Children of War
The origins of venture capital go way back to the mid-1950s when an American research organization American Research and Development Corporation began investing small amounts in private companies.
The goal of the ARDC was to finance post-war veteran companies, as soldiers would look for other means of employment after the end of the World War.
While one may even qualify the financing of Christopher Columbus’ expedition by the King and Queen of Spain as “venture capital” (adventure capital?), professional VC would begin in earnest on the East Coast of the US.
Professional venture capital would get seeded with ex-employees at ARDC, who would start in and around Boston. Greylock Partners would be formed, but the real action would start miles to the west.
That would be Silicon Valley, of course.
A Cottage in a Valley
In the land of the Gold Rush, the birth of the semiconductor would help attract technological talent from all over the world.
The pioneer of this semiconductor land grab would be the unknown but highly influential Shockley Laboratory, that would be the meeting ground of some of the most well-known names in technology.
The traitorous eight of Shockley’s lab would create Fairchild Semiconductors. The Eight would have their hands in building legendary technology and VC firms. While Moore and Noyce would go onto setup Intel, Eugene Kleiner would setup Kleiner Perkins. An employee at Fairchild, Don Valentine, would setup Sequoia Capital.
A cottage industry called venture capital was born.
Venture capital would step in to provide financing to young companies that could not raise capital from the traditional financing institutions, like banks.
Companies that did not qualify for such financing would be those with new-age technologies, unique business models, or strong management teams but little revenue. None of these would fit the criteria of banks, but there was a need.
These were high-risk investments, but if they worked, they could change industries.
VC investors would provide a small amount of capital, like $500K, in exchange for significant equity of a company, like 20%. While the company would be unprofitable today, the expectation would be that it would be profitable in the future. If the company could grow and become profitable, 20% would be worth a lot more than $500K.
Simple arithmetic, but very difficult to put to practice.
Most companies would take the money, but never grow to see the light of profitability. But, even if 9 lost $500K each, but one made more than $5MM, the portfolio of 10 would make money for the venture capitalist. If one made $355MM, like on DEC, that would make you a great venture capitalist.
A lot of venture capitalists would attempt for greatness in 1999.
Y2K is The End
Riding on a new something called “The Internet”, startups would spring up trying to provide everything online.
Books (Amazon), Music (Napster), Search (AskJeeves), Email (Hotmail), Apparel (Boo), DVD Rentals (Kozmo), Everything (Yahoo), Browser (Netscape) and Petfood (Pets). A lot of these companies were significantly well funded by venture capitalists trying to make it big.
Netscape and Yahoo would have incredibly successful multi-billion$ IPOs in 1995/6 that would make every venture capitalist think (s)he could be great. Money would follow everything and anything built on the internet.
The Nasdaq would not see 5000 for another 15 years after March 2000.
The dot-com meltdown would take a lot of companies with them. Of the companies mentioned above, only Amazon exists in a form better than 1999. The rest were acquired, gradually declined, or simply collapsed in 1999/2000.
VC in the US temporarily died, but it was taking birth in an entirely different place.
Welcome to India
The liberalization of 1991 opened up the Indian market to the world.
External capital would flow into the Indian market, wanting to tap a new growth story. It would grow from a tiny $100MM in 1991 by 50x, reaching $5.3B in 1996. The stories of the successes in US VC would inspire Indian entrepreneurs.
ChrysCapital would be founded in India as a PE/VC fund in 2000, run by Ashish Dhawan who had spent his educational and professional life in the US. WestbridgeCapital would soon follow, and India had its first few funds in 2000.
The Indus Entrepreneurs (TiE), which had been extremely successful backing Indian entrepreneurs in the US, would start its Bangalore chapter. The lull after the dot com crisis would dissuade VCs from arriving, but angels would start actively investing in young Indian companies.
Many of these angels would end up being the founders of storied Indian funds.
After 5 years of strong economic performance, and the dotcom crisis out of sight, VCs started to rapidly setup to India. In 2006-8, Sequoia would acquire WestBridge,Helion would kick off, Nexus would be founded, Erasmic would be acquired by Accel, Norwest would start India operations, NEA would invest in Indo-US Ventures (now Kalaari).
These 2 years would see incredible VC setup activity, which seems to be done in tandem to not miss out. The bigger question would be, how would these VCs make money?
The Business of Businesses
All the Indian VC funds would be incorporated in Mauritius, because of its tax-friendly regime with India. Mauritius had a double taxation avoidance agreement (DTAA) with India, which meant that Mauritius companies would not be taxed for their gains in India.
The interesting rule was, capital gains were not taxable in Mauritius. That would, quite literally, be a golden rule for Indian VCs.
VCs are fund managers, essentially managing a fund that invests in young companies (“startups”). Just like startups “raise” from VCs, VCs raise from wealthy individuals or institutions known as Limited Partners or LPs. The fundraise would lock in capital for 5-7 years, known as the fund lifetime.
All LPs would be sending their money to Mauritius based funds.
The General Partner, or GP, would be responsible for managing the fund. Like every fund manager, a management fee would be charged on the amount raised to run operations. For VC funds, that fee is usually 2% every year. For a $100MM fund, that would be $2MM a year.
In addition to the management fee, VC fund managers also take carried interest, or “carry”. Carry is taken as a % of capital gains (profits) earned by the fund. Let’s say the $100MM fund has exits $300MM in 5 years. Let’s assume a hurdle rate, which is the minimum expected return, is set at 10%. $100MM is thus expected to be 100*1.1^5 = $161MM.
The remaining $300-$161 = ~$140MM is profit. The VC fund manager makes carry on this profit, usually being 20%. In 5 years, the fund manager would make 5*2MM = $10MM through management fee, but 20%*140 = $28MM through carried interest.
Clearly, carry can be gold.
While it may have seemed puzzling to take management fees, unlike most businesses, VCs don’t make money on a yearly basis. VCs only make money on an exit, and till an exit does not happen the VCs investment is locked in the startup. Exits usually take 4-5 years.
It is little wonder 2-20 (fees-carry) is now standard in the VC business. As capital gains were not taxed in Mauritius, and VCs made all their profits from capital gains, Mauritius became standard for VCs.
India would see hectic activity in the next decade.
Coming of Age
As I had elaborated in my previous piece, the successes of India’s IT giants would make Bangalore a hub of startup activity.
VCs would follow and set up shop in Bangalore, backing startups that would get created. Seed rounds would start happening. A small e-commerce player called Flipkart would raise a seed round in 2007, whose story would also very aptly tell the story of India’s decade in VC.
Flipkart’s seed would be the beginning of a strong decade of PE/VC investing, despite the financial crisis of 2008.
2008 would see $10Bn being deployed in PE/VC in India, across 300+ deals. 2009 would see a collapse, but India would soon see activity reaching $10Bn in 2013. Over these three years, Flipkart would raise a Series A, B, C and D, becoming a unicorn. Every stage of fundraising is given a letter of the alphabet, and Flipkart wouldn’t stop here.
2014 would be the inflexion point for PE/VC, as it would break the $10Bn mark. The next 3 years would be a literal gold rush, with $51Bn being invested, more than the first 7 years combined.
Flipkart would be the poster child of this rush, raising billions. In a downturn, Flipkart would also get marked down. In 10 years, more than 4200 investments would be made, and hundreds of large companies would be born. With Flipkart’s $20Bn acquisition in 2018, Flipkart’s early investors would be branded great venture capitalists.
With its mega exit, Indian VC would come of age.
Perceptive readers would have noticed that I don’t name any investor in a startup, largely because I want the focus to be on startups.
For this piece, which is a homage to all those who took risks to create a new industry, I have broken the rule multiple times. It is on the giants of shoulders that we stand, on the other side of the table, hoping to be part of a startup story that we can tell.
Venture capital is still a small, niche industry, and famously quiet on how it operates. I see it changing, and hope to be part of the change, as we VCs begin to describe what we do. Finding and backing a startup with potential early on is an incredibly complex task, and it turns out to be as much of an art as it is a science.
It is why I think that VC is here to stay.
In the classic piece “Is VC still a Thing“, Mark Suster elaborates how VC is going to be even more exciting as companies stay private longer. I would add to that argument to point out that VC is based on very little data (more art), and hence will be very difficult to automate.
VC involves few, deliberated decisions, that are driven more by the human aspect (“we back teams”) than anything else. Making these deliberated decisions could result in “Uber returns“, or not. The thrill of making these “right” decisions is not only in the returns but in being able to help entrepreneurs on long, complicated journies to success.
India, with its growing young, ambitious population will create incredible value over the next few years, regardless of who runs the country. VCs will, therefore, need to up their game as trusted advisors to help build these companies.
It is truly an exciting time to be part of the ecosystem.