The unsaid Rules of Venture Capitalists....
Is VC funding really the best mode of raising capital?
December 20, 2012 / 12:59 IST
Khyati Dharamsi
Venture Capitalists (VC) and Private Equity Funds may seem like an entrepreneur’s best friend but this relationship comes with some pretty serious riders that could derail even a potentially profitable start-up.Indeed, it is almost impossible to procure a bank loan to fund a new venture, and those who manage to pull it off are looking at an 18-25 per cent rate of interest. But did you know that VCs demand a much steeper return on their investment? And that’s the least of it!So think long and hard before running into the welcoming arms of a venture capitalist, who may not be very different from the ‘moneylender’ next door. If you’re starting out, here’s what you should know before you say, ‘I do’ to this potentially rocky marriage of convenience.It’s High-Risk CapitalVenture capital is very high-risk as VCs expect very high returns, warns Saumil Majumdar, co-founder and CEO, EduSports. “If you invest Rs 100 and are earning Rs 200, the VC will not be happy. If they have invested Rs 100, they are looking at getting back Rs 1,000.” A tough reality check!Expect Boardroom BattlesIf you have been struggling to get the numbers on the table, your investor will probably want a course correction, which includes the way you do business and even key people linked to your business. “It is fertile ground for conflict, especially if you’re taking debt into the company and leveraging too much. Investors may feel the cash flow is compromised,” says Loney Antony, Managing Director, Prizm Payments, a payment-services provider for electronic financial transactions. “But this depends on the nature of investors, whether they are active versus passive.”The pace of growth is usually the biggest stumbling block between investor and entrepreneur. “The entrepreneur says he will grow slowly but profitably, while the venture capitalist wants the company to grow quickly and also fetch the expected returns. That’s when sparks begin to fly,” explains Majumdar. “This is how it works. VCs are always playing the portfolio game. If a couple of companies they are funding do exceptionally well and the rest don’t, they have still made money.”Read The Fine PrintThe Shareholder Agreement and the Term Sheets reveal the intentions and expectations of the VC. Reading through them carefully will avert many a conflict. “In particular, look at clauses in the Shareholder Agreement relating to liquidation preference (redemptions or mandated exists). Check whether the VC is asking for assured returns on exit and won’t affect your day-to-day operations,” advises Antony. The essential clauses are those linked to lock-in of shares, liquidation, partial sale (tag-along rights), preferred and participating clauses and ESOP dilution.With regard to liquidation under extraneous circumstances, Alok Kejriwal, serial technology entreprennuer and founder of Games2Win.com, suggests, “A fair multiple in the liquidation clause is 1x of the principal back and not 2x or 3x, in favor of the VC.” When Selling A StakeIf a strategic buyer offers to purchase a percentage in the company, avoid a situation where all the VC’s shares are purchased and your own stake remains untouched. “In the event of a partial sale, it is critical to negotiate pro-rata tag-along rights, that is, where all the shareholders have a right to tag along,” explains Kejriwal.Beware of TrickeryVCs may play a trick that could reduce the promoter’s share in the company. Read the ESOP dilution clause carefully to understand how this can happen. “Try and negotiate ESOP dilution after funding and limit the commitment to 5 per cent, to begin with, since no one knows what the ESOP pool requirement will be when a business kicks off,” adds Kejriwal.However, these clauses are not set in stone, says Rahul Varshneya, start-up coach and co-founder, Arkenea Technologies. “I know of one venture where the exit was clearly defined but deferred as the company entered a new vertical. This added to their top-line immensely and made for a bigger valuation.”How To Avoid Or Resolve ConflictsKeeping it real goes a long way towards avoiding conflicts. This means setting realistic expectations in the initial stages and using efficient communication channels. Says Antony, “You must provide regular feedback on how you are performing vis-a-vis annual operating plans. Tell the investors how the money is being put to work, rather than them asking the question. Monthly review meetings, quarterly board meetings, business and market reviews have helped Prizm Payments avoid conflicts.”Know Your PartnerAlso, spending time with each other and getting comfortable before striking a deal is invaluable, adds Varshneya. “Just like a marriage, choosing a VC is a long-term commitment. Take the time to research whether the VC has funded companies in the domain they are operating, what companies have they invested in so far, and what is their level of involvement with each of them,” he says.But do not succumb to bullying. Remarks Kejriwal, “Request changes in agreements, etc if you must. When you have a good thing going, capital chases entrepreneurs and you must negotiate hard.”Happy Handholding!
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