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How VCs view the moral universe of startups

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By Venkatachari Jagannathan

Chennai, March 6 (IANS) Investment by private equity/venture capitalists or angel investors is a marriage contract with divorce clause. One of the various factors taken into account by investors before investing is the moral hazard of the entrepreneurs.

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And investing in a startup is like funambulism or tightrope walking needing skill, practice and safety net to reach across safety, said investors.

“At the end of the day, the venture capitalists/investors take the risk. We construct a portfolio of investments to diversify the risk. As a fund manager we are more of a risk taker and less risk averse,” Sarath Naru, Managing Partner, Ventureast, one of the long standing venture capital firms in India told IANS.

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For startup investors taking risks is their game like the famous Tamil movie comedian Vadivelu dialogue “taking risk is like eating rusk for me.”

While the books of accounts of a startup can show its financial condition, how do the investors assess the moral hazard of the founder/promoter is the moot question that has come up in the wake of BharatPe episode.

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Indian business canvass has seen several fraudulent promoters and it is famously said: “In India companies go sick but not their promoters.”

“Investing in a startup is like tightrope walking needing skill, practice and safety net to reach across safety. A lot of due diligence goes before writing out the cheque,” Gopal Srinivasan, Managing Director and Chairman, TVS Capital Funds, a private equity company, told IANS.

An investment banker, not wanting to be quoted, told IANS: “The actual fact is a private equity or venture capital investor is an economic animal and is not here to promote entrepreneurial skill. Their template is simple as they have to return the money raised to their investors in 8-10 years. So, the time frame will be 3-4 years of investment in a startup, 3-4 years for value accretion and the remaining period for strategizing the exit route.”

The investors spend time to know about the founder and also have a detailed probe done – due diligence as well as forensic audits – before writing out the cheque. The rigour of checking varies from fund to fund.

Terming it as a myth that some investment firms write out cheques just by speaking to the startup founders over phone, Srinivasan added investors also hire consultancy firms to scan the market for prospective investment avenues and do the background checks.

“It is easy to cross check about an entrepreneur. TVS Capital invests in companies whose founders are in the age group of 30-40 years by which time they would have left a strong trail about themselves,” Srinivasan said.

“Moral hazard – Not a metric I am used to. I do not know any specifics or about a particular business. This is the role of the board. In today’s environment, we cannot believe social media or sometimes media. So, you look at hard metrics and leave governance to the board or regulators. As an investor, I would look to the board,” Kris Gopalakrishnan, Chairman, Axilor Ventures told IANS.

Gopalakrishnan, one of the founders of Infosys wonders how one decides on these things with the limited information available.

“In startups, typically the VCs (venture capitalists) have board seats. You work with a small set of VCs and invest with them. Also, one does not get time to dig deeper; hence if things don’t work out, one moves on. One expects a percentage of startups to fail,” he added.

According to Gopalakrishnan, it is the job of the regulators to identify frauds and misgovernance.

But in the case of famous scams like Satyam Computers and the National Stock Exchange (NSE) the board members were silent spectators.

“If it is a con job as in the case of Satyam Computers where the promoter, auditors and others were involved, it is very difficult for the investors. The moral hazard can be known in case of normal entrepreneurs,” Prof Murali Panchapagesa Muthuswamy, Hon Chairman, Golden Jubilee Biotech Park for Women and President, Council of Presidents, Association of Biotechnology Led Enterprises (ABLE) told IANS.

Investors in startups are actually investing on the promoters, their vision and enter at an early stage based on their track record and how they behave with their team.

“We will speak to present and previous employees of the startup. That will give out how the founder behaves with the staff. High employee turnover is a major point to be taken into account,” a senior official of an investment company not wanting to be quoted told IANS.

Investors will also talk to the startup customers to get their feedback on the product and the company’s attitude towards their buyers.

“While startup founders are not made to undergo any psychometric tests, they do hire experts who can assess the personality traits of a startup founder. Investors do forensic audits of the startup founders and they also talk to present and past employees and others and connect the dots,” a venture capitalist told IANS.

Single or multiple founders, politically exposed founders are some of the metrics that investors take into account.

“We look at the track record, single or multiple founders, market apart from their business model,” Shreyas Shibulal, Founder, Micelio Fund that invests in the electric vehicle segment.

“Multiple founders are not a guarantee for checks and balances and a safety net for the investors,” TVS Capital Funds’ Srinivasan remarked.

As regards the red flags, Srinivasan said an overambitious founder is one. Being ambitious to a certain extent is fine but overambitious is a risky proposition.

The former workers will share details about any sexual harassments or attempts made. Such things will blow up big at a later stage, added a senior industry official.

According to Naru, the moral hazard of an entrepreneur will not crop up at the angel/venture capital funding stage but at the private equity funding stage when the startup would have grown to a decent size.

But there can be exceptions, as it had happened to Ventureast several years back, he added.

“In one instance a founder was imprisoned for a couple of months. He had served his sentence. We decided against investing in his company based on advice. In another company, the promoter had to go to jail. We used an agency to check on the case. The agency gave a clean chit and we invested in that company,” Naru said.

“Normally last minute pull out by a potential investor could be due to many factors like: “One finds both founders are not working as a team; Balance sheet is not accurately reflecting the financial situation of the company; Unfavorable contracts and partnering agreements; Intellectual Property rights are not good and could be challenged; Key employee moving; On due diligence we find a similar company far ahead and hence will reach market ahead; Regulatory environment turning sour suddenly due to policy changes. These are a few. There could be other reasons for last minute pull out,” Muthuswamy said.

As regard BharatPe issue, industry officials told IANS that it was a conscious decision of its investors to put in their money.

(Venkatachari Jagannathan can be reached at v.jagannathan@ians.in)

–IANS

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