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Men and money

Mahesh Murthy

Who you take your money from is as important to you, an entrepreneur, as how he evaluates your business and revenue models. With money abounding now in the Internet economy, it is now important for entrepreneurs to understand the different kinds of peopl e - with the money - that they bump into, and the role of due diligence in the evaluation process.

Now, let us attempt to differentiate among incubators, angels and venture capitalists.

Incubators

An incubated company is, classically, one that physically resides, along with other startups at the incubator's location. Typically, incubators provide real estate, bandwidth, often even computers, and sometimes common back-office functionality: HR, MIS, administration, finance and such. Many incubators also provide access to experienced heads in the network or in the business community. Some provide cashflow financing too.

An incubated company `hatches' when it grows bigger than 8 to 15 people and moves to its own location. Typically, incubators take upto 50% or more in stock for their services. This can be a good move for people who have no assets or 'rich uncles' but an idea and the willingness to own what will eventually turn out to be a minority stake in (hopefully) a large company. Some of the world's better known incubators are Idealab, Divine Interventures. Advantages are: fast time to market, no hassles with organ isation and day-to-day stuff. The disadvantages are: You usually end up owning less of the business.

Angels

An angel, typically, is a high-net-worth individual who works directly with entrepreneurs and funds them for a stake in the business. Real estate and other support services are usually not part of the deal. Angels usually provide start-up level funding t o allow a company to come to a point where VC or other funding can be obtained. (Very few VCs will invest less than $1 million in a business - so if your idea needs to be built up to a stage where you want to get $1 million but want to give away less of the company to the VC, you might look at going to an angel, building up your valuation, and then going for additional funding at a higher valuation.) Hundreds of Silicon Valley millionaires, Michael Dell, Bill Gates, Jim Barksdale et al are among the 'an gels' startups have 'touched'. This is usually a good move for people who can get an idea off the ground themselves, but need a jolt of adrenalin to take it to the next stage. Advantages: Money without the hassles, no management interference, sometimes y ou get from-the-frontline advice and contacts. Disadvantages: Usually not enough money to take you to IPO.

VCs

A money manager who typically invests funds they've raised from banks, corporates, FIs etc in high-risk ventures where there's little or no collateral. VCs nowadays have huge warchests ($1 billion and upwards in some cases) and tend to work on the princi ple that some of their investments will fail, some others will get phenomenal returns - and on an average, they'll do much better off than being in any post-IPO stock market. Many VCs today bring contacts and relationships that are immensely beneficial t o entrepreneurs - the now-legendary Kleiner Perkins Caulfield Byers (http://www.kpcb.com) is a case in point. This is usually a good idea (actually not too many other alternatives) for anybody who needs significant funding in the $1-2 million plus range. Advantages: Lots of money, in some cases, good contacts and relationships. Disadvantages: VCs need to show a return on investment and may push you to a liquidity event (merger, IPO, buyout etc) sooner than you might think. They're also usually more acti ve on your board (this could be a plus or a minus).

Also, these are just three ways to go - there are others. And, there are also firms who fall into the cracks somewhere between these three.

With the differentiation clear , let us step the realm of evaluation.

Due diligence

The process of due diligence is looked upon with jaundiced eyes sometimes. For instance, the typical due diligence is often ascribed to ``institutionalised VCs and knowledgeable angels.'' Alternatively, it is looked upon as a gut-feel and averaging-drive n process that is ascribed to ``opportunistic moneybags.''

The due diligence process is, usually in reality, anything but. How do you do due diligence on a new idea that can change the world? Imagine the church calling a Big 5 firm in the middle ages and asking for due diligence on a strange idea somebody called Galileo had - or the Government of Spain asking for an analysis and recommendations on what this fellow Columbus wanted to do. Due diligence efforts are undertaken by VC firms and institutional investors (i.e. where it's not their own money) - but it's a process perhaps more designed to offer a justification and defence should an investment not pan out.

One is not detracting from the basic checks that need to be done to verify claims made by promoters - but one believes that any promoter who seriously wishes to hoodwink a due diligencer will do so virtually every time. (This may well explain some of the wondrous sums of money being thrown around on average ideas in India today.) Aspiring entrepreneurs, one might add, shouldn't worry all that much about due diligence - it may more often be a security blanket for the investor than a judgement on your bus iness idea. Keep your papers and back-ups ready - and go on with your work.

Which actually leads to another contention: One believes that nothing matches gut-feel as an indicator of comfort in a promoter or a plan. Yes, the gut feel may come as a side result of months or years of familiarity with the business - or with people on e believes will be successful at what they do. In the final analysis, this gut feel will probably be far more accurate than any given shelf of well-bound Forrester reports. Gut feel also works both ways. One believes entrepreneurs should also choose to w ork with funders who drink the same kool-aid, and truly believe in their dream, as opposed to those who merely rationally approve it.

Which brings one to averaging. Money managers do averaging. The true investor wants a ten-bagger - or a hundred-bagger - on every single investment he/she makes. Many - if not most - VCs are money managers who need to show year-on-year and quarter-on-qua rter returns for their investors. Many are happy giving their investors a ROI of 50% per annum. Which sounds quite all right.

But if you are an entrepreneur, do think about this a while. Do you want to be with somebody where it's okay if you're the laggard in the group that averaged 50% and where you are NOT spanked if your share price has gone up only 25% in the year? Is it im portant for you to be led, cajoled or pushed to perform better? Or would you rather be commisserated with and left alone? One believes wise investment counsel does not solely reside in either VCs or angels of predefined IQ levels. People, firms and attit udes differ.

The author is an invester.

His Web site: www.passionfund.com.

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