Investing in Garage Firms

24 September, 2009

The Venture Capital decision-making process is often perceived as enigmatic and complicated because less than 1-2% of the plans received get funded.

A Venture Capitalist, a subset of the investor group, is equally driven to earn a proportionate return on the risk taken. To that extent, this investor class is no different.

In early-stage investing, VCs look at two things: The team and the forces that affect the growth of the business.

For almost all investors, the team’s abilities are of more consequence than the business itself. Every business, no matter what industry, will face tough times and it is the difference in response to such situations that separates success from failure. This is all the more true for early stage investments because the company is in a fledgling state and requires appropriate leadership to help it mature.

Therefore, an investor, through his interaction with the promoters tries to identify whether the person has a ‘can-do’ attitude to meet the rigors of entrepreneurship. In the first meeting itself, the investor tries to ascertain whether the entrepreneur can execute the business plan effectively and be a motivated and inspiring leader.

An investor also looks for someone who is likeable and easy to work with – after all, for the duration of the investment the investor is ‘married’ to the entrepreneur.

I recently met two companies vying for the same market. They were both founded couple of years ago, and were generating approximately similar revenues. While one promoter’s vision was to achieve $20 million in revenues in 5 years, the other targeted to achieve $100 million in the same time frame. The difference in approach and motivation was very clear from the actions each had taken to lay the foundation of their businesses, and the way each of them described his plan.

The more aggressive promoter surrounded himself with experienced and knowledgeable people, approached the business from the point of view of creating a world class enterprise and paid attention to processes that would help make the business scalable in the long term – and all this was evident in the first meeting itself. 

Moving on to the next piece – the business itself – the first thought in an Investor’s mind is ‘How big can this become?’

A typical early stage Investor will take a positive call if the business holds a potential of ten-fold growth over 5-6 years. While this may seem excessive to an onlooker, factoring in contingencies and risks, this return expectation is par for the course.

Investors will typically study the following primary factors before making their decision:

     Proof of concept: Validation from current customers and sales pipeline

     Scalability: The size of the market that is targeted by the company should justify that there is enough demand for its products and services.

     ‘Defensibility’: The Investor keenly assesses the impact of current and future competition on the company’s growth.

     Exit: The end goal of all investors. Ideally, they would prefer taking the company public for the most independent exit.

We have come across several prospects where promoters believe they are showing scalability by forecasting growth from $1-2 million in revenue to about $30 million over 5 years. While this is rapid growth, such growth is realised only if everything falls as per business plan. Unfortunately, the course of an entrepreneurial journey is very uncertain and execution can falter. So, if after about five years of staying invested, the company reaches only $14-15 million in size, not only does it unfavorably skew the risk-reward ratio, but also, closes the IPO route for an exit.

For a company that has achieved about $14-15 million in revenues in 6-7 years of operation, it is difficult, although not impossible, to find a business that would acquire it at a good price, and even more unrealistic that the promoters would buy-back the Investor’s shares. For this reason, it is very important for entrepreneurs to think early on about how their business can achieve a significant enough size in 5-6 years that it can either go public or find several suitors. 

So, all these factors have to align favourably for an investor to give a go-ahead. Given the grey areas in the investment decision, very often the investor’s instinct or gut feeling comes into play.


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Investing in Garage Firms

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