UNIT 3: NEW VENTURE PLANNING

Understanding Venture Capital

Venture capital (VC) is a form of private equity and a type of financing that investors
provide to startup companies and small businesses that are believed to have long-term
growth potential. Venture capital generally comes from well-off investors, investment
banks, and any other financial institutions.

However, it does not always take a monetary form; it can also be provided in the form
of technical or managerial expertise. Venture capital is typically allocated to small
companies with exceptional growth potential, or to companies that have grown quickly
and appear poised to continue to expand.

Though it can be risky for investors who put up funds, the potential for above-average
returns is an attractive payoff. For new companies or ventures that have a limited
operating history (under two years), venture capital is increasingly becoming a popular
—even essential—source for raising money, especially if they lack access to capital
markets, bank loans, or other debt instruments. The main downside is that the
investors usually get equity in the company, and, thus, a say in company decisions.

KEY TAKEAWAYS

 Venture capital financing is funding provided to companies and entrepreneurs. It

can be provided at different stages of their evolution, although it often involves
early and seed round funding.
 Venture capital funds manage pooled investments in high-growth opportunities
in startups and other early-stage firms and are typically only open to accredited
investors.
 Venture capital has evolved from a niche activity at the end of the Second World
War into a sophisticated industry with multiple players that play an important role
in spurring innovation.


Understanding Venture Capital

In a venture capital deal, large ownership chunks of a company are created and sold to
a few investors through independent limited partnerships that are established by
venture capital firms. Sometimes these partnerships consist of a pool of several similar
enterprises.

One important difference between venture capital and other private equity deals,
however, is that venture capital tends to focus on emerging companies seeking
substantial funds for the first time, while private equity tends to fund larger, more
established companies that are seeking an equity infusion or a chance for company
founders to transfer some of their ownership stakes.
Contrary to popular perception, venture capital plays only a minor role in funding basic
innovation. Venture capitalists invested more than $10 billion in 1997, but only 6%, or
$600 million, went to startups. Moreover, we estimate that less than $1 billion of the
total venture-capital pool went to R&D. The majority of that capital went to follow-on
funding for projects originally developed through the far greater expenditures of
governments ($63 billion) and corporations ($133 billion).

Profile of the Ideal Entrepreneur

From a venture capitalists perspective, the ideal entrepreneur: is qualified in a “hot” area
of interest, delivers ...

Where venture money plays an important role is in the next stage of the innovation life
cycle—the period in a company’s life when it begins to commercialize its innovation. We
estimate that more than 80% of the money invested by venture capitalists goes into
building the infrastructure required to grow the business—in expense investments
(manufacturing, marketing, and sales) and the balance sheet (providing fixed assets and
working capital).

Venture money is not long-term money. The idea is to invest in a company’s balance
sheet and infrastructure until it reaches a sufficient size and credibility so that it can be
sold to a corporation or so that the institutional public-equity markets can step in and
provide liquidity. In essence, the venture capitalist buys a stake in an entrepreneur’s
idea, nurtures it for a short period of time, and then exits with the help of an investment
banker.

Women-Led Startups Received Just 2.3% of VC Funding in 2020

Venture capital’s niche exists because of the structure and rules of capital markets.
Someone with an idea or a new technology often has no other institution to turn to.
Usury laws limit the interest banks can charge on loans—and the risks inherent in start-
ups usually justify higher rates than allowed by law. Thus bankers will only finance a
new business to the extent that there are hard assets against which to secure the debt.
And in today’s information-based economy, many start-ups have few hard assets.

Furthermore, investment banks and public equity are both constrained by regulations
and operating practices meant to protect the public investor. Historically, a company
could not access the public market without sales of about $15 million, assets of
$10 million, and a reasonable profit history. To put this in perspective, less than 2% of
the more than 5 million corporations in the United States have more than $10 million in
revenues. Although the IPO threshold has been lowered recently through the issuance of
development-stage company stocks, in general the financing window for companies with
less than $10 million in revenue remains closed to the entrepreneur.
Sufficient Returns at Acceptable Risk

Investors in venture capital funds are typically very large institutions such as pension
funds, financial firms, insurance companies, and university endowments—all of which
put a small percentage of their total funds into high-risk investments. They expect a
return of between 25% and 35% per year over the lifetime of the investment. Because
these investments represent such a tiny part of the institutional investors’ portfolios,
venture capitalists have a lot of latitude. What leads these institutions to invest in a fund
is not the specific investments but the firm’s overall track record, the fund’s “story,” and
their confidence in the partners themselves.

How do venture capitalists meet their investors’ expectations at acceptable risk levels?
The answer lies in their investment profile and in how they structure each deal.

The Investment Profile.

 

One myth is that venture capitalists invest in good people and good ideas. The reality is
that they invest in good industries—that is, industries that are more competitively
forgiving than the market as a whole. In 1980, for example, nearly 20% of venture
capital investments went to the energy industry. More recently, the flow of capital has
shifted rapidly from genetic engineering, specialty retailing, and computer hardware to
CD-ROMs, multimedia, telecommunications, and software companies. Now, more than
25% of disbursements are devoted to the Internet “space.” The apparent randomness of
these shifts among technologies and industry segments is misleading; the targeted
segment in each case was growing fast, and its capacity promised to be constrained in
the next five years. To put this in context, we estimate that less than 10% of all U.S.
economic activity occurs in segments projected to grow more than 15% a year over the
next five years.

The myth is that venture capitalists invest in good people and good ideas.
The reality is that they invest in good industries.

In effect, venture capitalists focus on the middle part of the classic industry S-curve.
They avoid both the early stages, when technologies are uncertain and market needs are
unknown, and the later stages, when competitive shakeouts and consolidations are
inevitable and growth rates slow dramatically. Consider the disk drive industry. In 1983,
more than 40 venture-funded companies and more than 80 others existed. By late 1984,
the industry market value had plunged from $5.4 billion to $1.4 billion. Today only five
major players remain.

Growing within high-growth segments is a lot easier than doing so in low-, no-, or
negative-growth ones, as every businessperson knows. In other words, regardless of the
talent or charisma of individual entrepreneurs, they rarely receive backing from a VC if
their businesses are in low-growth market segments. What these investment flows
reflect, then, is a consistent pattern of capital allocation into industries where most
companies are likely to look good in the near term.

During this adolescent period of high and accelerating growth, it can be extremely hard
to distinguish the eventual winners from the losers because their financial performance
and growth rates look strikingly similar. (See the chart “Timing Is Everything.”) At this
stage, all companies are struggling to deliver products to a product-starved market.
Thus the critical challenge for the venture capitalist is to identify competent
management that can execute—that is, supply the growing demand.

Picking the wrong industry or betting on a technology risk in an unproven market

segment is something VCs avoid. Exceptions to this rule tend to involve “concept”
stocks, those that hold great promise but that take an extremely long time to succeed.
Genetic engineering companies illustrate this point. In that industry, the venture
capitalist’s challenge is to identify entrepreneurs who can advance a key technology to a
certain stage—FDA approval, for example—at which point the company can be taken
public or sold to a major corporation.

By investing in areas with high growth rates, VCs primarily consign their risks to the
ability of the company’s management to execute. VC investments in high-growth
segments are likely to have exit opportunities because investment bankers are
continually looking for new high-growth issues to bring to market. The issues will be
easier to sell and likely to support high relative valuations—and therefore high
commissions for the investment bankers. Given the risk of these types of deals,
investment bankers’ commissions are typically 6% to 8% of the money raised through an
IPO. Thus an effort of only several months on the part of a few professionals and brokers
can result in millions of dollars in commissions.

As long as venture capitalists are able to exit the company and industry before it tops
out, they can reap extraordinary returns at relatively low risk. Astute venture capitalists
operate in a secure niche where traditional, low-cost financing is unavailable. High
rewards can be paid to successful management teams, and institutional investment will
be available to provide liquidity in a relatively short period of time.

Criteria of the venture proposal

 

There are many variants of the basic deal structure, but whatever the specifics, the logic
of the deal is always the same: to give investors in the venture capital fund both ample
downside protection and a favorable position for additional investment if the company
proves to be a winner.

In a typical start-up deal, for example, the venture capital fund will invest $3 million in
exchange for a 40% preferred-equity ownership position, although recent valuations
have been much higher. The preferred provisions offer downside protection. For
instance, the venture capitalists receive a liquidation preference. A liquidation feature
simulates debt by giving 100% preference over common shares held by management
until the VC’s $3 million is returned. In other words, should the venture fail, they are
given first claim to all the company’s assets and technology. In addition, the deal often
includes blocking rights or disproportional voting rights over key decisions, including
the sale of the company or the timing of an IPO.

The contract is also likely to contain downside protection in the form of antidilution
clauses, or ratchets. Such clauses protect against equity dilution if subsequent rounds of
financing at lower values take place. Should the company stumble and have to raise
more money at a lower valuation, the venture firm will be given enough shares to
maintain its original equity position—that is, the total percentage of equity owned. That
preferential treatment typically comes at the expense of the common shareholders, or
management, as well as investors who are not affiliated with the VC firm and who do not
continue to invest on a pro rata basis.

Alternatively, if a company is doing well, investors enjoy upside provisions, sometimes

giving them the right to put additional money into the venture at a predetermined price.
That means venture investors can increase their stakes in successful ventures at below
market prices.

Evaluating venture capital

For all these reasons, venture capital is an attractive deal for entrepreneurs. Those who
lack new ideas, funds, skills, or tolerance for risk to start something alone may be quite
willing to be hired into a well-funded and supported venture. Corporate and academic
training provides many of the technological and business skills necessary for the task
while venture capital contributes both the financing and an economic reward structure
well beyond what corporations or universities afford. Even if a founder is ultimately
demoted as the company grows, he or she can still get rich because the value of the stock
will far outweigh the value of any forgone salary.

By understanding how venture capital actually works, astute entrepreneurs can mitigate
their risks and increase their potential rewards. Many entrepreneurs make the mistake
of thinking that venture capitalists are looking for good ideas when, in fact, they are
looking for good managers in particular industry segments. The value of any individual
to a VC is thus a function of the following conditions:

 the number of people within the high-growth industry that are qualified for the
position;
 the position itself (CEO, CFO, VP of R&D, technician);
 the match of the person’s skills, reputation, and incentives to the VC firm;
 the willingness to take risks; and
 the ability to sell oneself.

Entrepreneurs who satisfy these conditions come to the table with a strong negotiating
position. The ideal candidate will also have a business track record, preferably in a prior
successful IPO, that makes the VC comfortable. His reputation will be such that the
investment in him will be seen as a prudent risk. VCs want to invest in proven,
successful people.

Advantages and Disadvantages of Venture Capital

Venture capital provides funding to new businesses that do not have access to stock
markets and do not have enough cash flow to take debts. This arrangement can be
mutually beneficial: businesses get the capital they need to bootstrap their operations,
and investors gain equity in promising companies.

There are also other benefits to a VC investment. In addition to investment capital, VCs
often provide mentoring services to help new companies establish themselves, and
provide networking services to help them find talent and advisors. A strong VC backing
can be leveraged into further investments.

On the other hand, a business that accepts VC support can lose creative control
control over its future direction. VC investors are likely to demand a large share of
company equity, and they may start making demands of the company's management
as well. Many VCs are only seeking to make a fast, high-return payoff and may
pressure the company for a quick exit.

Pros & Cons of Venture Capital

Pros

 Provides early-stage companies with the capital needed to bootstrap operations.

 Unlike bank loans, companies do not need cash flow or assets to secure VC
funding.

 VCs can also provide mentoring and networking services to help a new
company secure talent and growth.

Cons

 VCs tend to demand a large share of company equity.

 Companies that accept VC investments may find themselves losing creative

control as their investors demand immediate returns.

 VCs may also pressure a company to exit their investment rather than pursue
long-term growth.
Types of Venture Capital
Venture capital can be broadly divided according to the growth stage of the company
receiving the investment. Generally speaking, the younger a company is, the greater
the risk for investors.

The stages of VC investment are:

 Pre-Seed: This is the earliest stage of business development when the founders
try to turn an idea into a concrete business plan. They may enroll in a business
accelerator to secure early funding and mentorship.
 Seed Funding: This is the point where a new business seeks to launch its first
product. Since there are no revenue streams yet, the company will need VCs to
fund all of its operations.
 Early-Stage funding: Once a business has developed a product, it will need
additional capital to ramp up production and sales before it can become self-
funding. The business will then need one or more funding rounds, typically
denoted incrementally as Series A, Series B, etc.

Venture Capitalist in India are an essential part of startup ecosystem. Once a startup
has reached it’s growth stage, it’s most important requirement is undoubtedly the
backing by reliable investors and an ample amount of funding to scale up. Though the
concept of starting up has gained momentum recently, but the small number of
investors willing to show their trust and invest in new ventures has been a problem for
startups. Many startups find it difficult to approach venture capitalists and quite a few
times the investment structure of the investor is inadequate for the startup.

So this week we bring to you the much needed list of the most active institutional
investors and capital funds in India along with their investment capacity, investment
structure, investment industries and some of their most notable portfolio startups.
This article is part of our series on the essentials of starting up in India in which we had
earlier compiled the Top 15 Accelerators, Top 20 Incubators and CoWorking spaces in
India.

Helion Venture Partners 

Investing in technology-powered and consumer service businesses, Helion Ventures

Partners is a $605 Mn Indian-focused, an early to mid-stage venture fund participating
in future rounds of financing in syndication with other venture partners.

People You Should Know: Sandeep Fakun, Kanwaljit Singh.

Investment Structure: Invests between $2 Mn to $10 Mn in each company with less

than $10 Mn in revenues.

Industries: Outsourcing, Mobile, Internet, Retail Services, Healthcare, Education and

Financial Services.

Startups Funded: Yepme, MakemyTrip, NetAmbit, Komli, TAXI For Sure, PubMatic.

Contact Details: 8040183333, 01244615333, Email

Accel Partners 

Accel Partners founded in 1983 has global presence in Palo Alto, London , New York,
China and India. Typical multi-stage investments in internet technology companies are
made by Accel partners.

People You Should Know: Subrata Mitra, Prashanth Prakash and Mahendran

Balachandran

Investment Structure: Invests between $0.5 Mn and $50 Mn in its portfolio companies.

Industries: Internet and Consumer Services, Infrastructure, Cloud -Enabled Services,

Mobile and Software.

Startups Funded: Flipkart, BabyOye, Freshdesk, Book My Show, Zansaar, Probe,

Myntra, CommonFloor.
Contact Details: 8041232551, 8043539800, Email

Blume Ventures 

Venture capital firm, Blume Venture Advisor funds early-stage seed, startups, pre-series
A, series B and late stage investments. Blume backs startups with both funding as well
as active mentoring and support.

People You Should Know: Karthik Reddy and Sanjay Nath.

Investment Structure: Provides seed funding investments between $0.05 Mn – $0.3

Mn in seed stage. Also, provides follow-on investments to portfolio companies ranging
from $.5Mn to $1.5Mn.

Industries: Mobile Applications, Telecommunications Equipment, Data Infrastructure,

Internet and Software Sectors, Consumer Internet, Media, Research and Development

Startups Funded: Carbon Clean Solutions, EKI Communications, Audio Compass,

Exotel, Printo.

Contact: Twitter

Sequoia Capital India 

Sequoia Capital India specializes in investments in startup seed, early, mid, late,
expansion, public and growth stage companies.

People You Should Know: Shailesh Lakhani and Shailendra Singh.

Investment Structure: SCI invests between $100,000 and $1 Mn in seed stage,

between $1 Mn and $10 Mn in early stage and between $10 Mn and $100 Mn in growth
stage companies.

Industries: Consumer, Energy, Financial, Healthcare, Outsourcing, Technology.

Startups Funded: JustDial, Knowlarity, Practo, iYogi, bankbazaar.com

Contact: 8041245880, 2240747272, 01149567200

Nexus Venture Partners 

Nexus Venture Partners is a venture capital firm investing in early stage and growth
stage startups across sectors in India and US.

People You Should Know: Suvir Sujan and Anup Gupta

Investment Structure: Invests between $0.5 Mn and $10 Mn in early growth stage

companies. Also, makes investments upto $0.5 Mn in their seed program.

Industries: Mobile, Data Security, Big Data analytics, Infrastructure, Cloud, Storage,

Internet, Rural Sector, Outsourced Services, Agribusiness, Energy, Media, Consumer
and Business services, Technology.

Startups Funded: Snapdeal, Housing, Komli, ScaleArc, PubMatic, Delhivery.

Contact: 8049456600, 2266260000, Email

Inventus Capital Partners 

With the sole goal of making new entrepreneurs successful, Inventus is a venture
capital fund managed by entrepreneurs and industry-operating veterans.

People You Should Know: Samir Kumar and Kanwal Rekhi

Investment Structure: The firm does not invest in capital intensive companies. It

typically leads the first venture round with $1 Mn to $2 Mn and as the businesses grow,
it invests from $0.25 Mn up to $10 Mn.

Industries: Consumer, Hotels, Restaurants and Leisure, Media, Internet and Catalog

Retail, Healthcare, Information Technology, Hardware and Equipment,
Telecommunications etc.

Startups Funded: Poshmark, Savaari, Farfaria, Policy Bazaar.com, Insta Health

Solutions, CBazaar.

Contact: +91 80 4125 6747, Email

IDG Ventures 

Having a global network of technology venture funds with more than $4 billion, IDG
Ventures India is a leading India-focused technology venture capital fund specializing in
startups, early stage, growth stage and expansion stage companies.

People You Should Know: Manik Arora and Sudhir Sethi

Investment Structure: Invests in India-based companies and also in companies

outside India. The firm invests between $1 Mn and $10 Mn.

Industries: Digital Consumer – Internet, Mobile, Media and Technology Enabled

Consumer Services, Enterprise Software – SaaS, Software Products and Enterprise
services, Engineering – Medical Devices, Clean-tech and IP-led Businesses

Startups Funded: UNBXD, Yatra.com, Myntra.com. FirstCry, Zivame, iProf,  Ozone

Media.

Contact: +91 80 4043 4836, +91 11 3019 4145, Email

Fidelity Growth Partners 

Fidelity Growth Partners India is the private equity arm of Fidelity International Limited
focused on investing in India. Since 2008, FGPI has made several investments across
sectors including Healthcare and Life Sciences, Technology, Consumer and
Manufacturing.

People You should Know: Abhinav Sinha, Harsh Jhaveri

Investment Structure: Typically, FGPI invests between $10 Mn and $50 Mn for a

minority stake in the company

Industries: Healthcare and Life Sciences, Technology, Consumer and Manufacturing

Startups Funded: Netmagic, Yebhi

Contact: Email
Naspers 

Naspers is a leading multinational media group, incorporated in 1915 as a public limited

liability company and was listed on the Johannesburg Stock Exchange (JSE) in
September 1994. The group’s principal operations are in internet platforms (focusing on
commerce, communities, content, communication and games), pay-television and the
provision of related technologies and print media (including publishing, distribution and
printing). The group’s most significant operations are located in South Africa and
elsewhere in Africa, China, Central and Eastern Europe, India, Brazil, Russia, Thailand
and the Netherlands.

People You should Know: N/A

Investment Structure: N/A

Industries: Ecommerce, Print Media, Pay Television

Startups Funded: OLX, Flipkart

Contact: Twitter

Steadview Capital 

Steadview is a leading alternative asset manager based in Hong Kong. The firm makes
concentrated long-term investments across multiple industries

People You should Know: Ravi Mehta

Investment Structure: Early Stage Venture and Later Stage Venture Investments

Industries: Ecommerce

Startups Funded: Olacabs, Flipkart, Saavn, Urban Ladder

Contact: Website