Seven tips to invest in startups as a VC fund manager

This clause offers protection of VCs original investment in a startup when a liquidation event occurs. This event implies merger, acquisition or sale of a substantial part of assets of the startup. Investors negotiate for 2x or ‘1x plus participating’ liquidation preferences to protect their interests in such a scenario. At the ‘pre-series A’ investment round risks are extremely high, and hence higher liquidation preference in favour of Investors is a norm in India.

Founder Vesting & Lock-in

For the success of a venture it is pertinent that the founders are associated with it until the investors continue to stay invested in the start-up. VCs ensure that the founder can’t sell their shareholding until investors get an exit. VCs further protect themselves by making the founders to earn-back their original shares over an agreed period of 3-5 years. For example, if a founder quits within 12 months of an investment round, the founder shall have to give-up most of the shareholding in his or her startup.

Valuation Protection

VCs ensure that in case the business venture doesn't take-off as envisaged and the next investment round is at a valuation lower than the previous round, they get additional shares in the startup to protect the value of original capital invested.

These tools are exercised in addition to a Board seat involving veto rights with the VC on major decisions such as changes in business strategy, investor protection, and related party transactions.

Venture capital is all about investing in the future, today. It is about visualising what demographic, economic, technological trends shall emerge that shall pave way for newer business models to emerge.

VCs are generally optimistic. They ascribe value to a business much ahead of revenue or profitability justifying such a valuation.

To give a case study, Airtel in the year 2000 attracted VC investments led by Warburg Pincus, whereas the mutual fund managers discovered to re-rate the telecom sector & Airtel 6 years later in 2006.

The valuation given by VC couldn't be justified in Airtel, by the market until the end of 2003.

Once profitable, growth became a reality and the market started aligning to the telecom opportunity. We VCs have to visualize such opportunities at least 2-3 ahead of the market. Our evaluation tools are very many.

Let me collate them for simplicity across top 7 criteria that YourNest uses to chose startups to invest in:

Revenue potential

Any startup opportunity is attractive if it is addressing larger market size. Preferably the customer pain-point be giving it an opportunity to serve a market of USD 500 million - USD 1 billion. In this large market, the start-up must demonstrate the potential of gaining significant market share at an attractive gross margin. In addition, for early stage investment, the time to sustainable & profitable revenues segment, scalability prospects, month-on-month growth prospects are also evaluated.

Current customer traction

At an early stage of a venture, a paid customer matters a lot. These customers must be independent and not related to the founders. The results of field pilot, demonstration of customer retention or repeat order, and the feedback from the customer on the start-up surpassing expectations ease the decision to invest. The sales pipeline for B2B startups further eases investment prospects.

Differentiated value proposition– Significant value can be created by a startup if it has a sustainable entry barrier may be led by intellectual property, patents, business model or locking in customers via execution excellence.

Leadership team

Each fund manager should give a lot of weight to the quality of management team. This task of assessing the founding team becomes even more challenging for a VC at the early stage of a venture. Does the founding team demonstrate entrepreneurial skills of being audacious, adaptable, agile, and the ability to manage ambiguity or attract talent? Does the founding team have 3 core functional skills of a visionary cum strategist, tech cum product expert and a sales cum business development resource? For a VC, it is a non-negotiable parameter for investment consideration.

Understanding of competitive landscape and the Go-To-Market Strategy

Every customer need is being fulfilled by some or the other means. There can't be a situation that we don't have any competition. Startups usually feel - we are unique! As VCs, we have to assess how its current customer need is fulfilled. Even Hotmail had a competition from physical letters by postal services. Competitive SWOT and approach to winning customers vis-a-vis global players help in assessing unique selling proposition of a startup.

Return estimation

What kind of returns do we expect on the invested capital? It is driven primarily by the pre-money valuation and the exit potential. What matters is - the time required to say get a 25x valuation along with the estimated time to exit and realize cash for the investment made.

Is the story in place for the next fund raise?

Capital in India, in particular for startups, is in scarcity. The start-up founders have to be fabulous storytellers. Their preparedness to raise next round of investment shall enable them to grow the venture manifold.

The trend of venture investing largely remains constant, however, the economic cycles swing to extremes. In 2014 we experienced euphoria in investment in consumer businesses.

Such cycles give rise to extraordinary investments and create new market segments. However, for past 2 years, the flow of capital to start-ups is limited.

The shift is primarily towards unit economics and deeper validation of any business model.

Such a swing in risk appetite is normal and actually has been offering investment opportunities at attractive valuations.

For VCs, the mantra shall always be - invest in the future, enable innovation, and entrepreneurship to co-create a better future.

(The author is Managing Director & Fund Manager at YourNest Venture Capital. Views are personal. Edited for Moneycontrol.)