Curious Case of Venture Funding:  Silicon Valley at Its Best

Originally published under research section in Thequintessentialdude.com. Refer to the published paper for full details.

Executive Summary

This report’s idea came when I read the report Start Up India long time back.  Although I wrote this report a few months back, a more detailed version with lot of cultural history is what I had originally planned to write but will be released at a later date. I deliberately postponed the release of this report for personal reasons but plan to write an iterative report on the same topic.

This report is a primer in terms of giving an overview of Silicon Valley, venture funding and answers a few questions on types of funding when you set up a enterprise. This is more of a light read with a focus on large audience across demographics, age and nationalities. The report is dedicated to my mother and family, to spirit of entrepreneurship and innovation, to Silicon Valley, America.

To invigorate latent Entrepreneurship Talent In India, Mr. Modi unveiled the flagship Startup India Venture on 16 January in New Delhi. The venture has started with a corpus of INR 10,000 crore with initial corpus of INR 2500 to be invested over a period of four years. The plan has many innovative reforms which we look briefly later on in the article.

Let’s begin our journey by taking a look at Start up landscape in 2015. According to NASSCOM’s “Startup-India: Momentous Rise of Indian Startup Ecosystem” report, India ranks third globally with over 4200 startups (Source: Hindu). The growth in the Startups has been stellar with a growth of 40% in 2015 alone. According to an article by Hindu publication, the funding in 2015 alone accounted for USD 9bn which is a 125% jump over 2014. The funding in 2015 alone accounted for more funding for Startups for the period 2010-2014. The NASSCOM estimates that these ventures have grown to 110 a 40% jump over 2014 with almost half of them outside the dominant metros Delhi, Bangalore and Mumbai. India serves as the fastest growing startup-base worldwide and stands third in technology driven product startups just after US and UK respectively. The startups contributed employment of 80000 to 85000 people in India

The best part of investing is that the investment in late stage as well as Series A increased drastically. A venture starts from funding from incubators. Incubators help in providing mentorship, basic infrastructure and capital to start the venture. They are different from Angel Investors who come after incubators to fund business ideas. Usually the investment amount is lower than Venture Capital funding which comes out post angel investing. The difference between Angel Investors and VCs is that typically Angel Investors are High Net Worth Individuals with net surplus more than USD 1mn and earning USD 200000 for individuals or earning USD 30000 for couples as per definition in US while Venture Capital has limited partners who contribute capital in the Venture Capital. The VC has a mandate and they invest according to the given mandate through a General Partner. VC come after Angel Investors and brings in a higher level of professional guidance for Entrepreneurs. VC usually exits either through IPOs or selling their stake to other Private Equity players as a strategic sale at a later stage of the companies. Sequoia Capital and Klenier Perkins had invested in Google when Larry Page and Sergey Brein were struggling to raise funding for their search engine while still at Stanford University. (Larry Page is an undergraduate degree is in engineering from the prestigious University of Michigan, Ann Arbor which is rated one of the best research universities in America with an annual budget of USD 1.3 bn). The rest is history as Google became the Quintessential Technology Company of our era and in my mind the most innovative company in the world. Read book Google Way to know more about it. (If I remember correctly Sequoia Capital and Klenier Perkins had invested USD 5mn in Google and rest is history). Source: IAMWIRE.COM

Series A is part of Venture Capital funding when the company starts earning revenues but still is not making a profit and wants funds to expand its business. VCs or Angel Investors invest during Series A. According to an article by gadgets.ndtv  “ 2015 has been a landmark year for India’s tech startup landscape, with a total of 114 startups that filed series A rounds by December in the calendar year, with total funding amounting to $542 million (roughly Rs. 3,595 crores). If you do the math, the average funding round in a Series A comes to $4.75 million (roughly Rs. 31.5 crores).” Source: gadgets.ndtv.com

 Hey Dude what’s the difference between Private Equity (PE) and VC 

Investing in Series A is not easy since the venture is not making money and the future cash flows are not easy to predict. During this time it is not easy to compute the valuation of a company while Private Equity usually employs Free Cash Flow (FCF) models to value the company. (FCF models are made from the income statement of a venture/business). Private Equity come at a later stage of the venture when the venture has up scaled their business model and are usually profitable with constant stream of cash flow. This is called the mature stage and the company might not be making a profit due to management or other inefficiencies. VC invests usually in technology startups with funding size less than 50% while PE INVEST ACROSS diversified sector.

Depending on the type of PE Growth and Buyout, a PE could even invest up to 100% to take management control and streamline the business or in many cases divide the venture/ business into different strategic units and sell it off individually. Remember Barbarians at The Gate. In case of Buyout PE employ lot of leverage which is very rare in VCs. PE usually target companies which might be undervalued to some financial or operation inefficiency and would like to restructure the company to make it more profitable. PE also invest in companies which are listed on stock exchange while VCs only invest at very early stage and therefore in unlisted companies.

Hey Dude why sell of individuals companies

Dude: Smiles. Fantastic Question. It’s a concept in Corporate Finance

Hey Dude then VC funding is more risky as compared to PE funding.

Yes absolutely correct. Let’s look at in a different perspective. It’s like a Call Option

We look at an example. ABC stock is trading on a stock exchange at price of 50.

50 is also known as strike price in parlance of options. You are bullish on the stock but do not want to buy the stock. The other way would be to buy a call option. Just for the sake of example you pay 3 to buy the option to buy ABC at 50. This right is not an obligation.

 

Usually options are sold in contracts of 50, 100 so on and have different tenure which range from 1 month, 2 months or even longer. The other option you have is to square off the option before the expiry which is to sell it on exchange to someone else. Think VC funding is like a Call Option, the initial investment is like the premium and the downside is only limited to the investment while the upside is unlimited. Depending on post IPO price, the value of the venture/ company could be immense.

Growth PE 

This type of funding is between VC and PE Buyout ESPECIALLY when Ventures/ Companies need capital to expand their operations, enter new markets or but strategic units in their domain also known in Parlance of Marketing...Concentric Diversification. Ventures/ Companies go for this kind of funding since they have very limited free cash flows making them unattractive with a fall in their credit rating. They have limited debt funding options or the rate for the loan could be much higher than the market rates. They opt for Growth funding from PE companies in lieu of equity stake given to PE. The venture never gives management control to PE but PE takes some measures to protect the downside in terms of covenants which are deal specific.  One of the ways in which PEs fund the ventures/companies is through a type of Hybrid Funding known as Mezzanine Funding and Convertible Bonds.

Convertible Bonds are bonds which are issued as debt securities ( i.e. in parlance of fixed income or bonds with a face value, coupon ( interest rate) and a redemption value which is usually converted into equity depending on some preset conditions which could include the price value of stock or some debt ratios. They have embedded call option on the underlying security price of the company which is looking for funding. The stock price is the traded price of the company on any exchange. The company issues these bonds to PE which has an equity kicker.

Conversion Value = market price of share * conversion ratio 

Mezzanine like the name suggests is a type of funding which is in between Debt and Equity. 

To be continued…