Most entrepreneurs and investors in India will agree that certain technology sectors are getting into a 'frothy' zone. Stated valuations are beginning to border on the ridiculous and there is a herd-like mentality in both entrepreneur and investor communities. We are seeing incessant media coverage of these deals and signs of overheating in technology segments, such as e-commerce, social media, digital media and other Internet services.
Should entrepreneurs worry about frothy environments? In theory, they should be celebrating the situation, for how can any entrepreneur argue against high valuations and multiple term sheets? In reality, it is not that simple. Frothy environments often induce unnatural behaviour from investors. Following are some examples of investor behaviour that entrepreneurs should watch out for when raising money.
1) Beware of the overnight term sheet: Typically, there is heavy competition among investors to get into 'hot' deals or deals in 'hot' sectors. While brand, valuation, terms, etc., are the obvious competitive differentiators that each firm touts, there is another sneaky way that some investors try to win the deal "the overnight term sheet. I have seen recent examples in India where an investor issues a term sheet, at a high valuation and with vanilla terms, within a day of the first meeting with an entrepreneur. Of course, the term sheet has an expiration date (usually 24 hours) and has a 30-60 day no-shop clause which prohibits the entrepreneur from engaging with other investors. As a result, the entrepreneur gets pressured into signing the term sheet and the investor gets the exclusivity period to drive down the valuation and add terms to the deal. At this time, the entrepreneur is pretty much at the mercy of the investor because walking away requires starting the investment process again.
2) Holistically evaluate any investment offer: A high valuation does not necessarily imply a good deal for entrepreneurs. Most institutional investors purchase preferred shares rather than equity shares in an investee company. Preferred shares typically carry certain rights with them such as anti-dilution, liquidation preferences, put options, etc. Investors often trade valuation for such rights. These rights, if triggered, can actually lower the effective valuation of the company post-investment. I have seen many examples of entrepreneurs realising this after it happened. Of course, if everything goes well and the company gets an exit at a very high valuation, everyone is happy and there are no issues. But more often than not, something goes wrong, leaving the entrepreneur frustrated with his/her choice of investment.
3) Do extreme due diligence on the investor(s): Is it a stable fund? Has any of the General Partners left recently? Does the fund have enough money to close the current transaction? Do they have enough money for follow-on rounds? Can the General Partners really add value as promised? These are some of the basic questions entrepreneurs need to ask of the funds that offer them term sheets. In overheated markets, entrepreneurs are often eager to close the deals as soon as possible and overlook important due diligence, which can often be a source of regret later.
4) Raise as much as you can: If you are getting good valuation and interest from multiple venture funds, it is in your best interest to raise more capital than you think you need. There is almost always a delay in achieving projected revenues and profitability. So the extra cash can provide a much-needed cushion, should the company and/or the market go through a downturn. Most entrepreneurs worry about dilution but in general, trading dilution for that extra cushion is not a bad idea.
5) Think long term: It is easy to get seduced by larger-than-life valuations, top global investment brands chasing your deal, rapid month-on-month growth and the media adulation. But it is difficult to keep the perspective that venture investments are long-term investments and things can and will change over a period of time. You want to be sure that the firm and people you are dealing with will support you for the long term. If you hit a downturn, the last thing you want to do is worry about your investors instead of taking care of running your business. Celebrate, but never bank on an early exit, especially in India, where M&A in these sectors is virtually non-existent today.
This is an opportune time to be a technology entrepreneur in India. Many technology sectors are likely to move through a hype curve over the coming years, leading to frothy periods. Hopefully, entrepreneurs will use the right approach to ride the investment waves safely.
(Pradeep Tagare is the investment director at Intel Capital India. Views, observations and comments expressed by the author in this article are completely his own personal views and do not represent the views of the company. The author can be reached at email@example.com.)