Four Questions Entrepreneurs should ask any Angel Investor in India

Note: Angel investment generally refers to any small investment (may be up to Rs. 2-3 Cr.) in an early stage (pre-revenue) company. The people making these investments are called “Angel Investors”.

Yes. You can ask them questions. Angel investors are not doing any charity or favor to you. They are investing in your business with the expectations of high returns and you have all the rights to ask them questions. In fact, if you ask them right questions, it can save you lots of time, energy and resources.

Please ask the following four questions to them before you start discussing your idea. If they are reluctant in answering these questions, then it is advisable to stay away from them.

1. Have they made any investment in last 12/18/24 months? An angel investor is a person who has made any investment in an early stage company in return for equity. An angel investor is NOT someone who is claiming that he would make an investment in a company. Any one can make this claim. Please ask the person what investments he has made in last 12/18/24 months and if he has not made any investment at all then what are your chances of getting investment from that person? It is highly unlikely that yours would be the first company that he liked and felt confident enough to put his money into it. May be he is disguising himself as an angel investor for some other ulterior motive. So, please ask this question and, if the answer is “ZERO” or “I am evaluating a few proposals” or “any other vague answer” then you should stay away from these investors.
2. What are his specific investment criteria? You should ask this question in the beginning and if you get a very vague answer, you should be very cautious. A very common way for any investor to get himself out of the deal, once he has acquired all information/research/knowledge/money he wanted, is to ask for significant majority or put up some irrational conditions in front of entrepreneurs. If you ask this question early, you can save yourself lot of time in educating the investor and avoid any frustration at the end of this process. Ask for his investment criteria especially about the stage of business. At what stage he is going to invest – Idea, Product Prototype, Stable Product, First Trial Customer or First Paying Customer. If your requirements do not match with his criteria then you should not spend any time on this.
3. Are they charging money for listening to your pitch? If the answer happens to be YES, please stay away. Simple. The investor who can not even afford the expenses to listen to entrepreneurs’ pitch, what are the chances that he can afford to make any investment in the business?!
4. Do they have any other business? Yeah, while it is understood that most angel investors will have some other business but entrepreneurs should be wary of these two kinds of angel investors’ businesses:
• In India, many “investment bankers” are disguising themselves as “angel investors”. Their main intent is to get these entrepreneurs as clients for their investment banking business. They have absolutely no intent or desire to invest in your business. This is a marketing exercise for them to create pipeline for their business. You should clearly stay away from any angel investor who has investment banking as his other business.
• Also, many technology business owners portray themselves as angel investors to keep a check on technology happenings in the market. In some cases, they do invest in other businesses especially if they see some synergy with their own business. While there is nothing wrong with it but if any such angel investor has not made any investment in recent past, then he may only be interested in listening to ideas and getting it implemented by his team. I would not recommend you to stay away from them but you should definitely be cautious in sharing information with them.

Exit Options

Exit Options are one of the most discussed aspects of a venture capital fund-raising process. The promoters and the investors make money if and only if the company is able to provide a decent exit to the investors. Exit Options are important for all concerned parties (promoters, investors) as a good return on investment consummates the hard work, efforts put in by the promoters and the risk taken by the investors.

When it comes to exiting from the company (i.e. selling the common shares) the equity holders mostly exercise one of the following three options-

1. Initial Public Offering (IPO)
2. Mergers and Acquisition (M&A)
3. Company/Promoters Buy Back

Initial Public Offering (IPO): IPO is the process to selling the company’s shares to public. After the IPO, the shares are traded in a stock exchange and people can buy and sell shares by paying a small brokerage. This is one exit option that all investors love. IPO provides the investors time, price and quantity flexibility. Investors can choose to sell any quantity at anytime and at any price once the company’s shares are listed on a stock exchange.

Mergers and Acquisition (M&A): M&A is the process of selling the company’s shares, partially or completely, to another company. This is the second preferred option by the investor as it does not provide them the flexibility to exit at their chosen time and they have to sell all their shares in one go. In most cases of an M&A, the pricing, timing and quanta is specified simultaneously and investors do not have the flexibility in their exit.

Company/Promoters Buy Back: This is the least preferred option by the investor. In company/promoters buyback arrangement, the company or the promoters agree to buy the investors’ shares at a certain price if company is not able to provide any other exit either through the IPO or M&A. This option is least preferred because here investors’ returns are capped and there is no upside beyond that. However, investors like to put this in the shareholders’ agreement so that at least their capital and minimum returns are protected even if company does not do as well as projected.

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Sweat Equity and ESOs (Employee Stock Options)

Sweat Equity is fundamentally the equity provided against the “sweat” (in contrast to money) while ESOs are stock options giving the employees the “option/choice” to buy the company’s equity at a predetermined price. ESOs are actually a sub set of sweat equity as exercise of ESOs results in employees getting equity at a discounted price.

Sweat Equity and ESOs are used by the start-ups and early stage companies to acquire talent when they cannot offer them their market price due to cash constraint. Sweat Equity and ESOs are also used to retain talent as these come with certain constraints like lock-in, vesting and non-transferability that make sure that sweat equity owners can benefit from it if and only if they have been with the company for a definite time. Sweat Equity is also used to motivate talent to perform better as company’s equity value increases with its performance, which in turns benefit the employees holding the company’s equity.

The following terms are often used in conjunction with sweat equity and ESOs-

Lock-in: Lock-in period is the time before which the sweat equity or the ESOs owners cannot monetize their equity. This time is generally three to five years for a start-up company.

Vesting: Vesting is the mechanism specific to ESOs that describes the time and number of ESOs the employee can convert into equity. Generally, start-ups allow 25% of ESOs to be converted into equity at the end of each year.

Non-transferability: As the name implies, non-transferability clause does not allow the transfer of sweat equity or ESOs from the original holders to anyone else. This means that either the ESOs can either be converted to equity or be expired after the vesting period.

Employee Stock Option Plans (ESOPs): ESOP is a plan through which company allocates ESOs to its employees based on their performance.

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Term Sheet Series – No Shop Agreement

No Shop Agreement is not such an important term for a venture capital deal however it is an integral part of all non-binding term sheets signed between the Company and the investors. In fact, this term does not affect the final agreement between the Company and investor and it remains effective only for a certain time before signing of binding agreements.

No Shop Agreement simply means that the Company would stop “shopping around” for better deals till the time company’s discussion with this investor is logically complete. Through this clause, the Company agrees that it will work only with this investor for a definite period to close the deal. If for whatever reason, the deal is not close within that specified time frame then the Company can start talking to other investors.

Generally, the time specified in this clause is 30-45 days which is the time taken by the investor to perform due diligence on the company. The investors do not want to see that while they are performing due diligence on the company, the company is involved in discussion with other investors who can now offer better terms to the company.

One important thing to remember about No Shop Agreement is that if the company is found to violate this particular term then the deal with the current investor is definitely off as the investors lose faith in company’s management integrity.

Case Study Series: Analysis of a successful venture capital fund raising exercise

Over the last few years of my career as a venture capital consultant, I’ve worked on a number of fund-raising assignments for small and mid size companies. Some of these transactions were successful while others failed at some stage of the fund-raising process. This case series is started with the analysis of a successful transaction. The future articles in this series would talk about not so successful transactions as well. This series should provide a huge opportunity for entrepreneurs to understand as to what actually works with VCs when it comes to fund-raising for their companies.

Introduction to the Company: The Company in this case is a Delhi based small logistic services provider. The company’s business is to provide third-party logistics (3PL) service like warehousing, packing, unpacking etc for a number of large FMCG, Auto, Electronics companies.

Things that were working for the Company:

Team: The owner of the Company is a first generation entrepreneur who has built a good team by hiring two senior industry professionals to manage the future proposed growth of the company. Along with the promoter, these two provided enough expertise and credentials to the team. The team was a good combination of entrepreneurship skills of the promoter and professional experience of the other team members.

Clients: The Company had some of the best names in their industry as its clients to boast of though the revenue from each client was quite small. The company was providing its services to large and reputed clients in FMCG, Auto, Electronics and Beverages industry. This proved to the investor that the company has the ability to acquire, deliver and retain the best clients in their field.

Hot Growing Industry: Logistics has been a huge area of interest in the venture capital community in India for quite some time now. There have been a number of transactions in this industry already and most investors are still looking for good projects. Unfortunately, most Indian players who call themselves logistics companies are essentially transport companies but this Company was a good mix of warehousing, cold storage and transport business.

Things that were NOT working for the company:

Small size of operations: Though the company had some of the blue chip clients however the Company’s profits were very low. At the time of fund-raising process, the company was making net profits of close to Rs. 10 lacs. The proposed investment was quite large in comparison to the Company’s current scale of operations and it took some skill on the promoter’s part to convince the investors that the company can manage a comparatively large operations.

No experience of some proposed businesses like Cold Storage: Some of the businesses proposed by the Company were completely new. No member of company’s current team had any expertise in those businesses. However, inclusion of those businesses made tremendous strategic sense and that’s why they were able to convince investors about inclusion of new businesses.

Valuation: Since the required investment was significantly large in comparison to the Company’s current operations, the valuation became quite a challenge. Any standard valuation technique was leading to a very small stake for the promoters. The problem was solved by a performance linked valuation structure where promoters were rewarded by equity every time they met a performance benchmark.

Please send me an email at neeraj AT metalogosindia DOT com if you are interested in looking at a sample financial model for the above mentioned company.

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Private Equity and Venture Capital Deals in India in March 2010

The following deals were announced by Indian private equity and venture capital investors in the month of March.

Please feel free to let me know that if I’ve missed on any major deal which was announced this month.

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Term Sheet Series – Board of Directors

This is one of the most important clauses of the Term Sheet. I believe that it is as important as the valuation/price clause but somehow entrepreneurs do not realize its importance to the same extent. To understand the significance of board of directors in any company, please read on.

In any business, two of the most important parameters that are of interest to any VC investor are:

• Profit Sharing
• Control Sharing

While profit-sharing is determined by the respective shareholdings of all the shareholders, control-sharing is largely dependent on participation in the board of the company i.e. by nominating your own directors on the board.

Board of Directors are the people who approve all the major decisions proposed by the company’s management and they effectively run the company from a control perspective. These individuals are selected by the shareholders of the company to manage the company. Every major decision taken by the company like annual budgeting, fund-raising, changing key positions in the company, public listing, and major investments needs their approval. The Chief Executive Officer (CEO) or Managing Director (MD) of the company is answerable to the shareholders and to the board of directors. Board of directors exercises immense power on the company. So much so that these are the people, who decide the appointment of the CEO and they have the power to remove him as well.

When VCs invest in a company, they ask for a certain number of seats in the board of the company. This clause generally reads like “ of the total 5 directors in the company, at least 2 directors will be appointed by the VC investor”. Generally, percentage of board ownership is similar to the percentage shareholdings but this need not be necessarily true. Sometimes, VCs like to have majority in the board of directors even if they have only a minority stake in the company. Also, the board of directors appointed by the VCs are always a lot more active than the other board of directors.

When negotiating this particular clause with the VC investors, entrepreneurs need to take extra care of what all powers are vested in the board of the company and whether entrepreneurs have enough say in the major decisions of the company. Generally, VC investors give most of the operational control (day-to-day working) to the entrepreneurs while trying to keep all the major decisions making to themselves through majority in the board.

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How do Venture Capital funds evaluate an Investment Proposal?

While we have earlier talked about the venture capital fund raising process from the entrepreneur’s perspective, this article will provide a simplified version of the investment evaluation process from a VC’s perspective.

This article has broken the VC’s investment evaluation process into 4-steps. Entrepreneurs can use this to understand as to which step they are at vis-à-vis their fund-raising endeavors and how much work is left before they get a chance to see the money from the venture capital fund.

Step 1 – Meeting with the promoters: If the venture capital investor likes the first teaser about the company, they set up a meeting with the promoters of the company. During this meeting, VC’s objective is to meet the core team, understand the team’s strengths and weaknesses, get a good understanding of business model, market potential, competitive landscape and exit options etc. This meeting is generally followed by a list of questions from the VCs and promoters answers to these questions with a lot of information.

Step 2 – Validating the promoters “story”: After step 1, VCs do their own research to validate the promoters’ story. They mostly do it in-house but in rare cases, they hire an outside agency to verify the promoters’ claims about the business model, business potential, market size etc. They also talk to a few of company’s vendors, partners and/or customers to get some feedback on company’s background, market reputation of the promoters, product/service quality etc.

Step 3 – Internal brainstorming and Presentation to the Investment Committee: If the VC is satisfied with his findings in step 2, then the deal team inside the venture capital fund prepares the IM (Investment Memorandum) that captures investment rationale, valuation, exit scenarios, and key risk factors. VC presents this IM to his investment committee (IC). Investment Committee is VCs internal group, which comprises of their limited and general partners and they provide their feedback on the investment opportunity. IC raises a number of issues about the investment and if after their discussion, venture capital fund is still positive about the investment then they call the promoters of the company for a presentation to some/all members of the investment committee.
The meeting with the partners is an important step in fund-raising process. The promoters should try to reach to this step as quickly as possible by pushing their contact person in the VC fund. If the VC is being reluctant in setting up the meeting even after 10 weeks of first meeting the promoters, then promoters should realize that VC is not very interested in their proposal and it is most likely to result in a negative response.

Step 4 – Detailed validation (due diligence) and Shareholders’ agreement: If everything goes well during the IC meeting, VCs generally issue a term sheet mentioning their key terms and conditions of investment. Once there is an agreement on all the terms and conditions mentioned in the term sheet, VCs perform a detailed due diligence on the company. Since there are hardly any financial information to verify in case of a start-up company, the due-diligence process for start-ups is restricted to VCs trying to get into details of fund requirements, detailed usage of funds, month-by-month milestones etc.
Generally, VCs end up adding a lot of additional terms and conditions after the due diligence process under the section “conditions precedent” in the shareholders’ agreement. Once the promoters take care of all the issues identified during the due diligence process, VCs and promoters sign the Shareholders’ agreement and money is transferred to the company’s account.

Term Sheet Series – Anti Dilution Right

Note: For readers who may not be aware of this, the most commonly used term for each round of VC funding is “Series A”, “Series B”, “Series C” and so on. The first round of funding is referred to as Series A, and the second round of funding is referred to as Series B, and then Series C and so on.

Anti Dilution right is another very important right which must be understood by the companies planning to raise venture capital funds. Anti dilution right is always with the investor(s) in the company and as the name implies, it protects the investors from any dilution of their investment at the time of either next round of funding or issuance of fresh shares by the company for any other reason. This right basically says that in future, the company can’t issue shares to Series B investor at price which is lower than the price of Series A investor.

To understand this right, lets consider the following example:

1. Let us assume that the Series A investor has invested Rs. 10 Cr. in a company for 20% stake by subscribing to 10,00,000 shares out of the total 50,00,000 shares. It implies that the value of each share is Rs. 100 (Rs. 10,00,00,000 Cr. divided by 10,00,000 shares).
2. Let us also assume that the company has given Anti-dilution right to the Series A investor. It would ensure that if the company issues any shares in future to Series B investor the pre-money price of each share can’t be less than Rs. 100 OR the company will have to compensate the Series A investor from any dilution by issuing them additional shares.

Another important aspect of this right is that how the Series A investor gets compensated if the company plans to issue shares at a price which is lower than the Series A investor’s price. In this situation, one of the following two mechanisms can be used to protect the Series A investor from dilution. (the mechanism to be used is discussed at the time of signing the shareholders’ agreement)

1. Full ratchet based anti-dilution: Full ratchet based anti-dilution means that even if the company is issuing only one share to Series B investor at a price lower than the Series A investor’s price then all the shares of Series A investor’s are re-adjusted to Series B investor’s price. In the above mentioned example, if the company is issuing shares to Series B investor at Rs. 20 per share then the company will have to issue as many additional shares to Series A investor such that the price per share for Series A investor is Rs. 20. In the same example, company will have to issue 40,00,000 additional shares to Series A investors to protect them from any dilution. (Rs. 10,00,00,000 divided by Rs. 20 = 50,00,000 minus 10,00,000 (already issued shares to Series A investor) equal to 40,00,000 additional shares).As it would be obvious to some of us that this clause is pretty harsh on the promoters but interestingly, this is the norm in most shareholders’ agreement!
2. Weighted average based anti-dilution: Weighted average based anti-dilution implies that the Series A investor will be protected against the dilution only to the extent of either the new issues of shares to Series B investor or to a certain percentage of their existing number of shares. So if the company is issuing only one or a very small number of shares to the Series B investor at a lower price, either only one or those many number of share of Series A investor will be re-priced to Series B investor’s price. Other variant of weighted average anti dilution is that only a fixed percentage of Series A investor’s shares will be re-priced depending the formula agreed for weighted average anti-dilution at the time of signing the shareholders’ agreement.

If you believe that this article is not easy to understand, please leave a comment and I will try to simplify it further.

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What NOT to do while raising venture capital funds?

Venture capital fund-raising process is a difficult task. Only one out of the many companies manage to raise funds successfully. While it is very important to understand the venture capital fund-raising process and do certain things appropriately, it is equally important NOT to make any of the following common mistakes as it can reduce the company’s chances of raising capital considerably.

1. Lie, Misrepresent: It is a strict “No-No” to lie or misrepresent about any aspect of the business. It is really not worth anything to make any false claim about the past or present of the company because a) at some stage during the diligence process, the investors will come to know of the truth anyways b) it will put all other true claims made by the company under suspicion and VCs will start doubting the credibility of the promoters. Tell only the truth about the team, clients, financials and other aspects of the business.

2. Chinese Maths: It is not advisable to do Chinese maths to prove the market potential of your business. You should not say that total market size of this opportunity is Rs. 10,000 Cr. and even if my company is able to achieve only 0.5% market share, it will become a Rs. 500 Cr company. VCs generally dislike this kind of top down approach to calculate numbers and market potential which is not based on any solid business argument. The arguments behind the numbers should be a lot more bottom-up and should be driven from business fundamentals.

3. Lose Focus: Ever during the fund-raising process, the promoters of the company should not lose focus and start talking about different businesses if the investors are not showing interest in their main business. The promoters should address the investor’s concerns/queries about the business and should be open to suggestions from the VCs but they should not change their basic business model or start exploring other business ventures based on investor’s advice. Sometimes investors make such suggestions only to check the promoter’s commitment to its business.

4. Underestimate the VC’s knowledge: Companies should never underestimate the venture capitalist’s knowledge of business and should never treat them highhandedly. While it is obvious that the VCs would never be able understand the business as well as the promoters of the company however VCs are generally equipped with lots of research material about the industry and they probably would have seen the similar businesses from other promoters in same or different geographies and they would always be able to ask intelligent questions about the business. Treating them with disdain or disrespect will not benefit the company in any which way and it will categorize the promoters as non-listening and non-cooperative types which will reduce the VC’s comfort with the promoters.

5. Approaching the wrong VCs: The companies should not approach VCs in an ad hoc manner. The company should first identify a competent investment banker or a financial advisor to assist them in preparing the business plan and the financial model. The the companies should not approach any VC without preparing a list of prospective VCs based on VC criteria of investment.