Quarterly Journal on Management
From the publishers of THE HINDU BUSINESS LINE

Vol. 2 :: No. 2 :: August 1998

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Nothing Ventured, Nothing Done

C. Venkat Subramanyam

Every successful small business reaches a critical stage where it finds itself on the threshold of entering a growth phase which would catapult it into the bigger league. Typically, this is the stage where the business has managed to survive the initial hiccups and stabilised its operations. Everything appears optimistic for the business-Its products have found an acceptance, the market is growing, new technologies are available and above all the entrepreneur himself is being driven by a strong desire of not remaining small anymore. All that the business requires is adequate finance-with the ideal mix and at the right time to translate the entrepreneur's vision into a reality.

It sounds so simple. Raising Rs. 50 lakhs or even a crore of rupees for a small but successful business should normally not pose a problem in a country which boasts of a Development Financial Institution exclusively dedicated to small businesses and where most Commercial Banks have to statutorily earmark a portion of their funds to the small sector. However, the harsh reality is that raising finance for small business has never been as difficult as it is today. No wonder that savvy investment bankers who often take pride in having syndicated millions of dollars for their corporate clients have consciously shunned the small business segment.

Theoretically, Venture Capital is recommended as the ideal source of financing for a successful small business. In the Indian context, though venture capital has been a relatively late entrant(it is only a decade old),it has already made a reasonable impact.Several companies, including start ups have been funded by dedicated Venture Funds during this decade. Despite this, an average Indian entrepreneur's understanding and appreciation of the Venture Capital concept has been woefully inadequate. Very often, X is these misconceptions and prejudices which have stood in the way of entrepreneurs fully exploiting the potential of venture capital.

It is important that entrepreneurs understand the concept of venture capital, appreciate its merits and are aware of the attendant obligations. As a Consultant, I frequently find myself spending as much time and effort in educating the entrepreneurs on venture capital as I do in convincing the Venture Funds on the viability of their investment proposals.

The need for Venture capital arises out of the need for equity. Till a stage, small business can grow through a combination of equity(seed capital brought in by the entrepreneur and his friends and relatives) internal accruals and debt. For fuelling further growth, infusion of additional equity becomes imperative because internal accruals may not be adequate enough and further borrowing, not feasible thanks to an adverse debt equity ratio. Since the entrepreneur himself is invariably a first generation promoter with limited means, it is almost impossible for him to pump in additional equity. That leaves him with only two options: raising equity-public issue or venture capital.

The complexion of the Indian stock markets has changed dramatically over the last two years. Unfortunately, the exit of the small investor has also signaled the exit of small companies from the bourses. The failure of the OTCEI to emerge as an alternative outlet for listing has compounded the misery of the small companies. Thus in a scenario where the public issue route for small companies seems shut ,the role of Venture Capital assumes added significance.

It is imperative that entrepreneurs who intend to explore the option of raising venture capital make an effort to understand the investment philosophy of Venture Capitalists, which is based on the maxim of high risk and high return. Thus it is potential capital appreciation which excites and induces them to invest and not an assured return through dividend or interest income.

It is pertinent to note that Venture Capitalists are extremely selective about the businesses that they invest in. Typically, a business with substantial growth prospects, significant entry barriers, high margins, export potential and high technology is the ideal candidate for Venture Capital. They are long term investors and the average holding period for their investment is between 3 to 5 years. Investment is normally either in equity or equity linked instruments.

Very often entrepreneurs tend to perceive Venture Capitalists as corporate raiders whose ultimate objective is to take over their business. I have come across several instances where entrepreneurs have been very adamant when it comes to the issue of diluting their stake in the business. Some of them even consider borrowing from private lenders at exorbitant rates as a safer option than Venture Capital simply because of the fear of losing control. This is a terrible misconception. Entrepreneurs should understand that Venture Capitalists are only financial investors-they neither have the intention nor expertise to manage companies. That is why most of them prefer to limit their stake in the investee companies to 40%.The obssession with control is so deeply ingrained in the average Indian entrepreneurs mind that even a 60% stake makes him feel highly insecure.

Another thorny issue that crops up in Venture Capital investment is nominee directors. It is common for Venture Capital Funds to insist on having at least one nominee of theirs on the board of the investee companies. Often, the entrepreneurs don't take kindly to such a clause. They conclude that the nominee director will interfere in the day to day management of the business and make decision making a cumbersome process. Typically, for most small businesses, the Board of Directors is nothing else but a conglomeration of family members and that's the reason for resisting a nominee director.

It is worth recalling an interesting experience I had with a promoter who had once approached me for raising venture capital. It took me a great deal of time and effort to convince him on this issue of nominee directors. However, when the deal was at an advanced stage ,he suddenly threw a spanner by telling me that though he personally was convinced on this issue, his aged father(who incidentally was the Chairman of the Board) was against any outsider joining the Board. When he realised that the Venture Capitalist would not relax its stand, he even offered to give an undertaking that the nominee would be appointed after the inevitable happens to his aged father! Obviously ,the Venture Capitalist did not buy his offer, the deal was shelved, the project got stalled and today the once profitable company is on the verge of being wound up. A costly price paid for obedience!

At times, some structural changes may be necessary to make a small businesses suitable for venture capital investment. My experience shows that quite a few of the successful small businesses are actually one man entities. It is the entrepreneur who controls all aspects of business from production to finance to sales-very rarely does one find a second tier of management. Even when there is a need to delegate and where the business can also afford it, the entrepreneur still prefers to handle all by himself. Venture Capitalists are never comfortable with one man entities and avoid investment in such proposals.

Another peculiar desi phenomenon is the strategy of floating several entities for carrying on the same business, presumably for small scale benefits. What entrepreneurs must realise is that such a strategy is misplaced in the present context where consolidation is the order of the day. A cluster of entities with the same ownership pattern and in the same line of business is anathema for a Venture Capital Investor. Another mistake which many small entrepreneurs commit is to get into unrelated diversifications. To cite an example, an entrepreneur running a successful auto ancillary unit may also make a casual foray into areas such as Finance, Real Estate, Resorts etc. Venture Capitalists are extremely uncomfortable with such entrepreneurs as it could result in diversion of funds as well as dilution of focus.

So far I have dwelt on how entrepreneurs should change their attitude on Venture Capital and also the structural changes they need to make in their business to make it an attractive investment proposal. This does not imply that a change in the attitude and approach of Venture Capitalists is not called for. The major criticism against Indian Venture Capitalists is that they expect a high rate of return and are not willing to assume the commensurate risk. This anomaly can be attributed to the fact that most of the Venture Capital Funds in our country have either been promoted by Financial Institutions or Banks and their conservatism is more genetic in nature. Another point is that of late, they have been reluctant to make smaller investments(between 50 lacs to 200 lacs) citing exit problems thus making it difficult for small businesses to approach them.

Despite the low strike rate with Venture Capital (one out of twenty goes through) and the fact that the process of raising Venture Capital is by itself a very painstaking one, it still remains as a viable fund raising alternative for small entrepreneurs and one hopes that with dedicated small industry Venture Funds likely to be set up shortly, the true potential of Venture Capital will be fully exploited by the entrepreneurs.

Being small is nothing to be ashamed of but to remain small is dangerous. The winds of change are blowing too hard and too fast and it is high time entrepreneurs realise that for a small business to survive today, it has to necessarily grow and in the process equity dilution is inevitable.