Insider View: a perspective on returns

Cisco. WhatsApp. Alibaba.

What’s the common underlying thread in their stories? These companies are all icons of the Venture Capital industry.

Let’s take a quick look at the rough estimated returns generated for the industry:

Cisco went public in 1990 with a market cap of $224 million and their estimated market cap as of 2010 was $115 billion.

WhatsApp had a total investment of $58 million– rumored to have returned $3 billion for investors through their $19 billion acquisition by Facebook.

After the recent historic IPO, Alibaba made hundreds of people multi-millionaires. Jack Ma’s net worth is estimated north of $18 billion, while the investors Yahoo and SoftBank made $37 billion and $74 billion respectively.

In this article, I try to explain why it is extremely important to understand the concept of returns if you are an entrepreneur.

Let me begin by saying Venture Capital is not well understood in India

In India, the venture model is not well understood. The investor and entrepreneur relationship is not a lending relationship as most people confuse it to be; it is a shared risk relationship.

If you have a fixed deposit, you will get approximately 9% return, mutual funds will give you 10-20% return, but you have no further upside to these investments. Venture Capital on the other hand is about creating new markets and outsized returns.

Indian entrepreneurs sometimes think that venture returns should be capped. It is important to understand that venture investing is predicated on a few very successful companies and hence the investors take immense risk along with the entrepreneurs at a very early stage. Unless investors are convinced that there is a high probability of attractive returns they are not going to invest in your business.

Another important aspect of creating game-changing businesses in new markets is that, the promoters or entrepreneurs have to raise significant amount of capital to get to scale. Because of this, the entrepreneurs are usually not the majority shareholders, but the investors become significant shareholders – and this is most typical of the venture capital industry.

We are competing for Venture Capital that is truly global

Today, Venture Capitalists are present in India but the source of their capital for venture investing is not yet primarily available in India. Venture Capital managers maybe from India, but the capital itself comes from largely a global pool, regions such as North America and Europe where there is more understanding and experience of investing in venture capital funds. Thus Venture Capital’s attraction to India is dependent on its continued validation from a global perspective of returns.

We compete with China and the US for the same Venture Capital investment dollars. We are not based on a local index. Hence, it is important to understand that competing with companies globally from a returns perspective is extremely important. A sizeable number of companies in the new industries require significant capital to scale. Thus, in order to attract growth investment for these companies, we should be able to generate returns on par with the global markets.

To attract this capital, you as an entrepreneur need to be able to show a large market opportunity, aggressive execution capability, a highly scalable management team, and of course the ability to generate very attractive returns. Thus I urge entrepreneurs from early on to think scale and innovation so that they can compete for capital and commit to generating attractive returns through their ideas and superb execution.

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 Total number of VC-backed deals listed (in the past 5 years) for US = ~250

 Total number of VC-backed deals listed (in the past 5 years) for India = 15

 Total amount of VC-backed IPO proceeds in US = ~$ 45 Billion (excluding Alibaba) 

 Total amount of VC-backed IPO proceeds in India = ~$1B

Credits for data: Mukti Hariharan

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Ask yourself ‘Why am I raising what I am raising?’

When you are asking for capital, think about whether you can generate at least 10X returns for investors. If you are asking VCs for $2 million, and let’s say you get to $100 million in value (dilution 10%) 10 years after that investment and you never raised any further capital. If this were realistic, your investor would have made an annual return of 18%. Now benchmark this with other forms of returns easily available. If you need 10 million over the next 5 years from venture investors, then you need to ask yourself why does the VC investment make sense from a returns perspective?

Often entrepreneurs come to venture investors and say “I want to raise a next round of $20 million”. For investors to make a 5X return they need to get $100 million back, so they should be confident that your company will be worth a billion dollars for that to happen. How many companies have been created in India that are now worth a billion dollars? Entrepreneurs often forget that part of the equation. Venture investors are usually okay to write a $2 million cheque because they only need to make $20 million from this investment and for that to happen you need to be a $100 million company, and there are a lot of companies in India that have done that. Entrepreneurs have often not thought through this part of the equation while going to investors.

Are you going to be a billion dollar company?

Are you going to be one of the billion dollar companies? The bravado is good, but be prepared and be aware of what you need to do to achieve that milestone. If you want $100 million from investors, then you need to sell them the multi-billion dollar story.

However, there is exuberance in the market about India today. The booming middle-class and emerging consumer gives tremendous opportunity for entrepreneurs to out-innovate incumbents and create many new billion dollar opportunities in the next decade. I am very excited about this phase that we are in and look forward to meeting the next generation of entrepreneurs who will create the next Cisco, WhatsApp and Alibaba of India.

Credits for data pointers: Mukti Hariharan