During our interactions with seasoned entrepreneurs, very often, we gather information in the form of interesting ‘tit bits’ on a plethora of subjects and find it hard to share as part of a regular story. Nevertheless, the information is very valuable and hence, we decided to share it with our readers through this section titled ‘Startup School’. Our idea is to approach an entrepreneur and discuss a particular subject at length and basically, put together every tit bit there is.
The third article in the Startup School series discusses the topic “How should an entrepreneur weigh his different options while raising money?” To discuss this topic, we spoke to C Venkat Subramanyam, Founder Director, Veda Corp, an investment bank that advices entrepreneurs and investors on private equity fundraising and mergers and acquisitions. Veda Corp has closed over 60 transactions, aggregating to US $1.2 billion totally, over the last seven years. Subramanyam has over 16 years of experience in investment banking and he was the associate director at Ernst & Young, before he co-founded Veda Corp in 2003.
For this interview, The Smart CEO identified six scenarios entrepreneurs find themselves in and requested Subramanyam to offer his opinion and advice on each of these cases.
Let us assume a very exciting company is getting ready to raise its first round of financing. The company has two options: one, raise money from a venture capital investor and two, raise money from a strategic investor (a large company in the same space looking at entering the Indian market). How should the entrepreneur weigh his/her options?
Firstly, the entrepreneur must realise that in a way this is like comparing apples and oranges. The objectives of a financial investor are vastly different from that of a strategic investor. Venture capital investors are financial investors and their interests are largely confined to ensuring that they extract attractive returns from their investment. In most cases, they are content acquiring minority stakes and rarely do they get involved in day–to-day operations. On the other hand, strategic investors rarely take minority stakes and if they do, they usually structure it in such a way that it is a stepping-stone before acquiring a controlling stake. And given that they usually have the relevant operating experience, strategic investors will definitely be more hands-on.
So, if the company has good growth prospects and the entrepreneur has enough steam left in him/her to scale the business, there is no reason why he/she should look beyond a venture capital (VC) investor. The VC option enables the entrepreneur to enjoy the true flavour of entrepreneurship.
An entrepreneur has been running a small-scale industry for over 10 years. He’s grown through debt financing and internal accruals. Now, the entrepreneur wants to scale up by raising equity. The challenge: he’s fundamentally not comfortable with external shareholders. What would your advice be to him? And, if he decides to go the equity route, what should he do?
To be honest, this is a situation that we rarely come across these days. However, a decade or so earlier, it was quite common to find many entrepreneurs of small-scale ventures being quite apprehensive of external investors but over the years, this apprehension has subsided substantially.
Today, this sector craves for equity but given that VCs want hockey stick-like growth potential and private equity (PE) funds want size plus aggressive growth, by and large the small-scale sector has struggled to meet their expectations and hence is undercapitalised because alternate sources of equity have dried up.
Actually, we come across this situation in much larger companies, in the Rs.100 – 200 crore revenue range (across a wide range of industries). These companies are no longer small but medium sized and are largely self-funded. There comes a time when the entrepreneur wants to de-risk by looking at external equity. Invariably, what becomes the bottleneck is not the discomfort with external shareholders but discomfort with the kind of return expectations that VC/PE investors have and the entrepreneur’s confidence in delivering such returns.
There are multiple investors waiting to invest in your venture. The valuations are drastically different between, say, the three investors who’re interested in investing. What are the factors that one should consider and analyse before picking the right investor?
Obviously, price is the single most important factor for any entrepreneur and the instinctive response would be to choose the one who pays the highest. Having said that, I would recommend entrepreneurs to use a few more filters to eventually decide which one to pick.
To begin with, the valuation itself has to be normalised for comparison. One could be a straight equity, the other could be a convert linked to performance and the third could be a convert linked to minimum returns with a profit sharing. Also, exit related rights have to be closely compared – both from a timing and minimum returns perspective. And, one also has to watch out if there are any other onerous clauses that the entrepreneur is uncomfortable with.
The second filter is to take a closer look at the investor, their brand equity, market reputation, domain knowledge and also operating style and check if there could be any potential issues in the future.
Finally, of course the team that is managing the fund is also a factor. Often, deals are crafted not only on mathematics but also on chemistry! So, the equation with the fund manager and his/her team could also be a factor. However, given the high level of attrition in the PE industry, one is getting increasingly wary of falling for chemistry since you could end up having one team at the time of investment, another during the life cycle and a third at the time of exit!
Let us assume an entrepreneur is raising money at the idea stage. He has a great plan, a great team in place and is solving a big problem. How does one arrive at a valuation he can expect – because quite simply, it is a number that gets pulled out of thin air (with some logic thrown in)?
In early stage funding, there is nothing called a great plan and a great team. It is all relative. One VC may think it’s great and another may reject it in a flash. Every entrepreneur is perfectly entitled to have his dream number as far as valuation is concerned. But at the end of the day, the proof is in the pudding –what’s the price investors are willing to pay for it?
My advice to the entrepreneur is to just focus on getting the basics right, which is to ensure that the price discovery process has been managed efficiently. If that is done, it reflects the price the market is willing to pay and it’s a verdict that the entrepreneur has to accept gracefully.
He has two options. One is to choose the best amongst the various offers and sign the deal. If not, he can defer the process and wait for a more opportune moment to raise money. This could be tricky and there is no guarantee that there will be a better deal that he/she can get down the line, but it’s a gamble that the entrepreneur has to take.
While raising money, how far down the road should one think? The next round of financing can become really challenging if mistakes are made in the current round. What should entrepreneurs think about in this scenario?
I don’t think the entrepreneur should be too obsessed with what could happen in subsequent rounds. But being aware of a few pitfalls could help. An excessive dilution in Series A can often create problems in series B. Things don’t necessarily happen as per plan and when the entrepreneur realises that he/she has to dilute more in Series B than what originally intended, the cumulative dilution hits hard and triggers decisions that may not be good in the long term interests of the business. Also, complicated deal structures, which may help in bridging the gap and stitching a deal together in Series A can become a bottleneck in future rounds.
Of course, we have seen several situations where fancy valuations in Series A, virtually cripple a company, especially in situations where the sector is no longer in the hot list. Balancing the interests of the existing investor, the incoming investor and the entrepreneur becomes a herculean task later on. But then, it’s too much to ask entrepreneurs not to accept fancy valuations when the going is good.
Some seasoned entrepreneurs have relied on a combination of raising equity and debt. Some have built large companies by being self-funded until a point they can IPO. Your thoughts on raising debt, when can debt be raised and some advantages in doing so?
Debt is in a way like fats. One invariably looks at the damage fats can do without realising their benefits. In the same way, sometimes we tend to be paranoid about debt without realising its benefits if deployed in an optimum manner.
Debt has several advantages. Firstly, it ensures more discipline, which sometimes becomes a premium commodity when equity is available on tap. Debt is cheaper than equity and hence it makes sense for an entrepreneur to have the right blend of equity and debt. It can also be smartly deployed as an interim replacement for equity, especially in times when equity raising is tough and valuations are down.
Obviously, the amount of debt one should raise will depend on the industry, the company, its cash flows, end use of funds, security and the market conditions.
There was a point in time not long ago, when entrepreneurs were more comfortable with debt than external equity. The prospect of taking a loan from a nationalised bank was far less intimidating than knocking on the doors of venture capital and private equity investors. This was despite the inherent personal risks that the entrepreneur had to take, such as offering collaterals and personal guarantees. Today’s generation of entrepreneurs seem to embrace equity more spontaneously and more debt averse. It is clearly a sign of changing times.