Monday, October 01, 2007

VC and Founder Compensation are so totally different

Sramana Mitra has an excellent post about how skewed compensation is at startups. (Emphasis mine)

As for the compensations, General Partners at Venture Firms make anywhere between $1 Million to $3 Million a year without counting performance incentives. The carry is all upside.

In contrast, the poor entrepreneur bootstraps a startup, takes enormous risks, and if (s)he raises venture money, the first thing a VC does is to restrict his/her salary to a minimum.

Only one out of 50 startups succeed (or may be one out of 100, I don’t know the exact ratio), so the equity component of the compensation package rarely pays off after the liquidation preferences, etc. are settled.

1) For the entrepreneur, the compensation as salary is kept absurdly low by the VCs. And their equity returns are kept even lower with liquidation preferences, drag-alongs and such. The argument usually starts with saying that the founder needs to have the hunger and then moves quickly to "the golden rule is that the man with the gold makes the rule".
2) VC managers on the other hand have "carry" as an unrequired bonus, and get fat paychecks thus ensuring that their success is not linked to the success of their investments.

Patently unfair you think? There are simply two different kinds of skills: Fund raising for further investment, and fund raising for a startup.

The attitude of the former is: "Listen, I have this deal for you. You give me [x] million bucks. I then take a fat paycheck out of that as a 'management fee'. I invest the rest into some 10 companies. One of ten investments might succeed. I say might, it's like saying the sun might rise from the west. If anyone does make it, I get a piece of the profit. If they all go down the drain, you lose all your money, and I still get my paycheck. No I don't know which companies or even the broad area I'm targeting, but I'll choose them, that's why you're giving me money. If we go down the drain, then it's your money, not mine.".

When it comes to the entrepreneur raising funds, it's like: "Listen, I have this great idea. It's not just an idea. I've got a prototype. And this fantastic team. We have to work on bare minimum salaries? No problem. All our equity goes back and vests over four years? Uhm, ok. And if we fail you get your money first and then us? Ah, ok. Then you can fire us and we lose unvested stock? Oh, fine. And you want a drag-along so if you feel like the roses didn't smell good that morning you will sell my company and I *have* to sell my shares too? ok. Do you want me to bend over and grease up as well?"

Isn't it ridiculous then that venture capitalists find entrepreneurs "arrogant"? No wonder successful founders always tend to go and set up funds of a very different variety or start really helping other founders (like VentureHacks).

But closer home, there are very few instances of founders crossing the chasm, one of them being Alok Mittal of Canaan Partners, who also runs VentureWoods. (Disclosure: I have posted there earlier). Another founder - Prashant Prakash of Netkraft - co-manages a seed level fund named Erasmic.

Unfortunately some "angel" funds in India seem to ask way too much of the founders. Questions like these, requested by a member of the Indian Angel Network, seem to demand a lot an angel level presentation: while questions about the team, competitors, market etc. seem to be on the line, needing analysis of stuff like SWOT, IP (which is a ludicrous thing in India, I feel), marketing innovations (which I could game easily), "are you getting good sales/adoption?" etc. are simply premature (and do not belong in a pitch, they should be in an exec summary or q&a on the pitc). This isn't angel investing, it's a more like an early stage VC.

Note: I've just started Moneyoga which is a stock market website (still being constructed) and we have been thinking a lot about whether to get institutional funding. The decisions we're making is going to sound astounding when we write about them and look positively arrogant, but I think that there's a position where a lot of things come together, and give us a good life and excellent returns. Will talk about it when our stuff pans out.

Friday, June 15, 2007

Starting a company in India: The regulatory issues

I'd like to talk about some of the things you need to do if you're starting a company, aiming to get funded and the like. Note that you can get professional help for most of the below; accountants will help you through the process for a fee.

1. The "Private Limited" entity

You could create a proprietorship or a partnership, but if you're looking at investors and venture capital you will want to have a private limited entity. This is a "firm" - a company registered with the Registrar of Companies (ROC), and while it provides limited liability there are much more regulatory issues to deal with. Let me assume you're going ahead with a private limited company.

The way this works:

  • The company is founded with a certain amount of startup capital (we'll talk about that later)
  • Each founder (and angel investors) get "shares" allocated to them for a price they pay
  • These shareholders (called "members") elect a board of directors to represent them at the company. For a startup, you will typically have all working founders and representatives of any outside investors on the board.

2. Getting a "DIN" - a Director Identification Number

Registering a private limited company requires that all directors get themselves registered at the ROC. You should apply for a Director Identification Number (DIN) - you can do so online - by filling out a PDF form and submitting it. A provisional DIN is allocated, after which you need to print the page, sign, get a notarisation from a practicing CA and send it to the MCA office. This costs nothing, except a small amount you may pay for the notarisation.

3. Digital Signatures

All applications for creating private limited companies now require online forms and digital signatures. Details are on the MCA web site - and a number of certifying authorities provide these signatures as USB tokens. The cost ranges from 500 to 2000 per year.

You need just one DIN and one digital signature, even if you are a director in 10 companies. Also note that for the purpose of starting a company, only one director's digital signature is needed.

4. Naming ceremonies

You need to get the name registered first - this is to ensure that your company does what your name indicates.

Download and fill Form 1A (all forms are downloadable ). You can upload this to the MCA site and pay Rs. 500 for the service online. The name then must be approved by the ROC, which is a discretionary and sometimes, unfathomably arbitrary process. Amit Ranjan has a post on his experience.

A good CA can get your name approved with a personal sit-down and explanation.

About these forms: each PDF form has a "Check Form", "Prescrutiny" and "Submit" button. At this point, none of the "submit" buttons work - you have to submit the form manually.

5. Incorporation - Memorandum and Articles of Assocation

You can then get your CA to create your Memorandum of Association (MoA) and Articles of Association. In simple terms - the MoA specifies WHAT your company wants to do. The AoA specifies the framework of organisation (who are the directors, what kind of voting, how will expenses be approved, how many people form a quorum for an AGM etc.) The articles are important in that they should not be one-sided towards specific shareholders (will tick off investors, who'll change them anyway). Most likely your CA will draft one from a standard set of terms that they have earlier passed through the ROC.

These need to be attached with Form 1 (again, downloadable), digitally signed by you and your CA. When you submit, you'll pay fees based on your "authorised capital". This is the amount of money you plan to convert into shares. So for an authorised capital of Rs. 100,000 you can issue 10,000 shares of Rs. 10 each (or 100,000 shares of Rs. 1 each and so on). The "paid up" capital is the money actually converted to shares - so for an authorised capital of one lakh, you can pay up just Rs. 10,000 and divide that 10,000 into shares to founders.

You will pay a certain stamp duty and registration fee for the "authorised capital" - it goes from 4,000 for a 100,000 authorised capital to 26,000 for about 10 lakhs and so on. People may advise you to go for a lower authorised capital to save on this registration cost, and keep any excess capital as a "loan" instead. But this structure may reduce your later compensation when you get investors in, as the loan may be returned and your shareholding moved to a vesting structure, giving you very little value for the money you've put in. Don't lose out on future value for a few thousands today.

Remember, you are both an investor and a "manager" - meaning you have both management and control interests in the company. A new investor can come in and choose to vest the ownership you get as a "manager" but that should not compromise on your holding as an investor. Split the two - in fact, at important points, think independently of decisions as a manager and an investor.

ALong with Form 1, there are two other forms - Form 18 and Form 32, that need to be signed and submitted to the ROC.

6. Opening a bank account

Once your company is "approved" you will get a piece of paper called the "incorporation certificate". When you have this, along with a "common seal" (your CA will get this done) and a printed copy of your MoA and AoA, is you can pop the champagne or the poison of your choice.

But to pay for the champagne, you may want to open a bank account. Banks will ask for the documents and your PAN/TAN number (mentioned below). Account opening can be upto four days and you will be required to fund the "current" account with about Rs. 10,000 or so.

7. Registration with other authorities

  • PAN/TAN number: This is for paying and deducting tax. Can be applied for online. Needs an address proof, for which a copy of the aforementioned Form 18 is ok. You need this to do any tax stuff, or to open a bank account.
  • Bank Account: For a bank account, you need to provide, at the very least, your MoA/AoA, incorporation certificate and PAN/TAN acknowledgement of application. Some banks will ask for more details. Also you can ensure that two signatures are needed for cheques, and get a netbanking ID so all investors can be made aware of the expenditure.

8. Do you need an office?

If you're planning to work from home, don't bother with a few registrations because they will want you to put a signboard with your company name on the outside. Most residential societies will not allow this. Yes you can perhaps get away with bribing the labour inspectors etc. but frankly that's not the "clean" way to do things; if you're in the business to get other investors or to sell the company, you need it as clean as possible.

But if you do need an office or want to hire employees etc. you should get the following registrations:

  • Shops and Establishment : Karnataka has this act where you need to register an office, but other states will have their version as well.
  • Professional tax: A state levied tax on salaries paid out. You need to pay Rs. 2500 in karnataka to register, and depending on salaries paid, pay a certain amount (max. 200 per person/month) to the Professional Tax office.
  • Service Tax and VAT: The Central Excise department wants you to pay tax on pretty much any revenue - VAT is if you sell a product and Service tax, if you render services. Registration is important. Service Tax registration can be delayed till revenues are above Rs. 7 lakh a year.
  • Provident Fund (PF) : For 20 employees or more, this is mandatory. Lots of documentation, but you can get someone to help for about Rs. 5,000 or so.
  • Employee State Insurance (ESI): Applies to Karnataka, but other states do their own number. This is for employees whose income is less than Rs. 7,500 per month, and again, only applies if you cross 20 employees. Get someone to help, it's cheaper.

9. Compliance and Accounting

Post registration, a private limited company needs to maintain records and be compliant with the laws. That would sort of be obvious, but honestly it requires some work on a regular basis.

  • ROC compliance: Involves Maintaining a big fat "statutory register" - no big deal really - ROC filing at key points and maintaining board minutes (using signed minutes is fine, once a quarter is legally required). You can do this yourself or use the services of a Company Secretary (typical charges: Rs. 3000 - 5000 per visit). You might need to revisit this process once a quarter if you are a small startup.
  • Professional Tax, PF/ESI, VAT/Service Tax : For these there are monthly, quarterly and/or annual returns.

    Get a person to help you out in this process - typical costs are about 3-10K per month.
  • Tax Deducted at source (TDS) and Fringe Benefit Tax (FBT): again, monthly and/or quarterly returns, could be done by the same person as above.
  • Accounting: You need someone to maintain books of accounts. If you choose to use an accounting software, you can bring someone in to enter vouchers etc. Typical costs are Rs. 1000 to Rs. 5000 per month. You might not need them every day - once a week might be ok.
  • Tax and Statutory Audits: At the end of the financial year, you will end up needing to file accounts in two places - the ROC and the Income Tax department. The actual numbers will vary because of the great Indian fight between these two departments on what constitutes "depreciation". You'll need a Chartered accountant to "audit" your accounts for the ROC, and someone to help you file the Income Tax returns. Typically the same CA will help with both, and charges vary from 10,000 to 10 lakhs depending on many things including your accent.
  • Inspections: Officers from various departments may visit your office for "inspections". Do not instantly hand them bribes or even meet them as a "CEO" or such hi-fi designations. Let the process run through and you can even negotiate bribes if demanded. Whatever happens, ensure there is paperwork to back it up (like an inspectors report or such).

The entire incorporation process can be done is as less as 15 days, unless you want to start a company named "Infosys Wipro TCS Congress BJP CPI Indian Government Private Limited" in which case the time required is: forever.

While all this may sound daunting, a good CA can help you do this fast. Remember that although a CA will help you through the process, you need to ensure that no corners are being cut, since it is something you will have to explain later when legal and other due diligence is performed. Keep yourself informed about what needs to be done, but outsource it to accountants. While you can delegate this task, you can't absolve yourself of the responsible.

What you want to do is get this done with the least amount of one-time and continuous pain, and get on with the real work.


  • Post incorporation funding: When you incorporate and create a bank account you need to then fund the account with money. Assuming the founders and early investors will put in money, take care to note down the money received, and if required, provide equity shares for the money. For example, if you have asked for an authorised capital of Rs. 500,000 and four founders want to initially put in Rs. 25,000 each, you might issue 2,500 shares of Rs. 10 ("face value") each to the investor, for a total "paid-up" capital of Rs. 100,000. A few months later, some investors might put up a further 100,000 and then you issue fresh shares of the same Rs. 10 face value (but these shares can be sold for higher, like Rs. 50, if you please)

Some other Links:
Startup costs in Bangalore

Thursday, May 10, 2007

Hacking the venture process

I just stumbled upon (not StumbledUpon) a site that discusses venture funding: Venture Hacks. Started by Babak Nivi and Naval Ravikant, both of whom have been on the entrepreneur and VC side of things, the site brings oodles of information for you, the entrepreneur. They present a series of articles on term-sheet-hacks.

The VCs know more than you do.

You, the entrepreneur, negotiate a term sheet once every few years. You negotiate your most important term sheet (the Series A) when you have the least experience. You negotiate against a VC firm that issues two to three term sheets per month. You negotiate against a “standard” term sheet that encapsulates decades of combined knowledge from hundreds of venture firms.

If you're a newbie to what a "term sheet" means, join the gang. You might want to read Brad Feld's term sheet series first.

Let me give you the low down: Term sheets are what VCs use to tighten hold on your private parts. If you don't negotiate, you will be left with a very painful experience. Don't let them get to you.

You probably know this, but both Venture Hacks and Feld's series are representative of VC points of view. Yes, they're both much more leaning to the entrepreneur, but you'll note a subtle VC bias in the approach, which simply means making more money for the VC at the cost of the entrepreneur. They never tell the entrepreneur to break a deal on a clause, but mention how VCs will take certain things like no-founder-vesting as a dealbreaker. Just so you know.

One thing though: these hacks assume that VCs are willing to "discuss" elements of term sheets, and that you have some reason for the VC to listen to you ("leverage"). If you find that is not the case with you, you can shut down your browser and either take what you can get or carry on without the VC world.

You might think that all of these things are applicable to India. They are, but you have to see them in the right context.

1. Convertible preference shares are "debentures" in the Indian context.

2. Very few Indian lawyers that know anything about negotation will come cheap, so if you hire a lawyer, be ready to shell out lots of Mahatma Gandhi adorned pieces of paper.

3. The legal process takes a lot of time in India, so please expect a lot more anti-entrepreneur clauses in Indian term-sheets.

4. Option pools have a serious Fringe Benefit Tax impact. If you set up an option pool based on VC term sheet, be ready to understand how this impacts your revenue guidance, since FBT is payable by the company. (Yes, you can bill it to the employee, but which employee will pay for illiquid stock?)

A better approach is to create a trust that will issue the ESOP, but the company must not own the trust. VCs will balk at this. Why?

Think about it. Let's say you get a pre-money valuation of 8 crores (for say 10 lakh shares), and VC puts in 4 crores. You think, heck this is great! 33% to VCs, rest to founders! Founders are worth 8 crores!

But they say they want a 20% option pool, created pre-money. Means, post their investment, they will have 4 cr. worth shares, option pool is another 2.4 cr. and you have the remaining - 5.6 cr. worth shares. Suddenly you're worth a lot lesser. And since the option pool is not vested yet, the real shares issued are worth 5.6 cr. (to founders) and 4 cr. (to VCs). This means they hold 42% of the company at investment.

If you went and created an option holding trust, the VCs only get 33% (since the option shares are issued to the trust). That's not in their favour - if they get a buyer they will benefit from unvested shares in the first case, but with a trust the trustees will benefit (and the founders will be the trustees). VCs will not be happy.

I hope you enjoy the sites. I did. I will write more about the Indian context to these options.

Friday, March 16, 2007


Geni is this brand new family tree engine that allows you, in one screen, to see all the people you have to buy gifts for. Basically it allows you to create your family tree and has just received $10 million in funding, for a total valuation of $100 million. From The Founders Fund. Which I had referred to in an earlier post, about how they are ok with partially paying founders when investing.

In this case, the founders of Geni are perhaps not quite in the need of money - they're all ex-Pay Pal, Tribe and such companies that, if venture funding was a religion, would be senior Gods worshipped in every household.

TFF, to its credit, is not the one giving the $100 million valuation. They only gave it a piddly 10 million dollar value and stuffed them with $1.5 million. The $100 million value was provided by Charles River Ventures, which, albeit the valuation, involves more venturing by the Charles River.

But you may be thinking: Is this company worth a $100 million? I must be honest: Even with my exposure to large sums of money flashing on all TV channels in the forms of scams, frauds, bribes, ransoms etc. this sum seems ludicrously large. $100 million is about Rs. 440 crores. This is the kind of money that will buy you a two bedroom house in Bangalore nowadays, and should not be considered a trifle. This house has a real garden.

Some of you may think I exaggerate needlessly. But I think if we were not intended to needlessly exaggerate Darwin's law would have eliminated all writing anyhow. I originally intended to put god in the last sentence but after my baby boy's colic attacks I have finally understood there is no god. But I digress.

Now the question is: Is Geni worth Rs. 440 crores? Is this 18 person company a proposition that, if exchanged for currency, would yield a 100 million greenbacks? The last time such a question was posed, they all laughed at you. This was February 2000.

But we will assume this is not February 2000, because we haven't yet invented the time machine. So is Geni worth so much because it is unique and can't be copied?

Geni is perhaps easily copiable, and is definitely not the first family tree representation on the planet. Unfortunately it has also not taken into consideration the probability that someone could have 13 siblings, like in my father's family and therefore it will not work unless I have a dual monitor machine. (Which I do, incidentally) What actually worked, when I had to explain the 126 "close" family members to my wife, was pen and paper and lots of arrows. Actually it's better represented left to right rather than up to down - all family trees are, IMHO.

But they have a business model for sure. Have you seen the most popular serials on television? What are they about? Some of the biggest blockbusters in the hindi film industry were: Maine Pyar Kiya, Dilwale Dulhaniya Le Jayenge, Hum Saath Saath hain, etc. Think of the basis of all of them. Everyone's related. And now, look at Geni's logo.

Soon, you may see Geni sprouting the capability of saying "I don't like this person" and you will see strange music in the background when you drag and drop people near each other. Perhaps even red colors as you move across the evil people who try to murder their mothers-in-law using faulty fans (don't ask me, I saw this on TV, I swear).

Then there will be mock fights and in comes the revenue from online betting on who will win. And you can SMS to a four digit number who you like the least so that person's icon will be relegated to a corner of the screen. The SMS revenue itself, shared 50:50 with Airtel, will yield millions.

And there will be people who will pay to see who is having whose baby in the Bold and the Beautiful and to unravel how, through a series of bad marriages, a person has become his own step-aunt.

Finally of course, look at the ease of understanding large family battles. If Geni were to host the discussion of the Bajaj family and their various holdings in various group companies that hold stakes in various other companies, it would be so much simpler to understand. After all you hear that Shishir Bajaj said Niraj Bajaj was siding with Rahuj Bajaj and his sons against Kushagra Bajaj. THe reader's band is baja(j).

Take all the business battles: Bajaj, Ambani (whose battles don't even have the same last name), Birla, Tata, Rin, Surf Excel etc. All these battles look so much better explained in a flash videos marked by respective family trees, and I'm sure stockholders will pay to see the darn thing unravelled. Eventually, though, they may be pissed off that the real owner is a pair of underwear or something. Still, that's information that someone is willing to pay for, either to know or to ensure others don't know.

I have now come to the understanding how this can soon become a billion dollar company. Maybe even a trillion dollars. Yes, success is an absolute, but you will see how it can be a relative.

P.S. Maybe there can be a Geni for India that gets there before they do -

Monday, March 12, 2007

The ESOP workaround

For entrepreneurs this budget - Budget 2007 - has one dissapointing element. Employee Stock Option Plans (ESOPs) are now classified as a Fringe Benefit, and one needs to pay Fringe Benefit Tax (FBT) on them. In essense, this means 33.99% of the difference between the price at exercise and price of grant is borne by the company.

A startup usually offers part compensation in stock, and the grant price will be abysmally low, like Rs. 10 or so. The employee can't buy stock at grant, because the options will vest over a few years. Even at vesting, the employee needn't buy stock - indeed, buying it will be of no use when the company is not public. And if the company goes public or gets sold, the company has to pay a ton of money as FBT for the options exercised.

Even if an option is exercised before the company goes public, the Income tax department will value the shares at the time of exercise (based on a valuation method that involves net worth per share) and tax the company on the difference.

Now a company may choose to recover this tax from the employee. I don't know how, though - what will the accounting entry say? "Received money to pay FBT"? Will that not classify as "other income" and get taxed in the company's hands? But that's a petty problem which I'm sure smart accountants will solve using fantastic words and phrases that will light up the room with their very presence. I'm not too worried about that.

What I'm worried about is that the government takes away a chunk of your employees' profits when it comes to a liquidity event (IPO or sale). I think I have a workaround to this, though I'm not yet sure it's totally fool proof.

If you're starting a company, start a "trust" which will hold shares that you have allocated for ESOPs. This trust is a separate entity (you could even have a different "not for profit" company) unrelated to the company, and will own the pool of shares you have set aside for employees. Ensure that the company does not own the trust - though promoters may do so.

Run your ESOPs the usual way, X shares every month for N months etc. But if the employee wishes to exercise, have the trust sell her the shares instead of issuing fresh stock (which is what happens with stock options).

The difference here is that the company is not involved - there is a third party transaction that transfers stock from the trust to the employee. If the "market value" of the share is much higher than the value it has been sold at, the trust takes the loss. The trust is a not-for-profit entity anyhow, and does not have a tax liability, so the loss is neutral for the income tax department.

The Income tax department may of course take a different view and disallow the loss. It could term the transaction a "deemed profit" for the employee and add it to the income of the employee. The idea here being that the trust intentionally sold the shares at a loss so that the employee must profit. But this can be fought in court, if you have an agreement between the employee and the trust on an earlier date that fixes the price of the share for later purchase. Such "call" options are common and legal, and in fact the very basis for convertible debentures.

Problem: If you get Venture capital and they want you to augment the number of shares given as ESOPs, you will need to issue more shares to the trust. Obviously this is going to be at a lower price than the VC price, which means the tax department will say it's a "deemed profit". That phrase again. But if the trust is created as a non-profit, you can avoid tax liability on such deemed profits too.

But such an arrangement will have to be stopped after the company goes public. Obviously, ESOP grants can't be transferred to a trust at a lower price after a company is subject to pricing laws when it is public. But as a public company, it may simply be better to use RSUs (Restricted Stock Units) instead.

What do you think?

Tuesday, February 27, 2007

Where angels fear to tread

If you're reading my blog post by post, I will sound like a broken record about this, but bear with me please.

I'd complained about the general lack of deal flow and VC issues here, here and here. A recent post on Venturewoods had comments leading into the angel investment space. Angel investors, for the uninitiated, are those that give money to entrepreneurs when have diddly squat to demo. When people want money to build something that they can make very big, they will need to turn to angel investors.

Why? Because the typical amounts such ideas need are between 10 and 50 lakhs. Why that much? Two founders, salaries for a year @25K per month, let's say they need equipment, outsourced graphics design and programming perhaps, colocated or dedicated web space, collateral, etc. And perhaps a small team of people towards the end of the year to be able to generate the traction needed for a VC funding round. Okay maybe this is too big an amount, but everyone is not debt free and rent free.

You might think: Ok, why not go to a VC directly? VCs have $20-100 million dollar funds. They don't want to invest pocket change in you right now - after all, what you have is a dream and everyone has a dream, including Martin Luther King. For unlike him, everyone's dream cannot become reality. So they tell you to do something, hustle around, get some "traction" and come back.

Plus, if they gave you your 50 lakhs ($100K) they will need to fund some 200 companies like you in order to cover their fund of 20 million. Now if these 200 companies gave progress reports just ONCE a quarter, the VC will have to meet 3 companies a day just to cover them all in a quarter, and heaven forbid someone wants time in between. Typically VCs do 10-20 investments.

You might say: Uhm, why not find a VC that has only 5 million? I will now ask you to sit back and think about how VCs get paid. They get a "management fee" which is a percentage of the fund value, and they get a profit fee. Profits are five years away at least, so how does the VC pay their bills? Yes, management fees. Say that's 5% (I am picking a figure from the air). For a $20 million fund, fees are $1 million which pays for the lexus, the chalet and the trips to investor meetings in Honolulu. (To any VCs that are reading: I'm kidding! The Lexus is already paid for)

Now think about a piddly $5 million fund. The fees there are $250K which covers less than Bipasha Basu's clothing, speaking in the VC world. (Not that Bipasha Basu is in the VC world, though if that happened we would have a lot less bickering) That kind of VC would have to travel economy class, which means 'regular' VCs will have the room cleaned with water from the Ganga after they visit.

So VCs won't want to hear about your 10-50 lakh thingie. Now what do you do? Let's say your project manager, a smart guy with lots of contacts and good industry knowledge, professes interest in providing you the money - but he won't join you. Just be on the board, help with some initial setting up and refining, and provide the money you need to get traction, so you can go to the VC.

In return, you give him equity - say 25% of your company. He is now your angel investor.

If, after a year, you go to a VC who values your company at 18 crores ($5 million) and now is happy to invest another 9 crores. What happens to your angel investor?

In the US, many investors will pay the angel the valued amount of his stake (full or partial) and take over his stock. Your angel investor is happy to get this kind of a return and doesn't have to wait 5 more years - that was his risk taking capacity.

This kind of partial or complete cash-out happens at many levels in the US - from first round to second, and even founder partial-cash-outs . This is what I call deal-flow.

Deal-flow is non-existent in India and the reasoning for this, judging from the comments in the venturewoods post, is because VCs are not happy to see other investors exit. Why aren't they staying, they say, and is there something they don't like about this company that we are overlooking?

Plus, of course, financially it means someone is exiting when you are entering. The greater fool theory means that I will buy at a high price and find a bigger fool who I will sell to at an even higher price. VCs do not want to be the greater fool. The fact that they are buying from someone else makes them feel they could be one.

But that theory holds very little water. In mature markets like stock exchanges and such, there are people who buy high and sell higher all the time. Even traders buy high priced goods and add their margin when selling to others - and you have been a greater fool at some point in your life. Ever drunk Barista coffee? You're a greater fool. Ever eaten at a five star? You're a greater fool. Ever bought a cinema ticket in "black"? There you go. Ok these are consumption themes, but I don't know what business you are in - even so, do you take a salary from your company? You are a greater fool - it is far more worthwhile to take the same money in a consulting role. Being a greater fool suddenly is not as bad as you think.

Of course the other big issue is of valuation. Startups are founded by people who may not have too much of an idea about finance. When I started Agni, we brought in two other people who frankly provided very little to the company (though one did give us some office space to start, and later charged us the rent) - but we gave them stake at the same proportion as our money bought. Yes, really. This was 1998, and I was an uninitiated fool.

VC's will generally identify that the founders have been screwed in an angel round, and therefore readjust the capital to distribute the real value. The being-screwed part is obviously subjective, for angels will argue that they paid money where nothing was visible, so their investment would cover the risk. But then the VCs have the money, and the golden rule of finance is: Who has the gold makes the rules.

Thus VC investment generally means that angel stake gets substantially corroded, and therefore it may be in her best interest to sell the stake during the VC round - there is no management input by definition, and there is no control, and this in a private illiquid company; all reasons to sell out. Of course, all of this may be overshadowed by the phenomenal growth potential, and most angels would stay invested. Yet, some may decide they would like to exit, and providing them that exit path is best for all in question - the VC, the founder and of course, the angel herself.

The one way to avoid this is to find angel investors willing to stay very long term. Not that tough, even project managers will have that tenacity. And the second way is to use bridge loans.

At seed time, valuations are murky, so there's no end to valuation arguments. Therefore seed investors can provide capital as a loan, convertible to equity at two points - a) if the company is acquired and b) if there is VC investment. In either case, the conversion will happen at a discount to the valuation offered; say 30% or such. Such loans will be given at about 5% above the market rates, and the accrued interest is not paid out, instead it adds on to the loan amount for a later conversion. This is called a bridge loan (or at least, that's what I call it)

This is great stuff - in fact if you are starting a company, and investing your own money, go down this route. Reason it's great is - if you buy shares early, then you end up valuing the company way too low, which obviously affects other investors later. Secondly, you keep the cash as a loan so if the company goes down you will have first claim on any assets. Convertible debt as a bridge loan is what even big companies do now, through convertible debentures, FCCBs and such. In fact, if VCs were not afraid of losing control, they would also use convertible debt as an option.

Angels can therefore provide money as a bridge loan instead. This kind of thing is just starting to happen, and it may now be the evolution of the angel process. Yet, angels will want to see the possibility of earlier exits if the angel space is to really evolve.

And why should the angel space evolve? Because when you start, you don't need $2-3 million. With tech becoming cheaper and cheaper, why would you take that much money when you can do with far lesser? But VCs won't give you lesser, and angels aren't even in there because the model doesn't permit exits easily. Perhaps we should change the model.

As for founders - I would say put your money as a bridge loan, and take stock options for your hard work. So part of your stake will come as conversion of your upfront money and another part as options vested over time. That arrangement comforts a later VC also about valuation.


Sunday, February 18, 2007

Parenthood is here

Yes, I'm a dad now! We're all excited and wanted to post here to let all the people who read this blog know, if both of you are still around. Cheers!

Thursday, January 18, 2007

Limited Liability Partnership

If you want to start a company you have two choices: start a Limited Company or a partnership/proprietorship.

A partnership or proprietorship has been a loosely held entity where the ownership and responsibility of the company is defined in a registered agreement. If one partner decides to take a loan and run away, the liability is transferred to all other entities in the partnership. Given such issues, most companies are loath to recognise partnerships as proper suppliers or customers. (Exceptions are professional organisations like Auditors, lawyer firms or architects, which by definition cannot be private limited companies) Again, no one will passively invest in a partnership because of the unlimited liability it exposes.

A Limited company provides for limited liability - i.e. you, as an owner, are only liable to the extent of your shareholding in the company. Currently, limited liability companies have a whole lot of statutory requirements to follow - having strict board meeting regulations, annual general meetings, rigid documentation etc. Not a very easy thing for a startup, and the costs, as you can imagine, are much higher. Plus, given that closing a company can take years in India, the cost of regulation can be high for a failed company.

Enter the Limited Liability Partnership (LLP). A new bill proposed in the Rajya Sabha in December, creates the potential for a new entity - the LLP - which will have the benefit of limited liability and the statutory relief of a partnership. (Read the bill in toto)

If this bill is approved, it may be an interesting vehicle for entrepreneurs to use. Plus, you can convert from it to a limited company anytime. An option has also been provided to convert a limited company into an LLP, which will give a lot of relief to owners of now-bust-companies.

Tuesday, January 16, 2007

Thoughts that will make you think

Thanks to my friend Mohit, I saw a list of entrepreneur thoughts at the gaping void.

What I liked best was:

Bill Gates may have a million times more money than me, but he isn’t going to live a million times longer than me, watch a million times more sunsets than me, make love to a million times more women than me, drink a million times more fine wines than me, listen to a million times more Beethoven String Quartets than me, nor sire a million times more children than me. Human beings don't scale.

The one thing I can think of is: He can help a million more people than me. That's perhaps why I should want the money.

Wednesday, January 10, 2007

Profit is a four letter word

In India, there seems to be a cultural disrespect for the word "profit". I remember walking in an exhibition and hearing this conversation:

"Kitna hua" (How much)
"200 rupees"
"Bahut zyada hai" (way too much)
"Isme bahut kam margin milta hai" (i don't get much of a margin/profit here)
"To margin nikal ke bolo na" (remove your profit margin and tell me the price)

I was flabbergasted. Sure, this is negotiation. But the implication was Sell me this item at no profit. This, by itself assumes that the exhibitor will give you the item at just about break even pricing! (Of course, shops are smarter than that)

But we have a history of con-jobs. Most times people indulge in uneven pricing - meaning they price items at different rates for different customers. Foreigners get the worst treatment here; and even the unsuspecting middle-class gets stiffed ever so often. In that light, a strong negotiator is very highly recommended.

The problem, though, is in the abhorrence of profit. It's not like "Give me your best price" - that is perfectly acceptable. But asking one to ditch his profits so he can make a sale seems unfair, and is fascinatingly acceptable in this part of the world.

With a new middle class, and cash rich people, will all of this change? We just have to bet on it.

Monday, January 08, 2007

Startup hiccups in India

Dharmesh Shah analyses why there aren't more software startups in India. By "Startup", he means a company that produces a product - not the BPOs, or the software service companies. He means software product companies, of the likes of Tally Solutions, Picsquare and the new startup that I will be starting in a few days but haven't had the time to build the darn home page yet.

Now yours truly is going to counter-analyse and put in points from a) someone who started a company at age 23 and b) someone who is going to start once more at 32, but this time on a completely different front.

Service companies have lower risk
Startup or service company? When you look at it from an entrepreneur point of view, it's about food on the today (service company) or a gourmet meal far far away in the distance. Dharmesh says the risk of a software service company is lower; and I agree.

I will digress right now into a brief history of my first startup; we went down the "service company" route, though initially only as a funding source.

When I started Agni, I was 23, it was 1998, I had unending reserves of energy and was totally clueless. Which are the prime requirements for starting a company with nearly nothing in your pocket. We put in Rs. 30,000 each - four of us - which was all the money I owned at the time. All of us also brought in our home computers, and set it up in a first floor room of a company owned by a company that was ok with renting it to us without a deposit.

Chirag and I - two of the four founders - had no rent to pay or other big liabilities so we decided that we would go full time into the business, and Arun and Bhaskar, the other two, decided they will get themselves a day job. The deal was: Within three months we generate cash flow to pay us Rs. 15,000 every month, and we all go full time. Otherwise, we shut shop and go away.

We started as "corporate trainers" - meaning we would go to big companies and do five day training courses on C++, Delphi, Java and the like. Even the day jobbers took part - and in three months we generated the required cash flow, everyone went in full time etc. All a happy story till now.

Enter the product. Fin-Acc, an accounting software that would beat the pants off the competition. Two founders would develop it full time - but how to pay their salaries?

(Note: We hadn't even started to think of marketing costs - we were conveniently using Chinese math like 100,000 companies register every month, and where will they get their accounting packages, we can easily get 1% of this market and so on. Our eyes were the shape of dollar signs - because the rupee sign simply does not make for good eyeball graphics - and we honestly believed that if we built it, they would come, hand over their money in small bills in paper bags, and beg us to give them our product. I love those times.)

So, to finance this, there would be a "services division", which was the remaining two founders looking for service contracts worldwide. Luckily we got a break in Europe and then in the US and the "services division" became stronger.

Eventually, as the product started to take away more money than we could throw at it, we began to pull the rug. Take out the newspaper ads. Pull down the hoardings. No more stalls at IT.COM. And later, ditch the product idea - let's sell the service of getting companies accounts online.

What am I getting at? We were forced to go down the service route initially because we had no money. Later, we did it because the product was just not getting COMPARABLE revenues to the services division. Services is easy. Products are tough. Period.

Lack of precedence: Dharmesh says that the Indian story lacks the inspiration provided by prior startups, like in the US you have the Intels and the Microsofts. In India, whaddya got? Infosys, which landed a big contract in 1990 and became a services giant. TCS and Wipro, which was funded by an established house. And while these guys have some product lines, they are primarily service businesses.

But I think India has good stories, albeit not always in the tech space. Suzlon Energy, Bharti Airtel and Rediff have grown from fairly humble beginnings. The recent IPO of has brought a new angle to tech IPOs - that a web company can get an huge valuation in the Indian stock markets.

But yes, the garage companies have still not set a precedent. There aren't that many IPOs - I don't know why, in the face of growing investor awareness, large fund investments and lower regulatory problems - but I'm sure that equation will change. After all, I'm not the only soul that realises even a sub 100 crore turnover is enough to take a company public.

Early stage capital is hard to find: I've talked about it in the context of "not enough capital" and "no more VCs?" earlier. Deal flow is not acceptable and angel investors are either not there or are more chip-on-shoulder than VCs. Okay, gross generalisation.

Bureaucracy: Dharmesh says:

Here in the U.S., I can have a brilliant idea for a software startup and within about 72 hours have launched a “real” company. By “real”, I mean it will be registered (LLC or S-Corp), have a Federal Tax ID, have a merchant account to accept payments, a bank account and a small business credit card. I’m not sure how long the equivalent process takes in India, but I’m guessing at least weeks.

This may not be such a huge hurdle anymore, as even Dharmesh admits in the comments. But let me see:

- Starting a company: If you start a private limited company, this requires a Director Identification Number (costs Rs. 2000 or so and can take a while to get), a copy of a PAN card and such. You also need some "Memorandum and Articles of Association" and application documents which your accountant will snag from another similar company. You will then need to apply for the name of the company, which requires government approval. Okay, it's a pain in the ass. But if you choose to start a partnership firm, which makes sense because you're not going into debt, it's a 10 minute job.

- Getting a Tax ID for a company is an over the counter thing nowadays, and a bank account takes from 1 day to 7 days.

- Merchant Account: You can get one easily at CCAvenue. If you want to be an offline merchant, i.e. get a swiping machine and stuff, it will cost you more time and money. And you have to convince the bank you're not going to cheat customers. Such is life.

- Getting a small business credit card: You can probably forget about this one. Businesses don't get credit that easy, and all you can do is get a personal credit card.

- Dharmesh mentions that it requires a more gregarious attitude to get things done in India. Well, I don't know; I'm not an introverted shy sort of person, I'm more of the sort Dharmesh describes that will "get things done". You probably have to find such a person, but I've found that accountants and social circles help.

All in all, bureaucracy is a pain only if you want it to be. To me, it's the cost of doing business. I would love it to go away - and it's slowly easing up - but it doesn't stop me from doing what I want.

A small digression: One of the reasons I've never wanted to take up a job in the U.S. is because they grudge work permit holders the freedom to start a business. With an H1-B, you never get that freedom until you land a green card; and that process can take around 6 years. I'm ok with waiting a month for my company's tax id, but six years, man that's tough.

Recruiting employees is a challenge: This is the big one, mate. There are two aspects to this:
1) Finding people with the "drive": A tech startup needs people who are extremely passionate about what they do. So if you're going to write mobile games, you have to find people who will breathe games and understand mobile technology as if the acronyms were built into their chromosomes. There are about 10 such people, and the big companies have hired goons to protect them from you.

Okay, I'm exaggerating. But it will sure seem that way to you after a 100 interviews, 200 phone conversations, one-on-one meetings in coffee shops etc. You know what ticks me off? The kind of person that proudly puts "COM and OLE" on his resume, and when asked about how IDispatch interfaces work with late binding, will say "I don't know, we didn't touch that part in our project".

The very excuse that their "project" did not involve a certain area of a technology seems to absolve them from the need to ever learn it. This kind of person can never work in a startup. And yet, such persons are 95% of your candidates.

2) Ability to hire them: Now let's say you hit a gold mine and found a few potential hires. Convincing them to join is ultra-tough, like Dharmesh says, in the face of big corporate salaries, perks, and importantly the cultural peace you get by working with a "known brand". I'm one of those guys who doesn't give a rats ass about my "career growth", but the Indian recruit-o-sphere is littered with those that want a shiny, polished, smooth-upward-curve resume, in which your startup obviously causes undesirable bumps. So you can't hire the career types, the money types or the known brand types. Now you are left with a sum total of two people you can hire, one of whom is you.

It's also interesting that Dharmesh mentions the marriage angle; that startups are not considered kosher for the marriage market. One of my friends, who was a consultant making obscene amounts of money working only six months a year, had to join a big name company when his in-laws postulated that the lack of a fixed job was not explainable to their relatives. Think about it. His wife and his in-laws were ok with his job, and the money was great, but he got a job so that their relatives wouldn't raise eyebrows.

He quit the job a month after his marriage.

Product companies are tough and creative: What Dharmesh says here is a little subtle; that Indians, in general, don't want to spend time on the creative nature of product development, and are more focussed on practical, heavy things. Uhmm...I think he's right here. There are some essential small parts of development - usability, clarity, no. of clicks to get something done etc. which are largely ignored by developers and companies alike.

I think it's not that we don't think of it. It's that we don't try to refine ourselves once our product is out.

A commenter also mentioned that a huge problem is lack of local market. India by itself is not so much a consumer of software products. Not only is piracy rampant, but people simply do not pay in volumes that make any sense. The lack of local market means that most startups look to get customers from abroad; it is now painfully obvious that you should be where your customers are, therefore the startup moves to other shores for selling, customer acquisition etc. and leaves India as a development/testing location. It is now no longer an Indian startup.

The lack of a local market is relative. Maybe this is not the place for a youtube or a facebook. For mobile content providers, it's *the* market. For online travel ticketing, jobs and real estate portals and the like, it's showing tremendous potential. And I believe there is a big market for discount bookstores, tax return software, fast food restaurants etc.

Overall, I think startups in India will be tough to come by. It's largely the lack of good people that will kill the enthu of the few that do start. Yet, all it will take, and I shamelessly borrow from someone whose name I don't remember, is a few good men and women.

Thursday, January 04, 2007

Targeted New Year wishes

A Google search for "Deepak Shenoy" has yielded this snapshot:

Look at the right - Sponsored links with my name on it! What a way to target a New Year wish :) What's even more impressive is what happens when you "click" that link:

More power to Mahesh Murthy and the people at Pinstorm.

To Mahesh, Pinstorm and all of you reading: Wish y'all a fantastic 2007!