How is a VC Firm set up and how does it work?

This is key in understanding the motivations behind VCs and the kinds of companies that they will fund.

Very large pension funds around the globe, very wealthy investors all have percentages of money that they can spend on "Gambling Money" or money that they set aside usually (5 to 10% or all the money they have, I am guessing) to invest in High Risk, High Return investments. This is what goes into Venture Capital.

These are called Limited Partners.

Two or three people usually with lots of experience doing this in another VC firm start a partnership that is called say XYZ Venture Capital. They are the founders and managing directors of these VC firms.

They then go out and raise a round of Capital from the Limited Partners after selling them on their experience and focus - They would do it for Technology, Life Sciences, etc. They also need to define their investment objectives - Seed Stage, Early Stage, Middle Market, Late Stage , etc.

They can take out a 2 to 3 % management fee out of this for their salariesm expenses, etc every year out of this money.

So they will raise say XYZ Venture Capital Fund I to be invested in say Early Stage Technology Investments in Software and Services companies only. This fund has a life of say 10 years. This means that if they raise this fund I in 2009, they will have to return the money to the Limited Partners in 2019.

So VCs have their own bosses - Limited Partners. If they raise $100, they can return $150 or $80 back in 2019. That would mean a gain of 50% over 10 years or -20% over 10 years.

The VC fund can also take a Carry if they return more money than they raised, that is a cut from the gains that they caused in those ten years.

So the first thing to understand is that everyone has a boss - Enterpreneurs' bosses may be VCs, VCs' bosses are Limited Partners. They will not be able to raise a second fund if their first fund or their track record is not that good in returning the money.

The lesson for entrepreneurs here is that VCs have a performance goal just as entrepreneurs do. That's what motivates them to bet on certain things and not on certain things.

More to come in this topic! 

Nari,

Great start. Keep going. I am reading and sure many others too...

Suresh

What does it take for a VC to return 10% to their Investors?

Let's asssume that XYZ Venture Capital raises a fund called Software Products Early Stage Fund I with $100 in 2009. If the limited partners put their money in the bank in the US they can get only 2 to 3%. In India they might be able to get more but to get a decent return of 10% per annum they need turn this $100 to $200! If they need to return a spectacular (In VC world) 20% they will have to turn the $100 to $300 in 10 years!

This is not like putting the $100 in the bank and earning interest! The $100 needs to be invested in very risky investments. Only a small percentage of startups make it beyond even the first one or two years. So if they make 20 investments of $5 each, many of these $5 go away without a trace. So they need to hit that one Twitter or Google or FaceBook jackpot that turns that $5 into 50 times - $250 to get anywhere near their 20% goal!

But wait a minute! Not all this $100 will be invested right away. They will invest $5 in a company and then they need to reserve 4 or 5 times that money - $20 to $25 for subsequent rounds! So for every $5 invested, $20 is reserved. So they can do only 4 companies in $100!!!

Now you are getting the picture! That's the reason VCs go through many many business plans looking for that one Jackpot that can make up for all the other duds that will lose all of the money!

Nothing personal - the growth you need to show is that of a hockey stick to get that $5 to be worth 20 times or 30 times the investment:

Some examples of Hockey Stick Growth:

More in the next note on Company Valuations, How VCs get their money out, etc

Nari: Thanks for the lots and lots of details. Here are my questions:

1. Can anyone locate the Jackpot in a business plan?

2. They do all due diligence, but why they fail 95% of the time?

A good generalized summary of how a VC is setup, explains how VC Funds get their investment. How do they get their partners, their portfolio, their returns ? Most of these are knowledge and context driven. Look forward to reading more, especially in the Indian Context.

I know for a fact that most VCs in India don't even think about series-A without a topline of $3-4 Million. In the Silicon Valley, a company with $3-4 Million is probably looking at Series-B.

Getting past Series-A (and not seed) is the biggest challenge for Indian hi-tech startups. A company that is targeting sales of $40-60 Million in 4-5 years making a net profit of 30%, and growing at 30-40% year is an enterprise worth $400 - $600 Million, with a PV greater than 50% of that. That is phenomenal value created and only 1 or 2 of 10 funded companies can do that. In fact only 2 or 3 companies in a portfolio of 10 actually return nothing, in most cases there the VCs can recover a large share of their investment, and even a mediocre company would return 2-3x.

In most cases, series-a investment ranges between $5 - $10 Million with a 20-40% share of the equity. Employees get about 20% (ESOPS) and in most cases founders get the remaining (> 20%).  This creates an environment where every one wins if the plan succeeds, usually one of the biggest motivators for the plan to succeed. Of course, the more a startup can progress without VC, the less the VC gets !

Summary: If you have a good team, good idea a good TAM (Total Available/Addressable Market) and a prototype with a few LOI's, that is all you need to get Series-A (after knocking 20-50 VCs). Once you get the lead investor, it is supposed to be a lot simpler to close the round.

Disclaimer: I never raised VC funding

Lakshman:

1. Can anyone locate the Jackpot in a business plan?

I will address this after I cover some more topics in the VC arena.

2. They do all due diligence, but why they fail 95% of the time?

The other way to think about this is that there is an ecosystem that is encouraging startups with BHAGS - Big, Hairy, Audacious Goals, knowing fully well that 95% of them will fail but one that succeeds will succeed big time, like Google. That is the difference between Banking and Venture Capital.

Gopi: I will get into the Indian context after talking about Global Venture Capital in general. The rules in the Indian context are pretty much the same. The big global VC firms are the ones behind the Indian ones also.

Company Valuations, How VCs Exit and Return Their Money to Limited Partners

With startup companies, the valuation of the company is more of an Art than a Science. Twitter now is valued at $1B plus and they are not sure how they are going to make money! Valuation at this stage is purely a function of what someone is willing to pay for it. When some investors are willing to put in $100M into Twitter at a valuation of $1B plus, then today that's the valuation of that company.

When a VC puts in Seed or Early Stage money they do it at a valuation based on general norms that particular month. When times are good and lots of VC money is chasing very few companies the valuation shoots up and when it is not, it goes down.

After the first round, it is in the VC's interest to spread the risk of that company - so they bring in additional VCs to share the risk. They put in additional monies from the money they have reserved for subsequent rounds for this company.

Every round the valuation is bumped up like in the Twitter case above. If that sector is not hot, subsequent valuations can also be down-rounds or the valuation can also go down. So it can go either way.

VC funds may not wait till the 10 years or up. They may exit their investment in the company by going public and selling their shares in the company in the open market. Or they could get that money back when this company is acquired by another company.

These sound like stupid mumbo-jumbo but these are very smart, highly educated individuals. If the whole system does not make logical sense over a long period of time, VC firms would have been history long time ago! Many are history already since the Dot com boom because they defied the laws of VC gravity with many stupid investments and not too many Googles.

Why should some company acquire another company? IF they have Intellectual Property that cannot be done quickly enough or if they have customers.

Microsoft paid Sabeer Bhatia and Hotmail, $400M to acquire an instant customer base of 9 Million people who had hotmail accounts (Rumor has it that a majority of them were in India opening accounts so that they send resumes out!. But that's another story!). Oracle paid billions of $ to PeopleSoft so that they can get their customer base and convert them to Oracle solutions over a long period of time.

So it's a question of the value of time! Oracle would rather set up a group inside their company and develop your best-of-breed solution that your startup company has from scratch. But if you already have 25 customers and growing fast, it is better for them to buy you rather than develop it from scratch. So it's a Make Vs Buy decision for them.

So XYZ Early Stage fund I during the ten years of its life, sells companies it funded or get to IPO and take their money out. That money minus the carry goes into the account of that fund.

At the end of ten years, this fund returns the money back to the Limited Partners. Could be $200 if hey started with $100 or $80 depending upon whether they made one or two good investments that turned 20 to 30 times over! That's where thier returns are calculated. The VC firm or General Partners as they are called cannot raise the next fund if their track record with previous funds were not good! They may dissolve the VC firm as many have done recently.

Fast Growth Companies Vs Lifestyle Companies - When are you a good candidate for VC Money?

Not all companies are good candidates for VC money. Are you a Fast Growth (Hockey Stick Growth ) company or a Lifestyle Company?

Some very large companies in IT never took a dime in venture capital - Oracle is a good example. In India none of the large IT companies have been started with Venture Capital. In fact more large companies have been started without VC money!

This is no reflection on VC firms but it is just the nature of how they raise their money and how they get out and how valuations are done in between. They are designed to fund risky, new ideas that have high rates of failure but the one o two that succeed changes the game for everyone for ever.

Lifestyle companies are companies that have growth but not the Hockey Stick style growth. It is more like 10 to 15% per annum. There is nothing wrong with these companies. If you bootstrap them and they are providing a steadily increasing cash flow you can still build a good company, pay yourself a good salary and have the entire company to yourself when you sell it!

For the Hockey Stick growth, you may or may not need to look at Global markets! Mobile wireless in India has been growing at such a pace, that the Indian market is more than adequate to qualify for a deep hockey stick as the graph shows!

In other cases, you may need to look to global customers for growth. There are Indian startup companies that have developed web 2.0 companies for Local Sports Leagues. There are local sports leagues in India but they may grow much much faster if they look to the global market instead! So it all depends.

Why do VC firms need a Hockey Stick growth pattern? That goes back to the valuations of the company in subsequent rounds. If a company grows to $50M within 5 years in revenues, their valuations also will make sense in round after round and they can have that Jackpot exit. Other investors will not jump in until this rapid growth is shown. This rapid growth need not be in current revenues but also in potential revenues. Google was not making too much revenue when they went public but subsequently realized billions of dollars in revenues. So it is not all stupid!

So before you complain about VC money, understanding whether your company is a candidate for VC money or not is key. Are you a Fast Growth company or a Lifestyle company?

VC Firms need to report back to their Limited Partners on new companies they have checked out every week, month or quarter. So they will waste your time, taking meetings and putting them on their reports. It is up to the entrepreneur to make sure that they spend their time wisely chasing VC money in the first place.

If you don't need it and you can grow slower comfortably, things are actually better for you! 

Nari - Will be good to hear what is different from a practicing VC in India. What is same is generally known.

Nari - Would you think there are more VCs in one-block in palo-alto than all of India combined ? Is that really the difference ?

Gopi - Yes. It would be good to hear from a VC on just about everything in this topic on what is different in India. I will cover what I know in subsequent entries. 

The funny thing is that EVERY MAJOR VC in Palo Alto has offices in India, dedicated funds in India or work through an Indian VC like Helion Ventures by becoming limited partners with them. Checkout this article by Sramana Mitra that is somewhat old:

Venture Capital in India

Sramana lists almost all of the top VCs in Palo ALto - Matrix Partners, Kleiner, Sequoia, NEA, Battery, Bessermer Venture Partners and so on...

If anything, 90% of all VC in India are really Palo Alto VC firms. Europe and Middle East venture capital is more on less risky, very large Private Equity people rather than Venture Capital! They don't know or don't want to take risks like the Palo Alto VC firms. 

So make no mistake - the rules, approach, the pressures are all the same! 

Nari - good point, that shows these firms are interested in India and see potential there for their business. But then how many partners do they have in India ? VC is a knowledge-play. In addition to financials, a deep knowledge of Markets and Technologies is essential to succeed for a VC.

A  partner "transferred" from Silicon Valley to Hyderabad is definitely on loose ground for several years. He or she has to prove their capability in a new territory. A partner with experience in India is likely to be focused other "markets" than Hi-Tech Software products. Therefore in addition to the number of VC firms, the number of partners and their diverse experience is a major factor. Then there is accessibility, do they have offices close by ? How long does it take to make your presentation to 50 or 100 of them ? Even the best plans in the valley some times have to make presentations to dozens of VCs before they get funded. That is not an easy option for an Indian product company. 

It is clear that a positive spiral is required for any specific industry x market to start having multiple sources of finance (including VC) to be available. The primary engine for that spiral is a success story and then another. It is clear from this discussion that the spiral is all ready to start, various players have taken their positions and ready to jump.

On a lighter vein there are those (partners) who got in early, burnt their hands and then transformed to experienced speakers in most VC forums :-( I do admire their continued interest and support for the product companies in India.

In this context, I would like to add that the Angel industry in India is building up fast, with the likes of the IAN (Indian Angels Network) already listing of hundreds of members. There are government schemes for many incubators where funding is available for companies / universities starting incubation centers.

Cheers,

gopi

Gopi:

I will cover all of your good points in my coverage of India VCs where they were when they first started, where they were till recently and where they are planning to go now. My exposure to many Indian VCs proved  that they are immensely professional, highly available people who are trying their best given the geographical coverage they need to do.

In fact they are in Chennai. Bangalore, Mumbai and Delhi many times a month if needed, Hyderabad occasionally, no Kolkota till recently may be. Geographical location does not see to faze them. If anything they are less anal about location than US VCs!

The way they operate is also not that very different from their parent VC firms. These are the US VCs. Not the local Indian VCs who are of course, as you say, may be looking to less risk averse investments.

Nari

The Indian VC Landscape, What they have Funded and What they seem to be  funding now

The Indian VC landscape gets the majority of money from US VC funds that set up offices in India (almost all the major ones - locate the US VC directory and look up their website to see where the indian reps are) and have been and are funding many companies that provide the hockey stick growth or at least fast growth companies at the time they were funded.

Initially it was the time of IT Outsourcing and BPO Boom around 2004 to 2007 when a lot of the investment money found homes in Indian BPO companies - like ICICI One Source, now FirstSource, etc.

At the same time they started funding many Mobile related startups - Mobile Banking, Mobile Ads, etc - given the hockey stick growth they saw with Rural Growth of Mobiles in India and among the urban, high income consumers.

They also funded Travel Sites, Bus Ticket sites, etc where they saw fast growth just given the paucity of such facilities in India - ClearTrip, RedBus, TicketVala, etc where they saw rightly so, fast growth.

It is my guess that then they started seeing many ME-TOO websites - Oh - we are jinglee.com, just like LinkedIn, we crowster - just like Twitter, etc and were sufficiently dismayed  but see many many opportunities in unexplored places - like what Mohanjit Jolly writes here eloquently:

Will India Produce A Google?

India has a vibrant VC scene and a lot of them also present. You just need to go find them, understand what makes them tick or not and see if your business is a fit for what they want to do. The best places to start are the Us VC firm websites. They will lead you to the local offices and contacts.

After the initial few startups were funded, the Indian VCs seem to have hit a wall not finding enough early stage startups to fund. Or they needed the rest of their $100M India fund to be reserved for their follow on rounds.

Whatever the reason, right now these VCs in India also seem to have moved away from the early stge startups preferring only later stage ones!

So as of now, the situation with Indian VCs is not that good!

Is there any analysis of success rates of VC investments in India. Anyone know of  VC investments in India that hit 10 X return. Will indicate which ones really hit the J curve.

I think many of the India funds may not have reached maturity yet for them to return monies to their Limited Partners. So it will be very hard to come by any total Fund Return Stats.

In fact look at this Stats for August 2009:

India Venture Capital Stats: August 2009

They are not even disclosing the investment size. I think it will be difficult to calculate even company by company Return X!

The first half of 2009 shows a sharp fall compared to first half of 2008:

Venture Capital firms invest $117-M in India during H1 2009

From $413M for the first half of 2008, it has fallen to $117M in the first half of 2009.

I hope this is not disillusionment with the availability of enough plans in India with the J curve of growth!

This does not mean that good companies in India cannot be grown to be good, profitable companies. It just means that the kinds of companies with the J Curve of growth is not found in enough numbers in India.

Not surprised that many of the VC funds that came in looking for Early Stage deals quietly went into other areas like real estate and other later stage deals.

If you cannot find enough high growth companies, you could invest the bulk of the money in a few large deals and make at least a respectable 5 to 10% on the whole. Beats making  minus 20% at the end of the fund!

Understanding how and when VC capital works makes us understand what VCs in India do also. Not that it helps the entrepreneur any, but at least you can understand it as a rational business decision and not some genetic defect with the VCs!

How do I Identify that Jackpot Business Plan suitable for VCs with the potential Hockey Curve or J Curve growth?

There are companies in India that are getting funded by VCs even now, a few of them in Early Stage but alll of them seem to promise a steep growth curve.

Mobile Payments that rely upon Rural adoption of phones where farmers can easily transact where they are using SMS without having to travel to the nearest State Bank in the nearest town.

Or Mobile Games startups that show increasing adoption of slightly more capable phones beyond the  Urban Professionals in  Tier 1 cities to tier 2 and tier cities. Here also the growth rate seems promising.

Travel sites in India rapidly converted a lot of people to book tickets online (starting with Indian Railways - The Pioneer!) instead of dealing with paper. This rapid growth in millions and millions of customers attracted a lot of VCs to companies like ClearTrip, makeMyTrip, etc.

Or Rural Solar Generation projects that have the potential of adoption in the rest of India, in villages where India lives.

Anywhere, where you have a potential population is waiting for a solution and is in millions and millions in numbers and the adoption is expected to be rapid, VC money, even early stage may be easy to line up.

Enterprise Software if SaaS based and you show rapid growth as an alternative to traditional licensed software with Small and Medium sized businesses, you could line up venture funding. The key here is not to talk about potential but to show the past 6 months customer wins. If they show a hockey stick growth, you have a story!

Of course, if your business can really look to the whole world as a potential market rather than India and you are showing fast growth in the initial stages of your company, again you may be a good candidate.

This applies only to early stage venture capital. If you are midstage or late stage and you are showing steady growth, you could line up venture capital again.

This is not to say that you are a bad business or you cannot build a profitable business slowly, bootstrapping your operation.

It just means you may not fit the profile of a VC investment!

Thanks Nari for that input about the state of VC's

Even I would not put my money (if I were a VC) into Enterprise Software in its current form.

However it is a trillion dollar industry and if there is any likely reconfiguration of the market for the business of Corporates running applications, then VC's will be foolish not to play.

George: Can you please elaborate little bit?

Every 15 years or so technology shifts tend to replace incumbents. When the mainframe/ AS400 world got changed to mini/ unix systems a new breed of vendors took over. When the current spagetti code based Inpremise Systems move to SaaS/cloud/ mobile/ agile systems there could be a change - it essentially depends on whether the incumbents are visionary enough not to lose their positions to an upstart (How Google realized that Search was the key to internet and not content).

The rest of the discussions as to what form the future market will take place can probably be had over a cuppa coffee during the enclave (not sure yet if I can make it) given that most of the VC's and product gurus around dont seem to agree with my views on this topic - so I am not expanding it here. Everyone is entitled to theirs and only hindsight will tell what is right.

I hope some product from India is the one that takes advantage of the next shift that is happening to a trillion dollar market.