Arpan Khanal, June 21, 2017
(Each investment fund has its given investment objective and returns target. This article highlights few of the many factors that True North Associates looks into while making investment in a business. Any of the factors listed below may not be as important to other VC/PE funds while making investment decision.)
A few years back when I founded my own Quick Service Restaurant, I researched quite extensively on businesses funded by Venture Capitalists and what they look at before investing in a young business. Years later, I pursued my career in a Venture Capital/Private Equity (VC/PE) firm and started to sit on the other side of the negotiating table. Today, I know precisely what I am evaluating when making an investment call.
Actually, the major factors influencing decisions to invest donâ€™t actually involve any kind of complex mathematical/financial/scientific formula (as they say, itâ€™s not rocket science). An entrepreneur with basic business aptitude can shape their business to attract investors by keeping in mind the following five factors.
Founder and the Management Team
I can never stress enough how important this factor is. When an investor invests in a business, it is the people behind the business they are investing in. They want to be assured that the Founder has a strong team and each player in the team has the vision, sector knowledge and energy to deliver results.
We once encountered a Founder who seemed to lack the energy to take the business to the next level despite us willing to work alongside her; alas, that was the last contact we had with her. If Investors are going to risk capital on a business they want to know that the Founder will give his/her 100% to see the business expand.
Another crucial factor, which is not discussed enough in Nepali context, is ethics and value system. In one instance, we were dealing with a Founder who we discovered during the Due Diligence was trying to manipulate the financial figures of the Company to get a more favorable valuation. We immediately called off the deal.
Market problem and Value Proposition
Often I come across Founders who question why their business is not performing. Upon analyzing their business, I discovered the reason to be rather simple: their product/service does not solve any customer problem. Investors usually refrain from investing in such businesses.
As investors, we constantly search for businesses that are addressing a large problem with a fantastic value offering. Furthermore, itâ€™s not adequate that there exists a problem/opportunity; we see how the product/service offered by the Company solves the existing problem and eventually turns a profit. Technically itâ€™s also termed â€˜product-marketâ€™ fit.
Your past does matter
News of companies in Silicon Valley or Bangalore or Beijing raising millions of dollars on the basis of idea or prototype at questionable valuations have encouraged many young Nepali entrepreneurs to do the same. I have often encountered entrepreneurs who passionately paint a picture of where their company/product/service could be two or five years from today and when we ask about what they have achieved with this product till date, they are dumbfounded.
When meeting a Founder, I always ask a few crucial questions like how much capital has been invested into the Company, what the annual revenue was for the past three years, and what profits did the company book in each of those years. â€˜Product tractionâ€™ â€“ how the companyâ€™s product has been expanding among user base â€“ is extremely important to us. It helps us assess whether the management team has the capability to actually deliver results post funding.
Scalability and Market Potential
Investors are interested in businesses that have enormous growth potential and can be scaled up while taking advantage of economies of scale. This is because once the product/service is established, it can massively increase its user base without proportionate increase in costs. Consider an example of an EduTech Company. Once the content for a course is produced, the same content can help to generate revenue from thousands of users without incurring incremental costs (excluding marketing costs).
So what determines the scalability of a business? Market Potential. Investors invest in a business if they see enormous market potential for the Company to capture. One of our investee companies ACT 360, a digital marketing company, is trying to carve out a pie for itself in the domestic 10 billion marketing industry. Apart from domestic market, the Company also boasts potential and capability to service clients abroad.
Returns and Exit
At the end of the day the only reason VCs or PE firms get into this business is to make money. When evaluating among different investment prospects, investors carefully monitor several forward looking (projected) metrics such as payback period, internal rate of return, expected returns on equity, expected exit multiple and select the business which generates the highest returns. So numbers do matter after all!
VC/PE firms love it when the Founders can realistically tell them how they plan to provide an investor an exit from their business. Investors are attracted to businesses in which they perceive good likelihood of exit through IPO or acquisition. In Nepalâ€™s case, the conservative IPO regulations and undeveloped M&A market leaves the investors dependent on buy-back by entrepreneur as the only exit option.
In a nutshell, a business that an investors can easily exit at attractive multiples of capital invested is what investors are always looking for.
Arpan Khanal is the Investment Manager at True North Associates. True North Associates is a Venture Capital/ Private Equity firm.