GURUKUL > How VCs work - Part 1


"These articles were originally published in VentureKatalyst, India’s first e-zine aimed at entrepreneurs, started by Sanjay Anandaram in 1999. He brings two decades of experience as an entrepreneur, corporate executive, venture investor, faculty member, advisor and mentor. As a passionate advocate of entrepreneurship in India, he’s associated with Nasscom, TiE, IIM-Bangalore, and INSEAD business school in driving entrepreneurship. He can be reached at sanjay[at]jumpstartup.net"

How VCs work - Part 1

In the past Gurukuls, we’ve looked at various startup situations from an entrepreneur’s perspective. In this and the next few Gurukuls, we’ll take a look at how the people on the other side of the table, namely the venture capitalists work. It is important to get a perspective of how the other side thinks and works if you want to build a mutually beneficial relationship.

It is important to recognize that the entrepreneur and the VC are on the same team and have a congruence of goals – namely the building of a successful company. All the negotiation happens before investment. As in all partnerships, if the relationship between the VC and the entrepreneur is viewed with suspicion and in an antagonistic manner, the VC-entrepreneur tussles in the board-room will kill the company. Having said that, let us know take a peek behind the curtains at how VC firms operate. In this Gurukul, let us get an understanding of the overall VC situation.

VC firms collect money from investors and then invest the money in a number of carefully selected fast growing businesses. In the US, VC firms typically are partnership companies. In India, VC firms follow a structure more in common with a mutual fund structure (due to legal and tax reasons, VC partnership companies are not viable in India. The VC industry in India has been clamoring for an US style structure for a while now, but that’s another story). That is, there is a VC fund into which various investors invest and there’s an Investment Management company (commonly referred to as an Asset Management Company or AMC) which manages the investments of the fund. In the US, the typical investors in VC firms are the pension funds, university endowments, insurance companies, corporations, wealthy individuals etc. In India, typical investors are wealthy individuals, developmental & financial institutions and some corporations. Laws do not permit pension money or insurance money to be invested. Universities in India have no real funds or endowments even if they were allowed to invest! It is therefore quite hard to raise funds in India for venture capital purposes. The tax treatments of Indian VC firms also act as disincentives. Which is why a large number of VC funds operating in India are really off-shore funds - based in places like Mauritius - with overseas investors thereby ensuring operating flexibility, tax benefits and speed.

Contrast this with the VC activities in a small country like Singapore: A small country like Singapore, for example, invests huge sums of money (from a corpus in excess of $100 billion) all over the world in various VC activities. These investments which are government controlled are made keeping in mind the economic development of Singapore, strategic reasons (e.g. new technology, entry into new markets) etc. Singapore is also the source of capital for many of Silicon Valley’s marquee VC firms. There’s a lesson for India somewhere!

In India, traditional investors in VC firms have been development and financial institutions like ICICI, IDBI, SIDBI, and the like. These VC firms have had to deal with various operating constraints and have had difficulty dealing with high risk investing due to the very nature of the structure within which they had to operate. Indian VC firms have to be registered with SEBI (Securities and Exchange Board of India). Over the last few years, India has seen the arrival of several Silicon Valley style independent private VC firms like Draper (which pioneered this movement in 1995), Walden, Chrysalis, and Infinity Capital. Many more are in the pipeline and will bring in international class VC investing styles and standards with deep understanding of technology, finance and strategy. India is expected to attract about $10B in VC funds by 2008. It attracted about $300m in 1999.

With this backdrop on the VC situation, let us take a look at how a VC fund/firm operates 2 weeks from now.