Crossing the VC Rubicon - The Entrepreneur's Dilemma

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.

VC transactions: The business perspective



Appreciation of the business motivations underlying a VC transaction
will help an entrepreneur evaluate the various issues involved in proper

perspective. A successful and happy investment relationship - and mind

you, they do not always go together - can only blossom when the two

parties, namely the investor and the investee, balance what

would appear to be mutually conflicting interests.

Investor’s motivations



The investor's primary objective in a VC investment is to produce a
financial return on his (her) investment. Or, that is the case most of the

time at least, barring the case of strategic investors, where the driving

considerations could be access to the technology, product, or customers

that the investee firm may own. The investor seeks to realise this return

over a two-five year period. During this period he would like to watch the

company's sales and profits grow and sometimes even assist in the process

with his inputs. The holding period varies from investor to investor but

most serious investors prepare themselves for at least a three-year haul

before they expect to realise their return. At the end of this holding

period the investor realises his return by selling his investment

(shareholding) in the investee in the public equity (stock) market.

It is important to note that the VC investor looks for medium to long

term returns and not immediate yields such as interest or dividend

payouts. It is equally important to note that at the same time, VC should

not be mistaken for soft funding such as grants. The VC fund is thus a

patient but very much a commercially driven financial partner.

The VC investor’s capital is much more at risk than a conventional

loan, which is usually secured by hypothecation / mortgage of various

assets, including sometimes the promoter's personal assets. The investor

therefore seeks to protect his interest by asking for a say on decisions

which can affect the value of his investment in the company.

Through these privileges, investor seeks to ensure that:

• the business is managed professionally,
• its activities are conducted in a transparent manner,
• the investee firm complies with the laws of the land; and
• above everything else, the management makes best endeavour to
  
  maximise the financial value of the firm.

The entrepreneur' s considerations



All of these may appear onerous. So why should the entrepreneur raise
VC in the first place?

In the worst case, the argument for VC could be presented as that of a

necessary evil. VC is the only alternative for funding businesses that are

considered to be far too risky by traditional providers of capital such as

banks and financial institutions. And without capital, any firm would run

the risk of missing business opportunities.

Fortunately though, there are some brighter sides to VC too. Quite

often, the VC investor brings the value of his experience in building

successful businesses in several other investee companies to the investee

organisation. Many VC fund managers internationally, and a few in India,

were successful corporate executives, technocrats or successful

entrepreneurs in their previous professional incarnation. This helps them

bring the value of their previous experience to the investee.

Common experience also indicates that through their various contractual

privileges responsible VC investors help improve the quality of the

management of the investee firm and thereby enhance the value of the

investee. Such value manifests eventually in a better price for the

investee's shares when the company is floated on the stock market or is

sold to a strategic investor.

On balance, it could be argued that every entrepreneur who wishes to

build a successful, rapidly growing business will have to take recourse to

VC for meeting his funding requirements. Which leads to the three

important questions of timing, quantum and terms. And possibly the fourth

one of choosing the 'right' firm, will follow, assuming that the

entrepreneur has the luxury of choosing his VC investment partner.