Evaluation of financing decisions for early stage technology ventures

Abstract

While new idea(s) and a tangible business model inspire the start-up of new ventures, execution along with risk mitigation/management play a very important role in ensuring the success of a new venture. Apart from people and the capabilities, an important part of new venture development process is the financing requirements for a new project. Nine out of every ten new technology ventures fail and some of those failures can be attributed to bad financing decisions (including unavailability!). Within the broad canvass of financing options available with young firms, we have explored the strategy and the financial implications for firms approaching venture capitalists for funding their growth, in the Indian context. We have focused on technology firms. During the past three months, we have focused on understanding:*The various financing options considered before raising venture capital. *Strategic implications of raising venture capital for a technology entrepreneur.*The approach used by venture capitalists in financing such early ventures. Our results have been extremely interesting in so much as they have given us new insights into how entrepreneurs look at financing and venture capital. Entrepreneurs think differently than the rest of us and have very different ways of evaluating market opportunities. We found that some of this behaviour can be best explained by the following principles: Bird-in-hand principle: Most entrepreneurs start small, with what they know and then work on improving and expanding the business. e.g., Phani from red Bus started small with Charan and sudhakar and they started building the project with 4 other roommates. Affordable-loss-principle: This means that the entrepreneur only invests in whathe is prepared to lose. Both Insta Health and redBus financed their ventures throughpersonal savings and refused to take on debt to keep their ventures running. Crazy-Quilt-Principle: Good entrepreneurs try and widen the Quilt by getting people around them interested in the venture and make them a stakeholder in their success. e.g., redBus founders were able to convince their roommates to help build the first version of the website while the founder s at InstaHealth were able to get DrVenkataramana on board which helped make their sales pitch a lot more crediblesince Dr Venkataramana is a known expert in the medical field. Once the venture reaches a stage where additional funding is required, they approach seed funds or venture capitalists (VCs) depending on the extent of funding needed, need for value addition by the funders (VCs or Seed Fund etc.) and need for long-term investment the preferred duration of investment (exit duration the VC and the founders has in mind needs to match the founder s requirement).In addition, we got a glimpse of the Venture Capitalist s (VC s) way of analysing businesses for funding. In our discussions, we came to the conclusion that VCs look at the following main parameters in investing in companies:? Management Team? Market Size/Growth? Defensibility? Scalability? Current Traction? How many rounds of funding the venture would need Once the decision to invest and the valuation of the company is made, the entrepreneur and VC go through an iterative process to finalize the terms of the funding (in a term sheet agreement), all of which essentially try to reduce the information asymmetry and agency costs. Another interesting aspect of VC investment decisions is how their fund is organized and how much and in approximately how many companies they plan to invest during the fund life. It would be very helpful to entrepreneurs to get an approximate idea of how the VC fund operates so that they know which ones to approach and how to present their case.