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Interesting Reading September 5, 2011

Posted by Manish Katyan in Startup.
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Marc Andreessen

David Cowan
Steve Blank

What do VCs typically do? July 7, 2011

Posted by Manish Katyan in Venture Capital.
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Well, they make money – serious money 🙂

The job of a VC is really weird. Imagine convincing someone to part with his money that you would sink into something that is almost certain to bomb (80%-90% of cases). Then imagine sifting through 100s of half baked-wild ideas to find those very few, typically 1%, that you feel (yes feel – there is no formula or model to make your life easier) are worth investing. Then imagine praying patiently 4-6 years for those ideas to hatch that would get your money back, may be with some return. So every time you are going to raise money, every investment that you are making, basically, you are putting your credibility at stake – past performance is not indicative of future results. How would you feel when one after other your investees are vanishing in thin air?

Is this job envious? Well may not be for most. But it certainly is for some, including me. There is this thrill of identifying something that is going to change the world (various degrees of changes from Google and Facebook at one end and 100s of unnamed ventures on other end). There is this urge to connect the dots, see the pattern and figure out the changes that are going to happen couple of years ahead in future. You know how it feels when you realize a dream? When you make this your job to realize dreams of others? Well, a VC’s job feels something like that. Never mind that there is a little chance of you getting wildly rich.

At a more worldly level, VCs usually work in a team. They invest someone else’s money and, thus, have fiduciary responsibility towards those investors. Since they don’t know which 1% of the 100s of business plans landing into their inboxes are going to click, they have to go through any and all that come through. Once they evaluate a plan (I would be writing later on this), they talk to entrepreneurs and their clients and potential clients. They rationalize the assumptions that entrepreneurs usually make, run the numbers themselves and analyse to assess the size of the opportunity, market growth and competitive intensity. Once they invest, they provide the mentorship and support to the entrepreneurs.

Mentoring and support is an important element that a VC investment brings on the table, unlike other flavours of investments. VCs bring with them a huge network and rich operational experience. Especially for technology ventures, may be because of the tech background of the entrepreneurs, there is this need to fill the gap for sales and marketing expertise. VC can assist in providing such strategic directions. They can introduce the entrepreneurs with potential clients, vendors and partners.

VC s do monitor whether product development cycles are on track, how the initial customers are responding to the product or service, how the competitive landscape is shaping up etc.

Entrepreneurship is a journey that has highest of high and lowest of low in rapid succession. If you are an entrepreneur, you would immediately understand the need for a shoulder to cry on once the tide turns against you. Well, VCs do provide the shoulders to cry on. In fact VCs who are an entrepreneur themselves are better able to relate to the situation of an entrepreneur and are able to empathise with them.

With their huge experience, VCs are able to advise entrepreneurs in deciding when to go for funding and how much fund do they require. They also help entrepreneurs in deciding when to go for IPO or accept an M&A offer.

At the same time, it’s worth mentioning that a VC, especially a good one, understands that it’s the entrepreneurs who are creating value and not them. Hence it’s the entrepreneurs who would take the final decision on any matter of the venture and not the VC. The VC is only there to provide support and advice and not to take any decision on behalf of the entrepreneurs. A VC who starts forgetting this role-division would not be a successful one in the long run.

How does Venture Capital work? July 7, 2011

Posted by Manish Katyan in Venture Capital.
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VC (called general partner, GP, responsible for investing the fund and managing portfolio companies) typically raise money from high-net-worth individuals, institutional investors (called limited partner, LP – doesn’t get involved in day-to-day operations) etc for a fixed-life venture fund.
Suppose a VC raise $100 million fund with a life of 10 years. Typically VC would invest that fund in a number of early stage ventures for a period of 4-6 years. Once VC gets back his money though IPO, M&A or selling his stake in his portfolio companies to some other entity, he would 1st return $100 million to the investors (i.e. LP). After that, whatever amount remains, i.e. profit, VC would keep 20%-30% of that amount and return rest to the investors. Bigger and established VCs would keep 30% of the profit whereas smaller or newer VCs would keep 20% of the profit with the rest of the VCs falling in-between. So this is how a VC makes money.

Because of the higher failure rate of startups (8-9 failures out of 10), a VC expects a return of at least 10x on his investments. Once a startup fails, VC has to write-off that investment. At times, he may be able to find someone who still sees value in the venture that this VC thinks as a failure (or not going anywhere) and he may be able to sell his stake for 2x or 3x, whatever he is able to negotiate.
Given the risk involved and his responsibilities towards the investors, big financial return (at least 10x return) is the prime motive of a VC’s investment in a venture. Since a VC would have to return the money to the investors, all his investments must have a clear exit opportunity.

For example, if there is some venture that is valued at Rs 5 crore today and becomes Rs 30 crore at the end of 5 years, it won’t be of an interest to a VC since he won’t be able to get at least 10x return on his investment, even if he owns 100% of the start-up, which itself is impractical.

Similarly, suppose there is a venture with 50% profitability at the revenue of Rs 20 crore year-on-year (assuming no growth). Though this is a great business, such a venture is of no interest to a VC because there is no clear exit opportunity for him.

Hence, for a venture to be interesting to a VC, it should be in a fast-growing potentially large market with a very few players. Such a venture would not only present an opportunity for big financial return (priority 1 for a VC) but also have clear exit opportunity (priority 2 for a VC) through IPO or M&A or some other means.

By looking at a proposal, a VC would be able to figure out the potential gain from the investment or the exit scenarios. But that is the single most important thing that could risk an investment? That is the quality of the entrepreneurs a VC is banking on. No wonder, you would hear VCs saying that they are investing in the entrepreneurs and that if they are not comfortable with the entrepreneurs, there won’t be any deal, whatever be the potential of the business idea.

To minimize his risk further, a VC may insist on some revenue traction or some customer of the product or service of the venture. He would feel more comfortable if there are some other VCs lined up to fund that particular idea. He may further add some protective clauses in the agreement.

Valuing a Venture July 4, 2011

Posted by Manish Katyan in Venture Capital.
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Every business plan that a VC receives includes an attractive budget and aggressive growth plan. Assumptions related to minimum market penetration, product pricing and gross margin are usually over-optimistic. A VC has to rationalize the assumptions and run sensitivities based on various scenarios (competitive pricing pressure, degree of execution, seasonality). The resulting rationalized forecast may be a fraction of original forecasts.

Discounting from the original forecast may reveal significantly greater capital requirements than first expected. However, this revised capital requirement could guide the venture’s long-term financing strategy. How much must be raised now? When will the next financing be needed? What significant milestones will be accomplished during that time? An understanding of the long-term financing strategy is crucial. A seasoned entrepreneur would work with his investors to develop a financing strategy based on building value from one financing to the next and understanding how value will be measured.
Following are the different stages of financing a venture:

• Seed financing: The seed financing will provide the capital needed to support salaries for founders /management, R&D, technology proof-of-concept, prototype development and testing, etc. Sources of capital may include personal funds, friends, family and angel investors. Capital raised is limited due to its diluting impact at minimal valuations. The goal here is to assemble a talented team, achieve development milestones, proof of concept and anything else that will enable the entrepreneur to attract investors for the next financing.

• Series A Financing: Typically the Series A is the company’s first institutional financing—led by one or more venture investors. Valuation of this round will reflect progress made with seed capital, the quality of the management team and other qualitative components. Typical goals of this financing are to continue progress on development, hire top talent, achieve value-creating milestones, further validate product, initiate business development efforts and attract investor interest in the next financing (at an increased valuation).

• Series B Financing: The Series B is usually a larger financing than the Series A. At this point, we can assume development is complete and technology risk removed. Early revenue streams may be taking shape. Valuation is gauged on a blend of subjective and objective data—human capital, technical assets, IP, milestones achieved thus far, comparable company valuations, rationalized revenue forecasts. Goals of this financing may include operational development, scale-up, further product development, revenue traction and value creation for the next round of financing.

• Series C Financing: The Series C may be a later-stage financing designed to strengthen the balance sheet, provide operating capital to achieve profitability, finance an acquisition, develop further products, or prepare the company for exit via IPO or acquisition. The company often has predictable revenue, backlog and EBITDA at this point, providing outside investors with a breadth of hard data points to justify valuation. Valuation metrics, such as multiples of revenue and EBITDA, from comparable public companies can be compiled and discounted to approximate value.

Each financing is designed to provide capital for value-creating objectives. Assuming objectives are accomplished and value is created, financing continues at a higher valuation commensurate with the progress made and risk mitigated. However, problems can and will arise during this time that may adversely affect valuation.

Learning from Acquisitions at P&G April 29, 2011

Posted by Manish Katyan in Mergers & Acquisitions.
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Acquisitions are risky with a higher failure rate of over 70%. A detailed analysis of all acquisitions at P&G from 1970 to 2000 showed that only 20% to 30% of acquisitions succeeded in that period. An acquisition was successful if that “met or exceeded the investment case and going-in investment objectives.” An acquisition was partially successful if that “exceeded the cost of capital.”

The study above found five fundamental root cause of failure:

  1. The absence of a winning strategy for the combination
  2. Not integrating quickly or well
  3. Expecting synergies that don’t materialize
  4. Cultures that aren’t compatible
  5. Leadership that wouldn’t play together in the same sandbox

I have discussed above failure reasons in earlier post on Post-Merger Integration, quoting that post:

Buying a company is easy. Making that purchased company succeed in the post‐purchase environment is something else altogether. Just as anyone can get married, anyone can buy a company. But not everyone can make a marriage successful, and many companies wind up selling (divorcing themselves of) the very companies they initially enthusiastically acquired, often selling for a fraction of the original purchase price.

Further I discussed various topics Value Creation Strategies, Vision & Leadership etc in successive posts that outlines similar issues elsewhere and details aspects that should be kept in mind.

Coming back to P&G case, once above root causes were identified, the company worked on issues such as how should it organize each phase of acquisition, what processes should be in place, which interim measures would indicate whether the acquisition process is on track. So this is a disciplined approach with clearly identified  in-charge for each phase of the process.

These insights were used in the $57 billion USD acquisition of Gillette in 2005. The company identified all the value creation elements. It identified the integration the integration sequence and elements. It put a pretty senior manager in charge of every value creation initiative. It tracked progress for every value-creating initiative using a simple red (indicating not on track), yellow, green (indicating on track) process. It drove every phase of integration, every building block of value creation, to completion.

Above efforts resulted in delivering more than 150% of the originally estimated cost synergies. So the cost synergy alone created enough value to make the Gillette acquisition a success. The revenue synergies – such as in combining Crest and Oral-B brands and innovations in oral care products – all come on top of the cost synergies.

Source: Interview of A.G Lafley, Former CEO, P&G, HBR April 2011

Hot Sectors in PE February 5, 2010

Posted by Manish Katyan in Private Equity.
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  • Education: With an estimated $40bn market for private institutions, education sector will be one of the most favorite sectors for Private Equity and Venture Capitalists in coming years. A Venture Intelligence survey revealed that more than 80% investors are planning to make an investment of around $800MM in education sector over the next 12 months. Since 2006, $300MM has been invested in Indian education ventures.
  • Healthcare: Opportunity is being seen mainly in diagnostic services, medical devices, hospital chains and wellness products. India has a huge competitive advantage in clinical research. Hospitals are yet another area where a lot of investment to be seen in near future as the average number of beds is the lowest in India. During the last 18 months, PE players have invested $686MM in the health care sector.
  • Cleantech: PEs and VCs are likely to invest about $3.5bn in clean technology in next few years. Regulations in India (where 10% power is generated from renewable sources) are very positive for the sector.

Reference for survey and investment period: July 2009

Desired Regulatory Changes for PE February 5, 2010

Posted by Manish Katyan in Private Equity.
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  • Currently VC/PE firms make their investment decisions solely based on publicly available information. VC/PE companies should be allowed to conduct full due-diligence on listed companies to validate viability and sustainability. Lock-in period and NDA can be used to safeguard interests of targets.
  • Increase the threshold to trigger open offer to 25% from 15%.
  • Increase the time period to convert warrants from 1.5 years to 5 years.
  • PE/VC funds shouldn’t be treated as promoters or persons in control along with promoters and hence exempt from SEBI regulations for promoters.

Deal Design and Risk Management – Part II January 17, 2010

Posted by Manish Katyan in Mergers & Acquisitions.

Managing Risk in an M&A deal

In a stock-for-stock deal, the acquirer’s share price may drop before the deal is closed for various reasons including overvaluation of acquirer’s shares, market perception about over-payment, and weakening of operating and financial performance of the acquirer. This would reduce the deal value to the target shareholders. There are other risks to shareholders of the target such as exchange ratio may change or deal may not go through at all because of regulatory disapproval or walking away of the acquirer.

Similarly there are various risks to the shareholders of the acquiring company. The target’s operating or financial performance may deteriorate. There may be hidden liabilities in the balance sheet of the target. There is always a chance of paying too much, a competing bid or deal not going through at all because of regulatory disapproval or social issues. For example, target’s employees may go on strike fearing job loss post-acquisition.

The risk sharing is affected by the method of payment. In case of all cash deal, all pre-closing risk is entirely born by the shareholders of the acquirer company whereas in case of all stock deal, the risk is born proportionately by the shareholders of the acquirer and the target shareholders. During the negotiation phase, the buyer and seller maneuver to share the perceived risk and potential return. In doing so, substantial differences arise between the expectations of the buyer and seller.

There are several mechanisms of managing such risks and consummate the deal aimed to alleviate asymmetric information and provide incentives when the buyer and seller cannot reach agreement on purchase price. The following diagram shows risk management strategy in various stages of a deal:


Deal Design and Risk Management – Part I January 17, 2010

Posted by Manish Katyan in Mergers & Acquisitions.
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The deal design process is fundamentally about meeting as many objectives of the parties involved as required to reach overall agreement and determining a risk sharing mechanism.

The buyers may want to pay only reasonable price, use stock in stead of cash, sign non-compete agreement, retain key employees or make a certain percentage of the purchase price contingent on realizing some future events to minimize risk. For example, seller may claim an aggressive growth rate of the business. In this case the buyer may want to hold a certain percentage of payment till the claimed growth is realized.  Seller may be interested in fetching maximum price, tax advantages, rights to license patents or other assets or future reputation of the business.

Whether acquirer would assume all, some or none of the liabilities, disclosed or otherwise, of the target is about sharing of risk. This process can become fairly complex in a large transaction involving a number of parties, payment modes and source of financing.

Form of Payment for an M&A deal


Valuation of LBO January 17, 2010

Posted by Manish Katyan in Mergers & Acquisitions.

Leverage Buy-out

A buy-out firm buys 100% of the target by levering it up and takes it private i.e. shares of LBO no longer trades in the open market. After improving operational efficiency and lowering leverage, the target is brought for IPO or is sold. The buy-out firm usually exits in 3-4 years. A large portion of the buy-out is financed by debt.

Characteristics of good target company

A good target for buy-out would preferably have low debt with high level of “bankable” assets and high growth potential with scope for operational improvement. The target’s cash flow should be stable and sufficient to meet interest and principal payments on the debt and provide adequate working capital. The target’s cash flow should also be protected by patents, strong brand or market leadership.

Though difficult to estimate, the financial distress cost of the target company should be low. When debt is very high suppliers may get concerned about company going bankrupt, stop giving credits and start working with competitors having better chance of survival. For example, if there is a high requirement for after-sales service and the customer think that company may not be able to make spare parts available in future; she would not buy at all – resulting in high financial distress cost for such a company.

The management should be cooperative and receptive for changes required for turn around.

Sources of value in LBO


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