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Ernst & Young – 2008 Global Venture Capital Report: Sudhir Sethi interview


August 21, 2008

Innovation: The Growing Importance of Venture Capital Global Venture Capital Insights and Trends Report 2008 July 2008

Perspective from India

Sudhir Sethi
IDG Ventures India

Interview with Sudhir Sethi

Sudhir Sethi is Founder, Chairman and Managing Director of IDG Ventures India, a US$150 million early-stage technology venture capital fund backed by IDG, the world’s largest IT-focused media company. He founded IDG Ventures in 2006 after 26 years in the technology and venture industry.

Ernst & Young: What were your surprises in the last 12-18 months?

Sudhir Sethi: When we raised our US$ 150 million fund and started operations in September 2006, we focused on early stage technology investments. Our focus was and continues to be in Software Products and Services, manufacturing and engineering, medical electronics, digital consumer and telecom / semiconductor sectors.

Our first surprise was the pace at which funds are vacating the venture investment space and moving increasingly to the growth investment stage. Our intention is to dominate the venture stage technology focused sectors as an early stage fund.

Our second surprise was the extent of competition in our sectors; except for digital consumer space (internet / mobile VAS), we really do not face significant competitive pressures in our other sectors.

Our third surprise was on valuations; we find valuations in the venture stage of the technology sector extremely attractive.

Our fourth surprise was the maturity of the entrepreneur who today values relationships and value-add from a venture investor; the fact that the IDG Ventures team of six investment professionals have significant domain, operating and venture experience sets us apart in the industry. This combined with the IDG network value-add, is a significant differentiator.

In the past 18 months, we also found that venture investments in India require business model innovations to create companies and not just fund conventional deal flow; hence we funded ConnectM, a spin out from Sasken; Aujas a managed security services pure play, through an EIR Program and 3D Solid Compression, which was incubated by Stanford and Indian Institute of Science, Bangalore.

Ernst & Young: What’s the potential impact of the uncertain capital markets on the VC ecosystem?

Sudhir Sethi: The key potential impacts of the uncertain capital markets on the VC ecosystem can be classified under:
a) Fund-raising and general partner/team quality
b) Deal flow
c) Valuations
d) Exits
e) Co-investments

Limited Partners, as we go forward, will become extremely choosy about the quality of teams they back in partnerships. Very few general partners (GPs) in India have what I call a full-cycle GP experience of deal flow generation, investment, monitoring, exists, and fund raising. In essence, first time funds especially with teams who have not worked together will find it difficult to raise capital. However, second-time funds with a clearly articulated strategy of investment, with teams who have a partnership having full-cycle venture experience will get funded relatively more easily.

Deal flow is expected to slow down, with new start-up ventures reducing due to lower entrepreneurial inflow from corporate to start-ups. However, I do expect quality of deal flow to go up. In addition, we expect deal flow to be more spread across cities in India including tier-two cities like Pune, Coimbatore, Mysore etc.

I have already seen significant lowering of valuations in seed and early stage deals. This trend is likely to continue.

Another significant impact of uncertain capital markets in increased incidence of co-investments. Out of our seven investments so far, four are with co-investors (Erasmic, e-Planet Ventures, Softbank and Sasken).

As far as exits are concerned, the dependence on IPOs will reduce significantly; companies have to be built increasingly for exit by acquisition. This also implies founding teams to build significant disruptive business models and technology differentiators to command higher valuations at exit.

Ernst & Young: What have been the key insights and takeaways from the markets, mature and emerging, you have invested in?

Sudhir Sethi: In the past 10 years, I have invested in India; in the USA with India as a back end (development location) and in Singapore / Malaysian companies looking at India as a market.

My first key learning in an emerging market like India is to invest in companies based in India where the founders know the Indian environment very well, especially since India is a significant market for our investee companies as compared to yesteryears when the US used to dominate as a market for India-based companies. Hence, we do not invest in companies if founding team in the USA or anywhere outside India.

The second key learning is not to transport a USA investment model into India; for example an investment into the Internet space in the USA assumes a mature online market; whereas an investment in the Internet space in India will demand a significant market expansion based on an offline model as well.

Thirdly, in addition, since the India entrepreneur in all probability, cannot build a scaled company with India as a market alone (unlike the USA entrepreneur) it is essential for the founding team to have cross border experience in business development. The investment bar in an emerging market like India is thus higher. Incidentally cross-border experience can be India-China and not India-USA alone.

With India’s GDP growing at 8.5% and the technology industry still growing at above 25% per annum, attrition is a bigger issue in India than the USA. In addition, employee stock ownership plans (ESOPs) are not valued by employees as a replacement for cash compensation. Hence, ESOP vesting and grants find different treatment by our investee companies; we tend to have back-loaded vesting for ESOP as compared to straight-line vesting with a view to encourage retention.

Ernst & Young: What are the top three challenges for the VC industry in the next 12-18 months?

Sudhir Sethi: The Venture industry challenge in India for the next three to four years is one of opportunity management.

The Indian Venture Industry can support more venture funds; an increasing number of limited partners (LPs) we have met over the past 18 months have conveyed to us to continue with our focus on venture investments. First-time funds will find it difficult to raise capital; second-time funds would be able to raise capital faster.

We have increasingly found disruptive product companies to invest in, compared with the traditional services model. Interestingly, five of our seven investments are in product companies; these include Manthan, Kreeda, iViz, Perfint and 3D Solid Compressions. In the 700+ deals we have seen so far, products form 46% of our deal flow. We expect this healthy trend to continue.

Venture funds will face a challenge of retaining their teams with more private equity funds being formed. This can only be met through increasing responsibility to associates and principals and sharing gains with the full team rather than only amongst GP’s.

Ernst & Young: What advice you would give to an entrepreneur who is building a company today?

Sudhir Sethi: My first advice to entrepreneurs is to choose their investor based on track record and value-add. It is important for the entrepreneur to ensure the VC is worthy of sitting on his board and is his “first stop mentor”. The VC and Entrepreneur relationship in early venture funding is for three to five years; entrepreneurs must ensure chemistry and trust as significant criteria in addition to capital and valuations.

In second place is the quality of the team. Entrepreneurs / founding teams must build smart teams who can scale and also keep the flock together. Good teams can whether business down-cycles; bad teams find it difficult to grow in good cycles.

In addition, entrepreneurs must focus on building value and valuation from an exit point of view. In a tough IPO market scale, differentiation and plain old profits are critical to a successful exit for investors and founders.