Jagannathan: Is the venture capital (VC) climate in this country now right to really fund these kind of start-ups ?

Sudhir Sethi: What has been thrown up by our researchers are very interesting facts. First and foremost, lets categorise companies that are in the market space which are looking for funding under three broad categories viz., seed stage, early stage and expansion stage.

Almost 31 per cent of the companies that had come for VC funding were helped by faith funding. This is a unique things happening in India. That is parents, friends and relatives had the given money to fund these young entrepreneurs and from which they have no expectations of getting any returns.

For a VC this is a very good thing because a VC sees a prototype, especially in India, where angel investors are absent. You are de-risking your model and are seeing somebody who has done the work, maybe with lesser intellectual guidance. I consider that to be positive. I see this trend to continue in India at least for the next two years for the simple reason that it’s a cultural issue. I don’t see angels replacing faith money in a big way.

Moreover, there aren’t many angels in the country today, purely from a cash or high net worth individual perspective; however, they are sort of coming up.

The VC industry is also maturing. And I am talking about information technology (IT) and the Internet. There are venture capitalists, both multinationals as well as Indian in the market space. I think that in the last few years, the Indian VCs have played a strong role in bringing up the Indian IT companies.

They have been categorised as using the debt instruments instead of investing in equity many a time. It frankly doesn’t matter. Because, getting the right cash at the right time is very important for an entrepreneur.

But today, the game is different. The VCs are ready to invest in equity as well as in the debt instruments.

In India today, I think there are about 40-45 VCs and private equity funds in the market. Few, of course, are focused on IT. That number will increase.

Moreover, the market will benefit from the quality of companies visiting it which will only improve over the years. Why, because the VCs build up good management teams apart from providing capital.

Pankaj Vaish: They are also encouraging the spirit of entrepreneurship in the country. Because, if the entrepreneur couldn’t get the money the entire idea will certainly explode or die.

Rajiv Gupta: What at times, concerns me from this side of the table is that when a VC funds a start-up venture or in the early stages, it expects a 25 per cent dollar/rupee appreciation. It is commensurate with the risk.

But, there are so many VCs wanting to do mezzanine funding for well-established companies and they also expect a more than 25 per cent return. But, why do we see that kind of expectations from venture capitalists? Is it because more companies are approaching the VCs? What is creating this kind of expectations? That also seems to tell us that it is high cost money for the level of risk that the VCs are willing to take in India.

SS:I don’t know about the others. But I can certainly speak about ourselves. There are two-three issues. If you really focus the fund on a particular sector then obviously, you are in a sense de-risking. But, in a sense you are too risking. The reason is because its all high risk -- its within the same space. It is not risky because VCs are specialists in their field. So, it is both sides of a coin.

But the key issue is that if you take, lets say, the US marketspace, specialisation by a VC fund is happening there. Some VC funds fund only at the seed level and nothing else.

In India, currently the market is small. And, for the VCs they have just mobilised funds for the first time from the public. So, for the VCs to raise the second round of funding they need to show returns. And there is a pressure on returns. Hence, most VC funds are multi-staged funds in the country. The moment you are multi-staged you tend to do funding at all levels. It is a financial play in that sense. Because, if I go to set up a new fund I have to show returns. Moreover, India is not a mature market. Hence, returns on the listed company’s side tend to be higher. Factors like expecting huge returns will continue to happen for some more time.

RG: So does that mean the returns venture capitalists are getting in India is constant irrespective of the risk element?

SS: No, it cannot be constant. I would put almost 70-60 per cent of my funds in start-ups and in the early stages.

RG: From which you would expect high returns.

SS: Yes, I expect to get high returns from start-ups and from early stage investments.

RG: And the rest will go into mezzanine kind of funding from which you expect low returns.

SS: Yes, we have a clear focus. In the past, we have invested in listed companies as well. But, we are very clear we will not arbitrage. The reason being there are some listed companies which need a value VC. Its a unique market opportunity and we are fortunate enough to have that background. The entrepreneur is more in need of our expertise than our money.

By the way, lets be clear on one thing, funds have their own rules of the game. Most VC funds may not invest beyond may be 20 per cent of the capital in listed companies.

Private equity players are different type of players. But the private equity players have come into the IT sector mainly due to lack of opportunities on the brick and mortar side and, maybe due to the scarcity of disinvestments. They find a $10 million deal, a deal size they are used to, mainly in mezzanine type of funding.

J: Do you find these aberrations happening because the markets are immature?

SS: Yes to some extent. Let’s just look at two years from today. I think are few things which need to happen very strongly to improve our markets. One, on the regulatory side some tightening of knobs for disclosures needs to take place.

VCs today don’t have any norms in place. In fact, the VCs have many roadblocks to overcome. There are some very fundamental things suggested by the Committee looking into VCs in India to facilitate investments from a fund raising perspective, investing from an investing company’s perspective and, exits. But that again is a different issue altogether.

But fundamentally, two years down the line -- availability and need for larger capital-- more companies, tougher competition and more entrepreneurs will mature and, the markets, as a whole, will also mature.

RG: I think another issue is that the local fund raising effort have somehow not taken off. There are many high net worth individuals who would love to have a VC exposure because they cannot keep investing in companies themselves but would like to go through a good fund manager who knows to invest. But that channelisation is just not happening. And there are some tax-related problems too like say a local venture capital company paying a higher rate of tax than companies from Mauritius.

SS: Some uncertainties are there. Lets hope that in the next few months these issues get sorted out. But you are right, high net worth and knowledgeable individuals have not put their money in venture funds or the angel funds. I think Infinity is the first fund, which has happened, which is very good. I think other people are beginning to come in. I see many things happening.

AP: There is lot of enthusiasm in the market for such funds to come up. It is a good channel for the NRIs with a high net worth. It is also good for people who started this in the US are coming back to India because they understand India better than any other outsider.

J: Probably slow growth of VCs may be there as you said earlier, because most companies use the general public as venture capitalists.

RG: That’s a fact

SS: There is another perspective, a multinational perspective. I was attending a conference about two months back, there were around 200 venture capitalists sitting in one city for five days and I asked some of them whether they had any plans to come to India. The general answer was, "We are so busy doing things in the US, that we don’t have time to come to India." Now, this is an important point. The market frenzy in the US is so high and India is so distant that people don’t want to come here.

PV: Garage.com gets 30,000 business plans a year while they accept only 300. The ratio is 1:100. So, where is the time for them to say, "Well, I will go and spend a couple of million dollars in far off India," even though the market is lucrative.

SS: Most of the VCs that have come are there because there are motivated Indians, wherever in the world. This is the first phase. There’s an internal champion. Now the question is how can we covert this into a wave. That requires a VC reform in the country. From the angles of fund raising efforts, investees, taxation, exits, et al -- the works as such. And a few more big deals.

PV: I think the Indian corporate world will start investing in these kind of opportunities. We have done a few in the past where half a million dollar deals happened. There is lots of money if they can find the right investment avenues.

SS: So part of this, according to me, can be revolutionised. If the right things are done. Number one, a regulatory norm, and two, few more Rajesh Jains and Satyam kind of deals. Forget valuation for a moment, such deals are a huge positive to market space, because you have an Indian role model in India and not in the US.

So these are the things, which I think that could take the VC industry forward in geometric progression rather than in the arithmetic progression.

AP: The popular newspapers today are talking about dot.com success stories and I guess that’s a reflection of future expectations. If you look at the overall level, if the papers keep talking of valuing and things like that, it is getting reflected in the economy. People are now starting to look at this area from the investment and or an employment angle.

SS: VCs are going to be investing in companies to achieve optimum results from the entrepreneur, market, management teams and capital. And they stay with the company and build it. That is, assisting the entrepreneur not in the operating but strategic sense.

J: Sudhir, do you find established business houses coming into venture capital and taking up stakes in start-ups. Would they compete with you?

SS: Yes. But, I have seen very interesting set of things happening. Corporates are asking us, "You guys are doing it, can we come with you." Co-investment, because there is a pool of cash lying with them. So that’s happening. I don’t know whether you see it at all, but I see some steps being taken. We have talked to a few corporates and have actually recommended that they open a venture fund themselves.

Actually it is not competition. With overall good quality people in the market, it is actually going to build the market. In fact, I spoke to one corporate entity and I said look you should be opening a fund and the reasons for that are very simple.

There are two reasons. One, it is good from the corporate side to open venture funds because there is expertise involved in venture funds. One could focus on a certain sector. One may want to focus on pharmaceuticals on account of having a pharmaceutical background. So, I think in the future if funds are not focused, whoever they are, especially corporates, and they do what we call spray and pray, they will die. And if you just have money coming in, its spray and pray. If you have focus, the real difference in venture capital and private equity is made by the fund manager and not by the cash. So, it has to be a focused effort. That means, your possible gains will also be that much higher in the marketspace.

The second reason is that VCs do look for exits.

Now lets look at this from a corporate perspective. If an IT company looks at a VC fund setup, they can buy the exit from people like us. What are they doing? They are actually building their own company, in a sense, in a rapid manner because entrepreneurship in the corporate world tends to be slow. And at the end of the day there are business ideas outside which the VCs and private equity people are incubating, developing and building to a certain level which could add tremendous value to the corporate entity. Which is what Cisco Systems has done. Which is also what Microsoft is doing.

DM: In fact, one Indian software major is doing that. If one of its employees has a good idea they actually say: okay, sure you can leave, but we will fund you, so that, they benefit from the employee’s idea rather than just lose him.

SS: If corporates, whether the brick and mortar ones, or the information technology corporates the focus is on acquisitions. However, they are structured whereby, they can get tremendous value in the market. And its a win-win situation for everybody -- for the entrepreneur, VC, private equity, intermediaries and the corporate entity. That builds strong markets.

RG: And in many cases, that’s the only way for entering these sectors. So why not?

PV: Many businesses today don’t have long-term futures. So, they need ways to diversify into strong areas. For them, to invest makes great sense because their current businesses may not be there tomorrow.

J: Sudhir, if I were to ask you what would be the three criteria you would use as a fund manager for a VC to evaluate an infotech or an Internet company?

SS: I think the first would be to identify which side of the life cycle it is on. Whether it is at the seed or early stage or, is an unlisted company. Fundamentally, there are some companies which are on the financial stage right now. I would want to be very clear what the revenue model is as it grows in the financial stage. As Pankaj was saying at the seed stage side, non-financial value drivers becomes important. But even in the seed stage, one would be very clear at the pre-investment stage, to get a clear view of what the entrepreneur’s thinking is on the revenue model. I would not invest if there is no vision of the revenue model. In the US, VCs are asking on day one "what’s the revenue model?". Maybe three years ago they did not ask.

The second, I think is the management team. There are the issue of structures, skills, etc. But what I would focus on are softer issues like chemistry between the venture capitalist, the entrepreneur and the management team. Companies with the best management teams decline if the chemistry is not right. So, one would spend a little extra time to either build up the chemistry or test it out. If things go wrong which typically they do, you need all the shoulders you can rely on to build up the company. Chemistry issues are very soft issues. To give you an example, VCs and entrepreneurs should understand how the other person thinks at times when things are not going well. I don’t want to be having reports all the time to find what he is thinking. Those are the things which are difficult to build.

The third thing is what is so unique about the project. Is it a replication model or is there a unique play with an entry barrier. Is it a technology play, is it a market or a consumer play, B2B, B2C. What is so unique? I am sure there is another gentleman who is thinking of the same idea with better funding and a better management team somewhere in the world. If that is the case, then how do we make sure that this investment succeeds.