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.

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.

How to add little touches to a good business plan to make it great?

There are a number of articles, templates available on the Internet on how to write a business plan to get venture capital funding. While most of them are quite comprehensive and provide very useful pointers to prepare a good business plan but, they generally don’t really tell what exactly to write in each section of the business plan so that investors get that feeling of “wow” about the business.

In my earlier post, What Indian Venture Capital Investor really wants? Simplified., I touched upon some of the most important aspects of a business plan, which VCs love and like. The most important aspects of a business plan are Team, Business Description, Competitive Landscape and Financial Projections.

1. Team: In team section, it is mandatory to provide profiles of all the key team members. The profile should cover their previous experience, their educational qualifications, their role in the company and any significant achievement they have made in the past. This all is mandatory stuff. However, to make this section great, this section should also cover the following:

a. How long team members have been working together?
b. What reputation do they enjoy among their competitors, partners and vendors?
c. What are the gaps in the team? Or who should be added to the team to make it complete?
d. What is motivating them to do this project and how committed are they going to be if things start turning out adversely?

2. Business Description: In this section, the business plan should definitely cover the opportunity the business is chasing, the problem it is going to solve and why customers will buy their business’ offering. To make this section more appealing to the investors, it should also talk about the following:

a. The achievements/accomplishments that the business has made till date?
b. What has been the feedback of its earlier customers and how the business has modified its offering based on that?
c. What all has gone wrong till date and how the business has tackled that?

3. Competitive Landscape: In this section, the business plan should ideally provide a comparative study of all competitors in the market. The comparative study should compare business offering vis-à-vis competitors offering on various relevant factors like pricing, reach and other relevant attributes. To add zing to this section, the business plan should also throw some light on the following:

a. What have been the competitors’ latest improvements in their offerings?
b. How easy or difficult it would be for the competition to replicate business offerings?
c. What is competition doing better than the company and how do the company plan to bridge this gap?

4. Financial Projections: This is one the trickiest section of the business plan. While the business plan projects the company’s revenues, costs and profitability for next 5-7 years but in reality, hardly any investor believes in those numbers. The only thing, that can be projected with some accuracy, is the cost for next 6-12 months. It is definitely not possible to project revenues unless the company has signed contracts to deliver some services or products. Still, most business plans make this unavoidable mistake. To make this section any useful, the emphasis should be put on the following:

a. Identify all the cost drivers for the business in as many details as possible including all the fixed costs, variable costs, taxation and other regulatory related costs and an attempt should be made to predict how these cost drivers are likely to move in future. The investors will also appreciate a brief explanation of each cost driver.
b. Identify all the revenue drivers and provide a one-line explanation of each of those.

Term Sheet Series – Drag Along and Tag Along Rights

While Price, Investment Structure are the most important points mentioned in the Term Sheet and their effect on the investment is visible from the day of investment, Drag Along and Tag along fall into the category of rights which come into effect only in special circumstances like forced exit or dispute resolution etc.

Drag Along Right, as the name implies, gives the majority shareholders of the company the right to drag the minority shareholders (generally the promoters) with them in case the majority shareholders (generally the investor) have decided to sell their stake to a third-party. In other words, if the investor has the Drag Along Right and he wants to sell his stake to a third-party then he can drag the promoters of the company with him to sell their stakes on the same terms and conditions that he is getting from the buyer. Generally, this clause gets triggered when investor has found a buyer who is interested in buying 100% stake in the company and is not interested in buying the investor’s stake alone. In such case, Drag Along right becomes important for the investor as they can force the promoters and other investors to sell their stakes as well. Drag Along Right generally lies with the majority stakeholders so that the minority shareholders are not able to create issues in the selling process.

Tag Along Right gives minority shareholders of the company the right to be tagged on the same terms and conditions with the majority shareholders in case majority shareholders are selling their stake to a third party. In other words, if the majority shareholders of the company have decided to sell their stake then the minority shareholders can use this right to get tagged with the majority shareholders and sell their stake on the same terms and conditions as well. Tag Along right becomes important for minority shareholders so that they can sell their stake along with the majority shareholders and they will not have to be forced to work with the new partner without their willingness.

To read about other term sheet related terms, please click on the links below-

1. Liquidation Preference
2. Right of First Refusal
3. Valuation or Price
4. Investment Structure
5. Anti-Dilution
6. Board of Directors

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Venture Capital Fund Raising Process in India

Once your company has decided to explore the venture capital funding route, it is very important for your company to follow the appropriate process to raise funds. In India, the typical venture capital fund raising process involves the following steps –

1. Identifying the right investment banker – The company should decide to work with an Investment Banking firm (IB) who offers the following skill set-

       a. Very good understanding of venture capital business
       b. Good understanding of Company’s industry and business
       c. Ability to tell a good and true story about the company
       d. Experience of dealing with the VCs
       e. Good network in the VC community

2. Preparation of Investment Memorandum and Financial Model – Once the company has finalized the investment banking firm, then the company and the investment bank work together to prepare the Investment Memorandum (IM) and a Financial Model (FM). A good IM captures the company’s business in such a manner that it addresses most of the investor’s key questions and helps the investor make his mind about the company. A Financial Model captures various business variables like revenue drivers, cost drivers, capital expenditure etc. in a Microsoft Excel file and projects the company revenues, profitability, cash flows and fund requirements for next 5 to 7 years.

3. Short listing and approaching the venture capital funds – The next step is to short list the investors whom the investment banker will approach on company’s behalf. While short-listing the investors, it should be kept in mind that the short listed investors should be comfortable with the company’s industry, stage of business (seed stage, early stage, growth stage, pre-IPO etc.) and the company’s fund requirements.

4. Meeting the Venture Capital Funds – The investment banker approaches the venture capital funds and starts making presentation to them. The purpose of these presentations to get the first meeting between the promoters of the company and the investors. In the follow-up meetings, the company tries to convince the investors about the investment. Once the investors are convinced then they issue a Term Sheet.

5. Signing the Term Sheet – A Term Sheet (TS), as the name implies, covers the key terms of the investment. Two of the most important terms in the TS are the valuation of the company (price) and the transaction structure. There are a number of other important terms related to investor’s exit, board memberships etc, which are also covered in the Term Sheet. Once there is an agreement on all the terms, a non-binding Term Sheet is signed between the company and the investors.

6. Due Diligence by the Investors – After the Term Sheet, Investors conduct a due diligence process on the company. Generally investor’s due diligence process focuses on the following aspects of the company and its expansion plans-

       a. Financial
       b. Business
       c. Technological

7. Signing the shareholder’s agreements and Funds Transfer – Once the investors are satisfied with the outcome of the due diligence process, they issue a Shareholder’s Agreement (SHA). SHA covers all the terms of the Term Sheet and, in addition, it has a number of other important terms and conditions regarding dispute resolution, non-compete, lock-in, share transfer process etc. Generally lawyers from the company’s side and the investor’s side also get involved in this process. Once there is an agreement, all the shareholders of the company and the investors sign the SHA and investor transfers funds to the company.