST GROWTH COMPANIES VS LIFESTYLE COMPANIES - WHEN
ARE 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 India
none of the large IT companies have been started with Venture Capital. In fact more large companies
have 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 get
out and how valuations are done in between. They are designed to fund risky, new ideas that have high
rates 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 more
like 10 to 15% per annum. There is nothing wrong with these companies. If you bootstrap them and they
are providing a steadily increasing cash flow you can still build a good company, pay yourself a good
salary 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 in
India has been growing at such a pace, that the Indian market is more than adequate to qualify for a
deep hockey stick as the graph shows!
In other cases, you may need to look to global customers for growth. There are Indian startup
companies that have developed web 2.0 companies for Local Sports Leagues. There are local sports
leagues in India but they may grow much much faster if they look to the global market instead! So it all
depends.
Why do VC firms need a Hockey Stick growth pattern? That goes back to the valuations of the company
in subsequent rounds. If a company grows to $50M within 5 years in revenues, their valuations also will
make sense in round after round and they can have that Jackpot exit. Other investors will not jump in
until this rapid growth is shown. This rapid growth need not be in current revenues but also in potential
revenues. Google was not making too much revenue when they went public but subsequently realized
billions 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 VC
money or not is key. Are you a Fast Growth company or a Lifestyle company?
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10. VC Firms need to report back to their Limited Partners on new companies they have checked out every
week, month or quarter. So they will waste your time, taking meetings and putting them on their
reports. It is up to the entrepreneur to make sure that they spend their time wisely chasing VC money in
the first place. If you don't need it and you can grow slower comfortably, things are actually better for
you!
The funny thing is that EVERY MAJOR VC in Palo Alto has offices in India, dedicated funds in India or
work through an Indian VC like Helion Ventures by becoming limited partners with them. Checkout this
article by Sramana Mitra that is somewhat old:
Venture Capital in India
Sramana lists almost all of the top VCs in Palo Alto - Matrix Partners, Kleiner, Sequoia, NEA, Battery, and
Bessermer 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 rather
than Venture Capital! They don't know or don't want to take risks like the Palo Alto VC firms.
So make no mistake - the rules, approach, the pressures are all the same!
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11. THE INDIAN VC LANDSCAPE, WHAT THEY HAVE FUNDED AND
WHAT THEY SEEM TO BE FUNDING NOW
The Indian VC landscape gets the majority of money from US VC funds that set up offices in India (almost
all the major ones - locate the US VC directory and look up their website to see where the Indian reps
are) and have been and are funding many companies that provide the hockey stick growth or at least
fast 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 the
investment 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 growth
just given the paucity of such facilities in India - Clear Trip, RedBus, TicketVala, etc where they saw
rightly so, fast growth.
It is my guess that then they started seeing many ME-TOO websites - Oh - we are jinglee.com, just like
LinkedIn, we crowster - just like Twitter, etc and were sufficiently dismayed but see many many
opportunities 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, understand
what makes them tick or not and see if your business is a fit for what they want to do. The best places to
start are the Us VC firm websites. They will lead you to the local offices and contacts. After the initial
few startups were funded, the Indian VCs seem to have hit a wall not finding enough early stage startups
to 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 stage
startups preferring only later stage ones! So as of now, the situation with Indian VCs is not that good!
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12. I think many of the India funds may not have reached maturity yet for them to return monies to their
Limited Partners. So it will be very hard to come by any total Fund Return Stats. In fact look at these
Stats for August 2009:
India Venture Capital Stats: August 2009
They are not even disclosing the investment size. I think it will be difficult to calculate even company by
company 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 2009
From $413M for the first half of 2008, it has fallen to $117M in the first half of 2009. I hope this is not
disillusionment with the availability of enough plans in India with the J curve of growth! This does not
mean that good companies in India cannot be grown to be good, profitable companies. It just means
that 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 into
other areas like real estate and other later stage deals. If you cannot find enough high growth
companies, you could invest the bulk of the money in a few large deals and make at least a respectable
5 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 that
it helps the entrepreneur any, but at least you can understand it as a rational business decision and not
some genetic defect with the VCs!
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13. HOW DO I IDENTIFY THAT JACKPOT BUSINESS PLAN SUITABLE
FOR VCS WITH THE POTENTIAL HOCKEY CURVE OR J CURVE
GROWTH?
There are companies in India that are getting funded by VCs even now; a few of them in Early Stage but
all of them seem to promise a steep growth curve.
Mobile Payments that rely upon Rural adoption of phones where farmers can easily transact where they
are using SMS without having to travel to the nearest State Bank in the nearest town. Or Mobile Games
startups that show increasing adoption of slightly more capable phones beyond the Urban Professionals
in 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 customers
attracted 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 villages
where India lives. Anywhere, where you have a potential population is waiting for a solution and is in
millions and millions in numbers and the adoption is expected to be rapid, VC money, even early stage
may be easy to line up.
Enterprise Software if SaaS based and you show rapid growth as an alternative to traditional licensed
software with Small and Medium sized businesses, you could line up venture funding. The key here is
not to talk about potential but to show the past 6 months customer wins. If they show a hockey stick
growth, you have a story!
Of course, if your business can really look to the whole world as a potential market rather than India and
you 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 showing
steady 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 CAPITAL
COMPANY AND THE PARTNER LIKELY TO FUND YOU
As outlined in the previous entries, Venture Capital companies and their General Partners (The people
who run the VC firm) are beholden to the Limited Partners, the very very wealthy individuals and huge
Pension 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 they
turned down to earn their 2 to 3% Management Fee that they pay themselves every year out of the
total money raised. This means that VCs will give you meetings - lots of meetings. Many of them are
good 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 and
the right PARTNER within that VC firm that is dealing with companies like yours. If you want to waste a
lot of time feeling good about talking to many, many VCs, you should go ahead. But unless many planets
and 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 firm's web site and learning a lot about the kinds of
investments that are interested in and more importantly the kinds of investments they are doing
CURRENTLY! If all they are interested currently are fast growing Travel or Mobile businesses, pitching an
enterprise 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 look
for amounts that they say they invest in the first round - $30K to $2M in the Indian context may signal
an early stage investor. If they say that they are looking to invest from $5M to $25M they are clearly late
stage, 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 have
invested in. Remember that no VC firm ever signs an NDA. So you will be sharing your business plan
entirely at your own risk!
Look at the different partners and their backgrounds- Select partners that have some operational
background - either high positions in related companies or an entrepreneurial background. People who
are fresh off the MBA school or Investment Banking experiences only, I will shy away from. They may
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15. not know what it takes to start a company and run it! They will get in your way rather than help you
even if you land VC money!
Don't waste your time with VC companies that clearly say they are interested in Consumer IT, not
Software, if you have an Enterprise Software company. Similarly even if their web site says something
like Early Stage Information Technology company and their last three investments were Real Estate in
Mumbai, you want to shy away from them. This is true of Indian VC firms (branches of US firms) that are
becoming desperate as their funds are getting older and nearer their end and they need to invest and
show some returns.
You can also attend industry and networking events, meet some of these VCs and ask them specific
questions about what they are interested in and whether they would be interested in some company
like yours. Then do the research any way and make sure that there is a fit between what you do and
what they are looking for. Look at the last three or four investments they have made. Are they similar in
stage 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 rest
of the money they have in their current companies. If they are one year old, they are looking for
younger 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 up
with innovative companies or to provide you with risk money so that you can find out if your idea is
good or not. They are there simply to invest the money they took from their limited partners and
return back 10X or 20X that money. The rest may be your own assumptions and don't be disappointed if
they don't meet your wrong expectations.
And believe me, there are no big Asian VC funds of European VC Funds or Middle East VC funds that do
Early stage investing. There are only major US Funds and they are mostly the only ones that invest in
early stage in India through their own offices or giving it to Indian VC firms they trust. In India, even they
wait for a lot of risks to be taken away before they invest.
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16. THE COMING GLOBAL FREEZE IN VENTURE CAPITAL AND
IMPLICATIONS FOR INDIAN VC MONIES
Earlier this year, around January, Forbes magazine published this article entitled:
Venture Capital's Coming Collapse
It quoted that many VC firms, especially the US VC firms that raised record amounts of money during
and immediately after the Dot Com boom had invested willy nilly in all kinds of stupid investments and
have a net return of -1%. That's 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 in
them. There was a time when new Hardware, Software advances were closely followed by venture
investments, 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 breaking
types of investments.
So we are seeing the result of this prediction already. Add to the poor returns, the recent Global
Economic downturn and many pension funds have shrunk in size since. The IPO market and Acquisitions
markets have been lack luster around the globe for the past three or four years. The result is this:
Venture capital funding plummets 81% in quarter
Year ago, third quarter ending September, US VC firms raised $8.5B. This year same quarter -$1.6B. A
drop of 81%!! Globally non US VC firms would have had a similar outlook also given the global economic
weakness!
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 rose
for the firm and sent a similar amount to their own Israel offices to invest. Now with smaller funds, a lot
of 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 get
tighter in the next couple of years.
It could go the other way if something like Twitter or Google emerges out of India and grows
domestically 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 like
NASSCOM should create an Angel Fund and provide the catalyst for new and exciting growth companies
to sprout!
17

18. WHY DOES VCS THINK LIKE SHEEP, WHAT'S UP WITH THE FAD
WAVES OF INVESTING?
As entrepreneurs, we are often frustrated with why VCs are not able to see the Gem of a startup we
have, appreciate the hard work we have put in and invest?
The problem is that for VCs it pays to think like sheep! If anything that's the only way they are going to
survive 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 sure
that your continued livelihood is assured by spreading the risks that you take among the others in your
ecosystem!
This happens by making sure that if you as a VC invest $1M in round one, you want to bring in two more
VCs and put in $2M each, instead of you chipping in all of the $6M yourself. That also happens, if the
company 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 company
that may hit the 20X jackpot! This is where thinking like sheep helps! If everybody is interested in Social
Networking and you are here investing in a SaaS software company, you may not find the others to
share the risks with you! Putting money in a company that is not part of your current fad is risky for you
when you go for subsequent rounds. You may not find others willing to jump in!
That's why Green Energy, anything Green are all the rage in VC circles now. Even Social Networking is
out. Smartphone apps are in! Even there iPhone silly $1.99 apps are passe. IPhone enterprise
applications are the hot thing now! Long time ago, VCs were pure technology buffs and they took
informed 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, Investment
Bankers, etc who spoiled the entire ecosystem for all of us, unfortunately! If you want VC money you
should not be swimming upstream. You will swimming against a lot of this sheep like thinking and there
are perfectly rational reasons for it!
18

19. WHY DOES VCS THINK LIKE SHEEP, WHAT'S UP WITH THE FAD
WAVES OF INVESTING? - PART II
If 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 a
very 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 Mobile
Phones, Broadband, Laptops, desktops, RFID chips or other enabling technologies. This gives rise to ten
smart people around the world suddenly finding the same solution to any problem and does
something about it with a startup company.
Unlike what we imagine at any time, ideas are dime a dozen. Please be assured that about 100 people
have the same bright idea as you at any time and ten of them have done something about it with a
startup company. Those ten are the ones that graduate from the bootstrapped stage or Angel Invested
stage to one of VC funding.
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20. Indian Travel sites, Mobile Payments companies in India, KPOs, BPOs, every one of them in India or
Globally have all found themselves in the growth pattern above. That's when they get funded. The
above graph also shows the importance of Angel Investors in India. They are the engine that gets the
rest of the investments, innovations, going!
20

21. FOSTERING INNOVATION AND NEW STARTUPS DURING TOUGH
TIMES
As seen in my previous entry, there is a gap between an Idea and Venture Capital. That is bridged by
Angel Investments and Bootstrapping money. For services companies this is no big deal since you may
have cash flow from Day 1 after spending minimally on starting small, incorporating and may be even
providing services yourselves.
However, product companies have this gap as a huge insurmountable trench sometimes that cannot be
crossed easily.
That's where True Angel Investments are a crucial and indispensable part of fostering a Product
Ecosystem in India. This does not mean Private Equity masquerading as Angel Investing, asking
entrepreneurs where they have already crossed the Technology Risk in terms of "Do You already have a
product 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 just
someone to give you money but more importantly, their wisdom and experience in building similar
companies themselves. "Similar" is very important since Services and Product companies are two
different kinds of beasts. Lessons learned in one may not easily translate into another and may mislead
you sometimes!
In The Indian Context, Incubators like YCombinator and TechStars are good role models. Both are
incubators that provide much needed Angel Capital just based on your idea, space, meeting rooms and
most importantly, a whole network of Mentors made up of Entrepreneurs, Angel Investors and Venture
capitalists.
TechStars was cofounded by Brad Feld, one of the more successful VCs consistently and operates out of
Boulder, 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 $6000
per 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 your
product, provide you a demo day where you can demonstrate the products, they invite and in fact
sponsored by VCs. They have about 60 to 70% of their startups either not needing any more money or
raising the next round of VC money. This is a model that can be very useful if NASSCOM could organize
or at least facilitate the organization of such incubators!
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22. The large IT service companies, their founders could all be interested in something like this. You need
ideas and the seed capital to sprout 1000 startups if you need five Google like successes! But it will be
worth it and will truly build a product ecosystem! It does not have to be Google like businesses. It can be
businesses that exploit SaaS, a brand new market like India or some sector of India that's growing fast
like 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 you
that are growing at a more sedate pace. That does not mean it is not worth going after, it just means it
does not fit THIS model of funding, growth and faster exits! We have seen companies like Bharti, Tata
Telecom, Reliance Telecom and others grow into huge, huge businesses on the back of enormous
growth. There will be hundreds of others also!
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23. VC VALUATIONS AND EXITS - THE REASON WHY A VC WOULD GIVE
YOU MONEY
Ashim Bose referring to the company Hubspot and their continued Venture Funding is a classic case
study that makes my points about Why and How Venture Capital Funding and Exits Work in the ideal
case, recession or no recession, global slowdown or no slowdown. First, Hubspot is a SaaS Marketing
Automation company focused on what they call VSB - Very Small Business as opposed to SalesForce.com
which 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-Funding
This was raised from Private Investors. Then in September 2007 they raised a Series A fund of $5M. The
VC this time is General Catalyst Partners.
http://www.masshightech.com/stories/2007/09/10/daily39-HubSpot-spotted-5M-in-first-funding.html
Then in May 2008 they raise a Series B of $12M. The VCs this time are General Catalyst Partners and
Matrix Partners.
http://www.masshightech.com/stories/2008/05/12/weekly12-HubSpot-grows-grabs-a-12M-round-two.html
Then 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.html
The VCs this time are General Catalyst Partners, Matrix Partners and Scale Venture Partners of
California.
The above case study is a good case study in which everything goes right simply because they end up
lining 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 only
when the new investors feel that the growth is fast and genuine. Otherwise they would not put their
money that they need to return back to their limited partners in a10X or 20X multiple.
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24. I am sure that the $33M or so raised so far will be gotten back in a decent multiple when the company is
sold for $200M or $300M to someone like Oracle, SAP or IBM. The IPO market in the US is also showing
signs 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 Hubspot
focuses on the Indian market with the same kind of business model. But the key is showing consistent
growth 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 the
other way where future rounds of funding may be Down-Rounds where a new round is at a valuation
lower than the previous ones. In those cases, the valuations may not go in the positive direction all the
time. But that's the risk VCs take sometimes.
Valuation is more an Art than a Science. Sometimes there is no explaining the fact that some company
which has no business model and no revenues, like Twitter having a valuation of $1.3B. A valuation is
what some new comer is willing to put in new monies at.
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25. VCS, ANGELS AND CONTROL OF COMPANY
If you really like controlling your company, the pace, the direction, vision, mission of the company, stay
away from VCs and certain types of Angels! Venture Capital is fundamentally structured in ways that
with each subsequent round of funding, you lose significant chunks of company control. You own less
and less of the company, the Board of Directors is getting loaded with more and more of the VC's board
members. 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. There
are angels who write a small check and call you on Saturday evening 10 p.m to tell you about a change in
direction 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 been
entrepreneurs is very important. VCs with no operational experience will have wild and wooly ideas that
will make your skin crawl and you may feel that you are under the mercy of a pack of wild boars that are
running 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, you
hold the reins. You can tell the VC to go sit in a corner. If that hockey stick growth is not there, then the
VC may push down your company's throat all kinds of corrective actions, even drastic changes in what
they funded. I know of a VC funded company that was a Dot com shop selling consumer goods that was
reborn 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 of
things that they cared most about - the technology and some key aspects of culture while they
acquiesced to VCs and other investors in bringing in an able CEO, Erik Schmidt to manage things they
didn't want to deal with. If you take VC money, you need to make sure that you have enough control to
do the things you care about, the way you want them done. VC Money equals Control and take it if you
know what and how much control you want to relinquish!
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26. COMMENTS BY ADITYA
Let me add a few bits from my experience of being on the investment side for a few years and then a
few 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% of
all businesses being started. The rest of 98% are probably medium - low growth or niche market or
lifestyle business. A lifestyle business is one which maintains a good lifestyle for the entrepreneurs and
doesn't require a lot of work (read 9 to 6). Most of the businesses fall into one of these categories. While
VCs are glamorized as the funding agencies they are not the only source. The rest of 98% can turn to the
following in India:
1. Government: Govt usually has grants or subsidy schemes for different kinds of businesses that they
want to support in line with their policy. One example that is probably relevant for this forum is the
TePP (Technoentrepreneurship Program) under Department of Science and Technology. Under this
program, a grant is given for developing an innovative product. Do note that this is a grant and not a
loan or an investment.
2. Banks: Banks offer loans under various schemes again as a part of Govt policy. Under one such
scheme 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 to
get registered as an SME and then chase the bank officials a lot to get this done. I know a startup which
got this fund. They had to work hard at it - visiting multiple offices and meeting multiple people. In the
end they realized that talking to anyone less than a DGM doesn't help. Btw, they didn't have to pay a
bribe.
3. Angels: Angels are friends and family who take a leap of faith with you. Another set of angels are High
Networth 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 were
growing up. Eg - Startbucks. Indiabulls. India today has two large organized angel groups - Indian Angels
and Mumbai Angels. Both have been investing quite actively and have even funded just ideas. Also they
invest in all kinds of sectors.
4. Customer: This is the most ignored one but I'm sure that a lot of people on this forum have used this
source. What I do not see very frequently in India is the entrepreneur collecting money from the
customer for the product development. The customer typically does this as it’s a burning problem for
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27. him/her and also because they are the leaders in their space. The payment serves as an advance in
terms of accounting. While rare in India, I've seen at least one entrepreneur use it in Mumbai.
5. Incubators: Incubators provide support of infrastructure, advice and their network in exchange for
fees. However, some of them also offer cash assistance again for equity. For eg the incubator at my alma
mater IIM Bangalore has an arrangement with NSR where an incubate becomes qualified for cash
investment upto Rs 25 Lacs. The iAccelerator program at IIM A is modeled after the Y Combinator and
again the startups get a stipend while they're in the program. Its entering its third edition now and
would be in Bangalore this time.
6. Corporate: Large corporations are always keen on entering new markets. They find it difficult to do
that with their structure, processes etc. Therefore, several of them fund startups in-house. The good
part is the support and the bad part is that you're probably not far enough from the corporate. I've done
this twice and my advice is to do it only if you're a separate company from day 0. A similar option is a
corporate VC. They may relax the financial parameters a bit (and only a bit!) if there is alignment with
the strategic goal. A great example in Intel Capital. They are the largest VC on earth in terms of money
deployed and in terms of live portfolio (400+ the last time I checked). They tend to invest more in areas
that helps Intel's businesses.
All the options above give an entrepreneur capital upto max of Rs 2 - 2.5 Cr or $ 0.5 million (except
option 6). Hopefully this gets them to the next stage where 3 - 5 million is required and a no of VCs
operate in that segment. There also have been talks of 3 - 4 funds coming in at $ 1 - 2 Million as well but
that is still to be seen.
In general the VCs in India face a unique challenge. They find difficult to put in the usual silicon valley
kind of money in a similar startup in India because it doesn't need that much cash. But they need to look
at 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 up
investing there rather than the classic startup. Similarly PE funds find it difficult to get deals. If the deals
are there then valuation is too high due to competition. So they have moved to PIPE deals. In all, since
the investors raised money abroad and used the same model, the VCs have been forced to become PEs
while the PEs have been forced to become stock market investors leaving large gap in early stage
funding. It’s getting addressed but not fast enough.
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28. ANOTHER CASE STUDY HOT OFF THE PRESS!
Google Pays $750M (yes, that's seven hundred and fifty million dollars!!) in stock to buy AdMob, a
startup company that serves ads on Smart Phones just as Double Click serves ads to Web Pages!
Here's why they paid this princely sum! The key is very fast growth - They served 2.6 billion mobile ads
on iPhone and iPodTouches in September 2009 as compared to 130million ads in September 2008. They
raised about $50 Million in a number of rounds, and grew to a 142 people company. Google could have
done 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 now
they 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 India
also 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 what's happening and more
importantly be capable of taking informed bets with nothing but their own guts telling them where the
world is going! Think Smart Phones! Laptops are about to be displaced by Handheld devices (not
necessarily just Smart Phones - iPodTouches are really small handheld computers with wifi connectivity
without 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!
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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-Market
VCs! Mid-Market VCs are those that provide expansion capital. They come way after Seed and Early
Stage, Series A, even sometimes, Series B capital. And the majority of them were Indian and Middle East
Venture Capitalists. What struck me was that almost ALL of the Early Stage VCs were American VCs
that put their money to work directly through their Indian branches or work through a VC that set up shop
in 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 base
in India". Unfortunately, none of these things will happen if every Indian VC is a mid-market VC!! You
need people to take some bold risks to make any of the above happen! If every VC waits for every
technical and business risk to be gone, they could as well be bankers, not VCs. This is not to be taken
lightly 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 me
when 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 venture
and angel funding and Colorado a distant third, when Silicon Valley significantly outperforms all the
other 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 is
the Prosperity Supply Chain that seems to be needed to build a powerful venture ecosystem. If any link in
the whole chain is missing, it does not fully form and bear fruits. For example, Boston has all the other
ingredients 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.
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30. THE PROSPERITY SUPPLY CHAIN
Arvind's note instigated this entry I have been meaning to write for a long time. This is one of those six
blind men and the elephant story deal! It's entrepreneurs, it's the government, it's research, it's the
education system, etc.
The thing is that all of these are right and if you look at how it works successfully in other countries like
the US (Or used to!), it appears to be a proper Prosperity Supply Chain and all components in the supply
chain 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, Indian
Space Research Institute, TIFR, etc that get money to do research in many interesting topics like
electronics, computer science, biotechnology, aerospace, rocketry, medicine, agriculture, that the
government deems is of strategic importance to the country. Masters and PHD students interested in pure
sciences are key here and you need to have goals to produce so many of these every year focusing only on
pure science for its own sake! Entrepreneurs talking about local innovation is meaningless without this
large factory of ideas from which to choose from.
Advanced Development - This is to take fruitful research ideas and do the first baby steps towards
product development but not quite. This is where Small Business Innovation Research (SBIR) grants that
Arvind mentions could come in very handy. The US government identifies Advanced Product
Development topics that it deems of national strategic interest. If you are an entrepreneur you get money
to propose taking a research idea in one of these topics and develop a product out of it. Yes. You get
money to experiment whether a research idea can be turned into a product. The entrepreneur owns
everything 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 taking
mindset and money to back up 20 crazy ideas so that one of them is a blockbuster. We can name anything
Venture 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 educated
in specific skills needed for these growth stage companies also need to be part of the supply chain at this
stage.
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31. Global Competitiveness and Export - Huge internal consumption without being competitive globally will
not save your industry in the long run - witness the US automotive industry and how it could not compete
with Japanese automakers paving their downfall over a fifty year period. This is a great example if export
and global competitiveness is ignored in the long run!
Floundering around and addressing individual items in parts of this supply chain may not do much except
promote protectionism which does not do good in the long run anyway, China or India. It's a long term
project and all aspects needs to be addressed systematically. Addressing individual things without
addressing others will just result in unintended consequences, unfortunately!
When I was in India, I was so thrilled and impressed by Mr.Narayana Murthy's article - Securing India's
science 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 Ceremony
These 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, but
the other things need to fall in place also! Of course, the Government needs to do its part, set up all the
right incentives and get out of the way. No give away, no direct investment, but just act as a catalyst in a
chemical reaction and make the reaction happen.
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32. ONE INVALUABLE TOOL IN THE ENTREPRENEURS CORNER
If you are an entrepreneur or founder or CEO or President of a company, you can become a member
of www.thefunded.com . It is meant for entrepreneurs to rate Venture capital firms and partners within
those firms.
Check it out! It can be very valuable when you are considering VC firms A, B and C. What can you
expect from which one? They do cover a lot of Indian VC firms also.
Much more valuable than you think!
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