Thursday, October 19, 2006

There won't be no more VCs in India.

A Unified Theory of VC Suckage is a phenomenal article by Paul Graham about how the structure of Venture Capital funds explains why people who (wo)man them are usually jerks. It's the structure of the fund, he says, that pays them a percentage of assets managed, that results in their "suckage". Meaning they need more money to invest, to make more money as commission, and more money is not always good:

VCs don't invest $x million because that's the amount you need, but because that's the amount the structure of their business requires them to invest. Like steroids, these sudden huge investments can do more harm than good.

That's just lousy for the founders who need lesser money in todays world. Imagine you, as a startup, need some money. Not a heck of a lot, around a million bucks. Because you're either outsourcing, or have a lower-cost marketing idea, or you don't need as many servers as google, or simply that hardware and bandwidth costs are low enough to serve out of your basement. You're not going to get these piddly little sums from VCs, who want a minimum of $5 million per deal because they got a $2 billion base to work with and each guy has to deploy like $100 million and she can manage 20 deals at the absolute maximum.

So, the startup thinks: What the heck, let me get the money, at least more money is better than nothing. Well, it turns out it's worse. Getting more money means giving up more control, and now the VC owns you; they will then do the standard thing of putting their own CEO, CFO, C-everything-O until you're left with C-toilet-cleaning-O. That's still ok, I would guess, if you got paid for it - but Venture Capitalists shudder at paying founders for their stock.

So why am I ranting about this? Because this spells the death knell for traditional VC investments in India, which are already under some amount of duress.

1) Indian startups require a lot lesser capital than, say, a similar startup in the US. I don't mean a start up that sells in the US, I mean one that sells to Indian customers. A software startup with a great idea, 20 employees and a few customers and a reasonable growth plan will perhaps need about ten crores, which is about two million dollars. If VCs are coming with truckloads of cash, they need to back up those trucks a little bit and get them one truck at a time. Unfortunately their own structure denies them that opportunity.

2) Deal flow is practically non-existent. That means there are very few VCs whose ego is not inflamed by the idea of taking another VCs handouts. In fact, the little deal flow that exists is always an ACCRUAL; meaning a downline VC will pump in money into the company but refuse to buy out an earlier VC or angel; meaning there's a lot lesser enthusiasm for the early stagers.

Exits have to be through IPOs or acquisitions. Either option is perhaps too far away, and if founders aren't going to get some payout at the time of investment (part of their stock for instance) their ability and interest in keeping the business going is going to flag, especially if they are just C-toilet-cleaning-O. You will take away their control and management powers, and won't even pay something for what they do own (stock), and you expect them to work as enthusiastically as before. I may be quoting Bill Gates here, but that's the stupidest thing I've ever heard.

No wonder VCs are not getting the best deals; if founders know that VCs will take control AND screw it up (I'll talk about that later) they won't give up a good idea.

3) Okay, let's say we can fix deal flow by saying it'll happen tomorrow. Founders are still going to lose (and perhaps lose more control). If VCs don't help founders by giving them a little bit (equity or cash) on each deal, the residual founder ownership is going to be very low and they will walk away. VCs will be left with the business people that they CxO'd and those guys, to show they can deliver, will go about doing what they do best, making big-ticket deals. They'll just acquire each other left, right and center, with no real profit to talk about. Sounds familiar?

4) Valuations in the past have been unnervingly low. Take, a recruiting site which was sold in 2004 to for about $9.5 million. They got (unknown amount of) angel funding from the Dalmia group and two rounds from ChrysCapital totalling $5 million. I'm guessing ChrysCapital wouldn't have got more than 70% of stock - that's a total return of around 60% over 3 to 4 years, about 12-15% annualised. Not exactly print-worthy.

Another example: was acquired by eBay for $50 million. VCs Funded: $22 million. Net return would be around the same - 12-15% or so.

More: NetKraft gets bought by Adea for $8 million. Actis & Jumpstartup: 67 percent paid $8 million. Net return: (MINUS 33%).

I don't know what happened in the above cases, but it seems to me like acts of desperation. Take the deal and run seems to be the mantra, and VCs have LOST money or face. In all the above cases, VCs controlled more than 50% of these companies, and I believe that they decided to exit while they were still profitable. Now you know why VCs become Vulture Capitalists!

Initially I thought founders would not have been too happy. But when you're C-toilet-cleaning-O, money for your stock is always good, so these founders would've been honestly happy. Some of them have gone on to start VC funds in India or incubators or become members of India's band of angels.

But I think these valuations kinda prove a point. This is what happens when you give VCs control - they sell out for stupid valuations, and they ruin it for the next set of entrepreneurs.

4) I think many VCs have figured out they can't run companies. VC funds are now coming as PE funds, meaning they invest in public companies and get stock in return; for in such companies there's a need for big money, and the funds don't get as much control, so they can't do things like change CEOs and CFOs etc. No matter what anyone says I don't believe VCs do this management changing rigmarole because they like it; they feel existing people don't have the pedigree or the experience they can bandy to THEIR (the VCs) investors.

The rules of the VC game are that you put in money and then you protect it by surrounding it by your people. The rules of the PE game are that you give the money and you get a cocktail + dinner presentation every quarter, and if you get all cranky you can go sell your shares in the market, thank you very much.

So is this the end for Venture funds in India? Note carefully that I said "traditional" VC funds. It's the end of the road for you guys. Pack up your bags and go home.

To the smart lot that's left; come hither and have a cup of chai. Let me be an arrogant asshole and tell you what I think. I think you guys belong here. This is where it will happen, where the biggest amount of money is. But it needs money, and you're the only ones that have it. You know this, but you're afraid of the past. The Indian past of low valuations, lousy VC performance etc. Forget the past. So some people screwed up. So what? You're smart. You're smarter than those guys boarding the plane back. You can find, and fund, and foster the next big thing here. Look at India, not just the IT sector - look at India.

Look at dishing out smaller chunks of money, and managing more excel sheets. Look at giving founders more breathing space in this non-credit-rated, low-debt-availability market. Look at larger valuations. Look at making money in 10 years instead of five; you're smart enough to convince your investors, I'm sure. And you know this already, but wait and take the IPO route rather than jump into a pool of choreographed acquisitions.

Your chai is getting cold.

P.S. Sramana Mitra has a neato-article on the same wavelength, calling for sub $25 million funds.

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