Before we deep dive into strategies of Venture Capital firms, let’s first understand the Investment strategies of Angel Investors
Angel investors are of many types. A Banker working in Singapore or Dubai, an Industrialist from traditional industry, or even a housewife are Angel investors if they invest money in Startups. A successful investment strategy for an Angel investor would call for segregating great potential products and companies from the good ones and spotting the right talented team from amongst the also-rans.
It also helps that the Angel invests in the same sector they are from, allowing a greater appreciation of the investment opportunity and giving the startup much-needed mentorship from his experience.
Suppose the Angel wants to reap the benefits of Angel investing but doesn’t have the time to understand a new sunrise sector. In that case, they can invest indirectly by first putting their money in ours or any other Angel Network platform, which, in turn, will invest in such Startups.
In terms of getting conviction to invest in a particular company, we, as an Angel Network, deploy a confidence-building strategy – we take the lead in investing in a specific Startup after analyzing all the facets – product, team, market size, etc. The Angel can come in at the same valuation the Network is investing in, providing a safety net and building confidence in the valuation.
In terms of checking hygiene factors in any deal, we conduct local due diligence, which checks on-ground situations in terms of product/ service being in place, the team is properly hired, we talk to distributors, call on some select main partners, check addresses and ex-teammates of the Founders, maybe from the city they come from, and so on. All this gives huge confidence to the Angel investor that there are no loose ends in the investment.
Strategies for a VC (Venture Capital) firm to evaluate Startups
To simplify the primary factors on which investment strategy of a venture capital firm relies on–
- First– VCs really like a team that has this capacity to recruit world-class skills and to capture the hearts and the minds of the people that matter in their industry. One can perform diligence even remotely. But you feel it immediately when you sit in a room and talk to someone who knows their stuff.
- Second – the market is big enough to create a massive business over time.
- Third – Venture Capitals would like to see a fundamentally different shaded product, one that can stand out with just a modest amount of marketing.
Those three very simplistic arguments were held many years ago, and they still have for many VCs today.
Strategy Venture Capital firms use for ensuring rights, protecting the downside, securing return/ exit by Deal Structuring and building it in the Term Sheet and Shareholders agreement (SHA)
- Binding/ Non-binding – The investor prefers to sign a binding term sheet, usually in the scenario when there is more than one suitor in a deal. It gives the investor an exclusivity period in which it can thrash out the finer details and consummate the transaction. In most other cases, the Term sheet which gets signed is non-binding.
- Company valuations, Amounts, % stake, Instrument – An investor puts in money and takes equity in regular investment cases. This is when there is an agreement between the two parties. In many cases, there is a mismatch in valuation expectations; in such cases, the investor takes a convertible instrument which gets converted into equity at a future determined valuation basis the company’s future financial performance.
- Anti-dilution – The marquee investors keep this clause in the term sheet, which means that when newer rounds of fundings happen, their percentage stake won’t get diluted, and on each fund infusion by an external investor, they receive additional shares at face value, which keeps their shareholding at the same level.
- ESOPs (Employee Stock Option Plans) – Startups are usually not able to pay market salaries, so one of the options in front of them is to share equity with human resources. If they share equity directly, there is a chance that the person may leave early in the future. Hence, the next best option is to give ESOPs – by their very nature, ESOPs get vested in specific periods, say one year, two years, three years. If the employee doesn’t perform, the company cannot convert those ESOPs into monetary compensation. 15-20% of ESOP pool comes from Founders Equity, and while granting ESOP’s, the reverse pyramid structure is followed, which means senior management gets more ESOP’s
- CP’s (Conditions Precedent)/CS’s (Conditions Subsequent) – CP in a Term sheet implies that all the hygiene factors like information being shared by the founders being correct, company compliance and formation being fit and proper, and all such things are in place. CS would mean that the company will act to fully comply with all laws in seeing that the transaction is consummated post-signing of the SHA properly
- Voting rights, BOD (Board of Directors), Reserved Matters, Info rights – These clauses pertain to control of the investor on the company. This is by taking representation on the Board of Directors, having rights to get information from the company from time to time, and ensuring that there are certain reserved matters on which investors consent is a must before the company can act on them.
–> One-way voting rights are defined in some Shareholders’ agreements is to have clauses defining which way voting should happen in specific scenarios! For example, if more than 1/2 of the shares owned by the Partners are supporting typical voting behavior, then all Partners will vote in agreement with the 1/2 majority of Partners.
–> Secondly, certain decisions will require support by Partners holding at least 50% of all Partner shares; otherwise, all Partners agree to vote against these decisions.
- Founder vesting – If the founder loses interest in the business and either doesn’t pay attention to the business or leaves the business altogether, the Founder vesting clause ensures that the investor has enough control over the company to bring in new management to ensure the proper functioning of the company.
- Liquidation preference – In case of future follow-on rounds of the company, this clause provides that the investor has a right that his shares get sold first, thereby ensuring he gets an exit.
- Exits – This is most challenging for many investors because no company comes with an IPO (Initial Public Offering). Also, the company and the Founders refuse to buy back the shares from the investor by giving him the required IRR (Internal Rate of Return). In many cases, follow-on funding rounds cease to happen for various reasons. It is seen that investors resort to a variety of strategies like having arrangements with other investors where they invest in each other’s investee companies. Or they do M&A (Mergers & Acquisitions).
- Abnormal Exit situations – If the Partner leaves the company as a Bad Leaver, a defined percent of his shares shall be subject to mandatory transfer to the company at their nominal value.
- Drag along, Tag along, ROFR (Right of First Refusal) – These clauses are used when an investor wants to buy a considerable percentage stake in the company. The original investor can drag along the founders’ shares and sell them to the third-party investor. Or, if the founders have a buyer who wants to buy a considerable stake, the original investor can tag along with the founders and ensure their shares are sold to new investors. ROFR – gives the right to investors to have the first right in any follow on fund infusion.
- Competition Restriction Clause – The Partners who have an active role in the company undertake not to compete in any way, directly or indirectly, with the business of The Company.
- Founder Vesting – Investor has right on Founder’s Equity, and it gets vested with Founders every year – So if Founders leave early from the company, they lose all their equity.
Deal Structuring Strategy for a Global Investor wanting to structure their investment in India:
While structuring any investor’s investment in India, typically for a global investor, we would recommend basic factors like tax benefits, ease of business, and other factors like the cost associated with each activity.
If a company is setting up shop in India, the best structure we suggest is – to incorporate a holding company in Singapore. India and Singapore have a Double-Taxation-Avoidance-Agreement (DTAA), and the capital gains tax in Singapore is significantly less!
Singapore has access to colossal liquidity, which means a lot of money is available for investments. So in the future, one can make investments in the holding company in Singapore. Also, there is a lot of ease of business in Singapore in Singapore, so setting up a holding company in Singapore is straightforward.
Walmart bought Flipkart for $21 billion – one big reason was that Flipkart had a holding company in Singapore!
Singapore has a solid intellectual property ecosystem, and money available by collateralizing your intellectual property is effortless in Singapore. Singapore ranks number one globally in the ease of getting funding against intellectual property. The Intellectual property of the company can be filed in Singapore itself.
While India ranked 63rd overall in the World Bank Ease of Doing Business rankings, it ranked a poor 163rd in enforcing contracts. Because the holding company is in Singapore, one can use Singapore-based arbitration clauses and Singapore-based legal agreements to sign contracts.
Secondly, form a subsidiary company in India. Keep human resources from India, as they are cheap, skilled, and talented – hence keep back-office staff in India.
The income tax rate in India is 30%, and for a small income, it is 20%. But the Income-tax in Dubai, UAE is Zero! This means that the top management of this company can be based out of Dubai, so the taxation top management incurs Nil.
The unique strategy of a Venture Capital Firm – A South India-based VC Firm, had a special offering for Startups where it wanted to invest! The VC Firm was offering cash for equity and an assured buyback scheme with promised IRR and hence exits to the investors, plus the assurance of revenue for the revenue companies!
This Venture Capital Fund’s strategy is unique! – It promises a specific Revenue to the investee company in each of future three years. The more the other revenue generated by the investee company (from sources other than the VC Fund), the less the percentage equity the investee company would have to partake in the VC Fund!