Tuesday, May 21, 2013

Access + Ownership = Seed Fund Success

With the slew of small seed funds cropping up in the market in the last two years, I think that the biggest differentiation between these funds is the combination of both access to the best seed deals as well as as owning as much ownership in these companies as possible.  This sounds like an achievable and readily apparent feat, but it is rather difficult given the current investment environment.  The first seed funds to appear in the industry who figured out how to disrupt the seed stage and offer entrepreneurs something the larger life-cycle funds didn't have a recipe for (e.g., First Round, Baseline and Floodgate) had fewer barriers in getting access to the best deals and owning as much as they could in these companies because the small fund wave hadn't appeared on the horizon yet.  Access in any venture capital fund is the greatest differentiator between the haves and have nots.  At face value, anyone can tell if a fund has good access by taking a spin through an early stage VC firm's website.

This is all well and good, but unless you're investing in a very small fund ($10-30M), owning a small piece of a big winner won't return a Facebook-like multiple back to LPs.  The seed funding market continues to exist in a state of "coopetition" where seed investors rarely if ever single-hand a deal and always syndicate initial investment rounds.  This cooperation part of the market either forces seed funds to take smaller allocations in a round or companies are required to raise larger rounds to accommodate the 2-3 hands around the table.  Writing $125-250k checks out of a $40-50M fund size makes it incredibly difficult to finance a fund-returner  (even assuming reserves), unless that company returns a 100x on a $500k investment (assuming a $50M fund size).  Seed funds that move slightly up market in size are going to have to find a way to have sharper elbows at the table without pissing off their co-investor friends and sources of collaborative dealflow, while also finding opportunities to own 7-10% of these companies at inception with an expected 5% terminal ownership at exit.

This sounds easier said than done, but it will be interesting to watch the seed fund space evolve in the next 3-4 years as the top seed managers have scaled up their fund sizes, in part as recognition of this very fact.  I think the seed space is the most honest part of the market today given this "coopetition" environment, but this model largely hasn't been deployed yet as many of these top seed managers have only recently scaled their fund sizes and began to reserve more heavily.  

Wednesday, May 15, 2013

De-Bunking Spray and Pray

I had an always inspiring meeting with Dave McClure today which got me thinking about why does everyone use the phrase "spray and pray" as a bad thing.  I immediately Wiki'd "spray and pray" and got the following definition:

"Spray and pray is a derisive term for firing an automatic firearm towards an enemy in long bursts, without making an effort to line up each shot or burst of shots. This is especially prevalent amongst those without benefit of proper training."

A few observations on this.  First, I think it's important to note that if you're going to invest in any seed-stage VC fund, it's critical to be backing a manager you think is making an effort to line up each portfolio company investment.  Whether a seed fund is investing in 100 portfolio companies or 30, each company should be invested in with the same level of due diligence and passion about building a 100x company that will return the fund several times over.  There should be a distinction when rushing to criticize a seed fund with a larger portfolio because there is a big difference between un-thoughtfully investing in tens or hundreds of companies with little diligence and hoping for the next Facebook, LinkedIn or Google, and taking a rifle shot approach to making an investment in tens or hundreds of companies with that same hope.  

The second part of the definition is key as well.  Investing in a seed fund with the benefit of proper training.  Anyone with enough capital can become an angel, and there is no shortage of cashed-out entrepreneurs seeking to raise a "micro vc" fund (see earlier post on why I loathe the term "Micro VC").  However, there is a huge difference between an angel and a venture capitalist.  That key difference is simply managing other peoples' money (OPM).  

I'm trying not to make this a defense of 500 Startups or Dave, but rather simply want to make the distinction between a VC spending OPM wildly by investing a huge portfolio and hoping that the law of large numbers and the passage of time will shake out a blockbuster over time.  After all, there's a reason why Dave is on everyone's list of references, both on and off record, in the seed space...  With the right team and proper training prior to managing OPM in the seed space, a 200 company portfolio can conceivably return the same and/or better performance as a seed portfolio with 30 companies.  

In fact, I'd love to see a seed manager never follow-on its initial investments and invest in every company that it had conviction can return the fund.  #Conviction.  If you place a $2 bet on every horse on a day's racing form to win, won't you end up making money when the 10:1, 70:1 wins once in a day's racing form?  Pick a good trainer to back and your bound to make money, regardless of the size of the field and the racing form.  

Thursday, May 2, 2013

Is Mauritius the Death Star for Indian Venture Capital?

Ever heard of Mauritius?  Probably not.  It's a tiny island 2,500 miles from India located off the coast of Madagascar in the Indian Ocean, which serves as one of the largest tax havens for Indian-based companies and foreign private equity and venture capital firms investing in India.  

Since 1983 India and Mauritius have had a tax treaty that permits non-residents to forego capital gains taxes on the sale of Mauritius-based companies doing business in India.  In addition, Mauritius levies no local tax on such gains, allowing Mauritius residents to avoid the approximately 10-42% capital gains tax applicable in India on the sale of securities.  Sounds like a great deal, and it has been for decades.  In fact, over 40% of India's foreign direct investment (FDI) comes from Mauritius, a tiny country of 1.3 million people. 

This very favorable tax treaty was recently thrown into the spotlight when British multinational Vodafone paid $5 billion for a stake in the communications divisions of Indian conglomerate Essar Group.  The purchase took place more than five years ago and involved several court orders with billions of potential tax dollars at stake.  Ultimately, in January of 2012, a Mumbai high court ruled that because Essar Group was a Mauritius-based company doing business in India, Vodafone did not have to pay any capital gains taxes on the acquisition.  

As a result, the Indian Finance Ministry and Securities Exchange Board of India (SEBI) are taking a harder look at the legitimacy of certain Mauritius-based companies doing business in India, and are requiring Mauritius tax residency certificates proving that a company has a business in Mauritius with bona fide employees. 

This is making it increasingly more difficult for venture capital and private equity firms to invest within India as the India-Mauritius treaty requires that a Mauritius-based venture capital fund have at least two directors domiciled in the country (or be there at least 183 days of the year).

Now don't get me wrong, being a venture capitalists investing in India and living in Mauritius (pictured to the left) sounds quite glamorous.  However, as an LP in an India-focused venture capital firm, I don't think I want any investment professional sourcing deals from the beautiful shores of the Indian Ocean.  This new bona fide domicile requirement is going to hit smaller firms with a smaller partnership. Moreover, this domicile requirement will also make it harder for smaller teams to execute cross-border investment strategies focused on the U.S. and Indian markets as two GPs will now need to also split their time with Mauritius beach-combing duties. I fear that this may significantly dampen the inflows of venture capital limited partner commitments to India.  This will be an interesting development to continue to closely monitor and should be top of mind when evaluating prospective managers in India.