Crossing the VC Rubicon - Some multi-million dollar questions

With all the recent excitement about instant riches that the IT

industry appears to hold lately, entrepreneurial activity in the sector

seems to have increased dramatically. At the same time, Venture Capital

(VC) investors must be feeling encouraged by the success of some of the

earlier investments, now generating handsome returns. The positive outcome

of all this excitement is the numerous investments that have been reported

in the past twelve months or so. In the days to come, one could expect

many more such entrepreneurs to seek out VCs and VCs to go after promising

IT companies.

In a four-part series, the author sets out some of the points that

entrepreneurs aspiring to raise VC may find helpful to bear in mind.

Achieving rapid growth requires appropriate funding. Appropriate

funding decisions are as tricky for the entrepreneur as they are for the

investor. The decision to raise external funding is in itself a difficult

Rubicon to cross. Having decided to raise external equity from a VC

investor, the entrepreneur further has the difficult task of deciding on

three difficult issues:

• When to raise money - the question of timing
• How much to raise; and
• On what terms, price and non-price related, to raise money.

The increased interest of VC investors in Indian IT companies adds a

fourth and equally important dimension to the problem of raising money:

Where to raise money from ?

All of the above are issues which the entrepreneur needs to be consider

carefully since raising VC and the terms on which the funds are raised

carry long term implications. And as with many other important questions

in life, there are no standard or straightforward answers. The factors

driving these decisions are eventually situation specific and depend upon

the entrepreneur’s comfort.

When to raise VC



This is perhaps the most difficult aspect to decide on. Delaying the
mobilisation of VC would mean missed opportunities for want of funds to

complete product development or ramping up manufacturing or sales. At the

same time, raising it too early on in the evolution of the firm may mean

raising capital at a lower price per share (than raising it later). Why?

Because investors hold the general view that the earlier the stage at

which you invest in a company, the riskier it is and therefore the lower

the entry price per share ought to be so as to compensate for that risk.

And lower price per share means giving up a greater percentage of the

equity of the firm to the external equity investor, implying giving up a

larger share of the wealth that the future value of the firm represents.

The balance between constraining the growth of the firm for want of

timely funding and the sharing of wealth with the investor is a difficult

one to achieve. A general approach for the entrepreneur to follow would be

to defer the induction of the VC by bringing in own funds and keeping

initial costs as low as possible. But when the firm finds that crucial

scaling up of manufacturing or completion of a prototype or a marketing

programme is being delayed for want of funds, it is time to call on VC

investors.

How much money to raise



The question of quantum of capital to be raised is related to that of
timing in many ways. Excessive capital, apart from leading to wasteful

expenditure of precious share capital could also lead to the dilution of

the entrepreneur‘s shareholding in the company. Undue parsimony in this

regard, however, can again lead to missed opportunities.

Raising and spending capital in small trenches helps preserve the value

of the firm. But again, frequent rounds of fund raising will divert

management’s attention from its primary task of running the business to

that of raising money; for, fund raising requires considerable effort on

the part of the management of the investee in structuring, negotiations,

etc. Ask any entrepreneur who has been through the mill seriously; he will

vouch for it readily.

What terms to raise the money on?



Terms of funding could, broadly speaking, be broken down into price
and non-price terms. Of all the various aspects of VC fund raising, terms

of funding receive the most attention both from investor and investee. And

perhaps many more deals fall through due to failure to reach an agreement

on pricing than due to any other single factor.

Clearly, the price per share (or valuation, in investor speak), is the

ultimate equation in the wealth sharing formula that motivates the

investor and the entrepreneur to do a deal. The non-price terms govern the

broad contours of the post-funding relationship. Thus, the criticality of

this latter aspect.

But does the question of terms still warrant what appears to be a

disproportionate attention? My view is that it probably does not. In the

final analysis, valuation is also an outcome of the timing / quantum of

funding and the fundamentals of the investee firm in question. By getting

the timing and the quantum right and focussing on strengthening the

fundamentals of the company, the valuation of the firm can be naturally

improved.

That leaves the issue of non-price terms. Strangely, in their anxiety

to raise money at the highest price per share entrepreneurs often lose

sight of the non price terms of a VC investment package. But it is

extremely important to view the package in its entirety; balancing price

against the sometime onerous non-price terms of the deal such as

restrictive covenants. These restrictive covenants (conditions as they are

more commonly referred to in Indian institutional parlance) can be the

cause of running feuds between the investor and investee over time as

compliance with the covenants could impede the smooth functioning of the

company.

Extending this further, it is even more desirable, if not essential, to

weigh the whole package against the value that the VC investor brings

along with the money. Some of these values could be associated reputation,

access to his network of contacts and value addition in other areas of the

business such as organisation building.

A final thought on these various issues. It would be an extremely rare

occurrence if ever one manages to strike the right balance between the

various contradicting drivers mentioned above. More often than not, the

mistakes committed while raising VC are realised by both investor and

investee in hindsight. But many entrepreneurs get shackled by a concern to

get this balance right upfront and in the process, waste valuable time

raising money that they should have spent building the business.

The ultimate moral of the story therefore is that it is important to

pay attention to these aspects, but not to the point of fund raising

becoming an all consuming passion that could potentially destroy the

business for which the money is sought to be raised. In my career I have

come across this instance of misplaced priorities once too often, killing

what might otherwise have been valuable industry leading businesses.