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10 Responses to “Canaan Partners update”

1. 1 Deepak Shenoy Feb 26th, 2007 at 4:36 pm

   Good interview, Alok.

   I liked your point about the larger capital developing deal flow. A few potential angel investors I know are concerned about the longer time for exits, typically six to eight years now, but most VCs are loathe to let an angel cash out in a round. I probably shouldn’t ask, but does Canaan have a different perspective? Will you buy out an angel if the opportunity is worth the investment?

   My best wishes to you and Canaan, and I hope you’ll all be rich and successful and build the ecosystem.

2. 2 Alok Mittal Feb 26th, 2007 at 4:45 pm

   Deepak, I think the question we ask is why the angel investor wants to exit? As an insider, we do assume they have better knowledge of the company than we do, and with that knowledge, if they dont believe its worth their while to stay on, it sometimes may send the wrong message. but then this business is full of exceptions!

3. 3 Deepak Shenoy Feb 26th, 2007 at 5:16 pm

   Alok, true - there is reason to think about why one wants to exit. As a stock market investor, I have made decisions to sell companies at (say) 400% profits, when the company went on towards 1000% of what I bought - yet, I wasn’t sulking in a corner. Because a) 400% is pretty nice and b) I’d reached that comfort level of profits.

   Angels may not want to stay the distance, which could be much longer than their cash needs, and if the current valuation is attractive enough for them to exit. As individuals I would imagine that angel investors are the kinds that put in Rs. 10 lakhs to Rs. 50 lakhs in a business - and honestly, there are a number of such people who have this kind of cash lying idle in bank accounts (idle = they don’t need it right now). Such people can be angels, but they won’t be because VCs won’t let them book profits until the final exit, years away. Which again they have no control over because further rounds have diluted their stake too much.

   The US has a huge background of such deal flow, but it’s absent in India. I was hoping a VC would take the lead and say that they would fund angel exits here (even partially so) and more angels would come out of the woodwork. We need those angels, if only to make more companies VC worthy…

4. 4 Roshan D'Silva Feb 27th, 2007 at 6:46 am

   Hi Deepak,

   I think the angels you’re referring to are probably those that fall into one of the two categories:-
   1. Purely financial a.k.a the family rich
   2. People whose net worth does not afford them the luxury to ‘angel’ - (20k - 100k usd in the bank wanting to angel?? ;-))

   They typically make the usual mistakes - getting in at too low a valuation, adding no value, bickering, neglecting paperwork etc. etc. Category 2 usually in a few years realizes that they’re not in the ‘zone’ and go into other asset classes. For Category 1, it really does not matter.

   The really good angels are very focussed on getting their portfolio companies funded and typically their angel rounds are done as debt convertible into equity at a discount to the subsequent round valuation. This also eliminates any negotiation between the angel and the founder and motivates them both to do ‘fair deals’.

   For companies (trying to raise money) or VCs (wanting to invest in a company) who is stuck with angels of categories 1 &2 I would never suggest providing an exit to the angels. I would rather make the founder take on debt (which could come from the VC or a new ‘real’ angel) and let him/her negotiate to buy out these guys before the VC round. If the founder’s unwilling to do so, I would want to think along Alok’s lines.

   Of course, I’m talking about ‘real’ VC’s investing in ‘real’ companies that can exit at 100mn+ numbers.

5. 5 Deepak Shenoy Feb 27th, 2007 at 9:17 am

   Roshan,

   You make some good points.

   The category 1 types you mention are the moneylenders of the angel world - who will try to value tech companies at “book value” and such, but then their exits are of little concern to me. I’m starting to see a lot of interest from such people but the mindset of “how much premium are we paying per share” will not go away!

   Cat 2 - the 10 to 50 L excess cash sitting in the bank types - these are going to be the real angels in the near term, IMHO. We don’t have a huge entrepreneur success story list in the tech landscape and VC minimums are too high for tech startups in India.(Note that I say “excess cash” meaning this is stuff that’s much beyond their required savings. Networth of such individuals would typically be a 1 crore plus) Such individuals will perhaps be the best bet for a startup today, but will they lock in money for years?

   You mentioned bridge loans (the convertible debt at discount to future valuations part), I think they are starting to see the light now - I know founders and founder families that have invested this way. In fact, I’d say founders that invest hard cash should probably go down this route - part of their stake in the company as a bridge loan, the other part as sweat equity vested over a few years.

   Giving founders debt to buy equity serves little purpose, though I would imagine that founders would have no problem with it - in my last company, even without angels and VCs, I had taken on debt to buy out someone else. Unsecured debt is usually not a problem But then it makes little sense because as a VC you might be able to increase shareholding if you buy out an angel directly, since the company will need only so much cash. Take a hypothetical case of a company needing $2 million and is currently valued at 8 million, which gives the VC 20% post money. An angel buyout would perhaps give the VC 26% or more which they would be looking for as a minimum, but without tampering with the valuation metrics.

   In all, I think if deal flow is to come to India, we are going to have to see partial cash outs by earlier investors. Paul Graham even talks about founders getting partly paid for their stock in subsequent rounds - that is our future as well in India. Why do I think this is necessary?

   We complain that our archaic Indian labour laws stymie growth, because they don’t allow you to fire someone. If you can’t fire, you won’t hire, we scream. Well, if we won’t let someone cash out when they’ve reached their goal, we won’t find them rushing to put the cash in either.

   (If you’re into bonds: Imagine the govt. make a 20 year bond non tradeable, and imagine the response to that issue)

   Maybe the big VCs won’t take to it, but there will be investors that’ll be happy to go down this route. I’ve seen a few UK and US investors who are very comfortable with partial cashouts; how long will it take to reach here? Perhaps I should hurry up and get rich, so I can do this myself.

6. 6 Deepak Shenoy Feb 27th, 2007 at 11:50 am

   Er…note that the Cat 2 types I mention are insiders - technology folks who like the idea and the team enough to invest in it but are perhaps occupied elsewhere. Not the average joe with some extra cash, because that is a waste of effort.

   Most startups I know need seed stage funding of less than 50 lakhs, which can typically be organised from within their friend circle or college alumni.

7. 7 Roshan D'Silva Feb 27th, 2007 at 2:51 pm

   Hi Deepak,

   Firstly these are my views. I do recognize of course that founders raise 10-50L routinely from ‘angels’. I just don’t feel its the wise thing to do. These amounts can usually come down significantly if the founding team agrees to take most of their compensation in stock. In addition, most entrepreneurs should have enough credibility to call up a few friends / family members and borrow these amounts with the understanding that if things don’t work out they would go back to a job and pay them back in 3-5 years. Doing the rounds of investors to raise such small amounts in my opinion is just wasting time. Sums under 50L are easily repayable by executives. Instead I feel the founders should maybe spend more time on activities that cost nothing - planning, strategy etc. so that they are able to figure out how to build an asset with 1-2mn USD initially that would be worth 30-40mn in 2-3 years and appreciating at 100% per year with marginal additional capital consumption.

   BTW, to give a practical example I know some juniors ( who graduated from Engg school in 2001) started their company in 2003 and it was funded completely by Loans from batchmates who were working in the U.S. Amounts roughly along the lines you mention.

   About funding founders, I feel what I mentioned is a really special situation that occurs rarely. In such cases, I don’t think the loan should be unsecured. It should be repayable from the founders compensation in the near term. These amounts in my opinion should anyhow be minor - something that maybe the founders annual performance bonus should be able to absorb. It could probably be secured using his founders stock and so in case the founder does not perform the investors could probably use it to reduce the capital base.

8. 8 Deepak Shenoy Feb 27th, 2007 at 4:37 pm

   Roshan,

   By “Unsecured” I meant you don’t have to get collateral-secured debt. Loan against salary (or even a loan against the stock itself) is fine - but if VCs say “go take a bank loan, pay off the stupid angel and come back to me”, I’d say there would be a lot of bad blood.

   You say the loan amounts should be minor - but why would an angel part with her stake for a paltry amount? She would expect to be paid at the same valuation as the VC, no? Let’s just say an angel invested Rs. 50 lakhs at a 1.5 cr. pre money valuation. That’s 25% - now after a year, a VC comes in, values the company at 10 cr. and says it will provide 5 cr of funding. Now if the founders need to buy out the angel they need to plonk down 2.5 cr, which is not a small loan and I doubt that annual perforamnce bonuses will cover 2.5 cr? If you were the angel would you agree to take say 60 lakhs and go away?

   In general, Debt is perhaps infinitely preferable to equity during a funding round. But the idea is to create wealth and leverage the investment. It’s not purely financial (as I’d mentioned) since the people that fund are usually tech savvy and could help with traction. Secondly the angel risks a lot more than a VC, and the reward for that risk must be manifold - thus equity.

   If you look back - Intel started by asking for small amounts from friends and family and pretty much anyone who wanted to invest (okay, this was pre SOX and pre regulation days) and gave them shares as consideration. You might look back and laugh at them - if they had only taken that as debt the founders would be worth that much gazillion more. But that funding made a lot of people rich, and some of them will be happy to fund others won’t they?

   Closer home, If Reliance had not decided to go down the equity route it could have survived (most Birla factories went down the debt route IIRC). Yet Ambani decided to share the story, and now he’s talked about as the person that changed the way people looked at stock.

   Now Entrepreneurs can take loans, yes, and “soft” loans at that. I know people who’ve started companies by doing “free” transfers from one credit card to another. And taking home improvement loans. But I would much rather see the equity ecosystem get more developed - angels must take the initial tiny funding risks and get rewarded by either VC buyouts, or eventual IPOs or such. With the money they’ll fund more seed investments, and thus we’ll create a lot more startups.

   The other thing is: Seed investments by techies will be valuable for getting advice and contacts as well. If you take a loan from friends, the dynamics won’t allow you to ask for free advice - equity means skin in game.

   I get the impression that angel funding, if not institutional, is somehow not kosher. If we don’t change that mindset, we’re not going to make us richer. Yes, you and me, mate, we’re going to be angel investors someday.

9. 9 Roshan D'Silva Feb 27th, 2007 at 10:13 pm

   Hi Deepak,

   Very valid points and I’m going to take an extremist view just to add to the debate. I agree that friends and family should get equity. I was just suggesting that the entrepreneur be clear that this would be debt convertible to equity if they chose so. If things go bust, he would repay them from future earnings. This is essentially because I feel this cash is put in with no regard for the business and more on the personal credibility of the individual.

   About angels wanting to get compensated at the VC investment valuations. Firstly, I feel we need to be clear that the Valuation at a VC round is not the real value of the asset. It’s the discounted value of the future valuation that would be possible given the team meets key milestones in the future. I like to liken it to the value of a bridge thats half built - it has no value. In the normal circumstance, if the angel has been fair maximum equity post an angel round should rest with the founders (>80%) esp. if the round is sub 100k USD. If he’s been unfair I think the founders and follow through investors would be justified in using the new capital to re-balance the equity distribution to ensure that the team responsible for the milestones that will drive the future value are compensated adequately were they to meet the same. Secondly, I think we need to differentiate between the ‘pre’ and ‘post’ valuations. When buying out the angels, the entrepreneur should at max be entitled to pay a ‘pre’ valuation or in more cases a discount to the same to take into account present value as opposed to discounted future value.

   Lastly, I don’t feel entrepreneurs usually reach a situation when they want to buy out their investors. It’s only in cases 1 and 2 as mentioned above. The value that a true angel brings is immense and all entrepreneurs recognize that.

   I don’t want to see the private equity ecosystem further evolved. Experienced hands making these investments recognize that there is a liquidity risk associated with such investments and invest accordingly. Economics is supposed to punish those with limited experience and who have limited time/skills to bring to the table. The slump of 2001-2004 cleaned the system of a large number of misguided angels/ founders. The present boom seems to be bringing other ones who look similar back into the game.

   All funding is kosher. It’s just that I feel it should be done as convertible debt and by those who have experience in similar companies to the one they are trying to fund. In the tech sector that means angels who have seen exits at the levels at which they expect their investments to exit.

10. 10 Deepak Shenoy Feb 28th, 2007 at 5:12 pm

    Hi Roshan,

    Interesting perspective. I guess this would pretty much be a VC perspective, where evolution from today is not in their direct favour - giving angels a raw deal or a high discount for a liquidity risk is largely favouring institutions. The stock market itself, in the years of floor trading, imposed such costs on lay investors, who would pay ridiculously high bid-ask spreads, get affected by front runners, and such. Those markets learnt and evolved - and now the lay investor is perhaps at a much better position.

    What I’m talking about is already happening in the private equity markets abroad, just not yet in India. Look at announcements such as
    http://www.sfgate.com/cgi-bin/article.cgi?file=/c/a/2006/12/13/MNGECMUMRE1.DTL
    where not just angels, but even founders may get partially compensated. There’s a Paul Graham article suggesting it too: http://www.paulgraham.com/vcsqueeze.html . While Founders may be essentially different from Angels, the reasoning against partial cashouts applies to both pretty much equally.

    As for the economics suggestion of punishing those with limited experience: the angels I talk about are perhaps far more intuitive about the business than VCs, going with most of the herd mentality and such. Managers of money are rarely the best persons for the job; in fact Peter Lynch, after a stellar role managing a 29% CAGR magellan fund wrote a book that, in essence, said good fund management is not rocket science, and anyone can do it. If economics really were to play a role, it would punish the fund managers - and so it has, with Vanguard, passive management and index funds becoming vastly popular. And active fund managers have not been able to consistently beat the index in the last 10 years.

    The example is perhaps stretched - but I believe the private equity market will evolve similarly. Today is easy picking for the VCs, but tomorrow it won’t be so; in the face of lower capital needs, early acquisitions and VC apathy, there may be little use for the current mentality (no partial cashouts prior to VCs exit)

    I agree with you though that buying out an angel or a founder is not going to be common; but the reasons for that will most likely be that the angel does not want to exit rather than that she can’t. Given lower capital requirements of tech companies, VCs may just want to take whatever capital is available, be it from an angel or otherwise. As I’ve said, it’s already happening and I’m not the first one to talk about this at all.

    As for convertible debt, the option’s fantastic, and it should then also be the route taken by VCs as well (not just by angels) because the argument holds water. Equity is a far more easier thing to sell, and a more secure option for the investor - if that were not the case VCs would prefer convertible debt.

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