When venture capitalists look at a company to make an investment, there are certain necessary criteria. These include strong leadership and potential value. But what does a venture capitalist look for before making an investment in a company? According to Sudhir Sethi, Founder Chairman & Managing Director, IDG Ventures, who delivered the keynote address at the event, “The whole cycle is categorized into 4-5 stages of funding. The youngest is the seed stage. A seed stage company has a team and nothing else. The next stage is the early stage, where there are few people, few products and services and a few perhaps non-paying customers. The role is to fund such companies in a larger space.”
“The next stage is the early growth stage. The difference between early stage and early growth companies is that the latter has real customers and their revenue has started to fill the gaps in investment coming in. Then the company moves to growth stage and larger investors start to come in at that point of time.”
Addressing the companies gathered, Sethi said “The first question to is ‘Why risk capital’? Fundamentally risk capital comes in where debt capital cannot. Risk capital assumes that equity is the only resource that is available to the investor and there is no other resource available if the company does not succeed.”
Investors look at emerging sectors that are converging and could potentially create great value. These include revenues or markets that are domestic, government, defence, aerospace, the whole sector of security (which is very large in India), BI, analytics, and energy.
Giving the statistics for the last five years, Sethi said, “Between 2004-09, about 660 organizations got funded to the tune of about $3billion. In 2010-15 this amount would be about $7.5billion, available to about 1,500-2,000 firms. But it is a long and tedious process.
Last year IDG Ventures saw 750 companies but invested only in two. These according to Sethi were normal ratios. “There is full set of criteria. Venture capitalists look at large number to arrive at the final few.” So what exactly are they looking for?
The number one requirement was that potential value had to be built in. This comes from predictable revenue. He cited the example of Infosys who could predict revenue for 8 quarters. He also gave the example of a smaller company that they had funded that could predict revenue for less than a month. Two years later, they could predict revenues for the quarter and that frame would steadily grow over time.
The next area was Product companies. Sethi said that while these were not the current norm in India, going forward, it was an area that would see funding.
The third was Services companies, a category that included many of the SI organizations that addressed the domestic and international market.
The other area was growing companies. Sethi said, “Investors define growing companies as giving Rs 300-500 Crore revenue in 7-10years’ time with potential with 10-15 percent profit after tax. These are the financial norms. I’ve funded 27 companies is the past 12 years and haven’t deviated from this standard.”
Sethi that it was a myth that good organizations with good products were the only ones to get funded. One of the most important requirements that venture capitalists looked for was a strong leader. “If there is no leader, it won’t get funded. A strong leader does not come from experience, inexperience or an MBA.”
The one thing that put off investors was multiple entities doing parallel businesses. “If there are tree or four legal entities, the investor may ask you to merge these as he is looking for one leader who does nothing with any other legal entity,” said Sethi.
Sethi went on to address the implication of investors coming in. “It means calling in an outsider who would be on the board and would influence decisions.”
“The only reason he is there is capital gain. There is a 66 percent chance that the he will sell his shares and you could no longer be in charge of you company. Are you willing? You could buy it back but returns of investment expectations are so high that it is difficult,” said Sethi.
Sethi also spoke about alternatives to risk capital. These included having an advisory board, hiring senior professionals from companies like Wipro where people were used to handling a Rs 100 Crore business, approaching professional angels who used a softer approach to funding, proper governance practices and consolidation of the business.
“These are not just baby steps, but fundamental to building a good company over time,” said Sethi.