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Economics of Investment

Certain economic agents (individuals, households and corporations) have excess of income over their consumption (because of their plan to defer consumption).

Certain other agents need more money than they have (temporarily).

Intermediaries exist who bring together the above two types for economic gains (commissions, brokerage).

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HNWI

Households

Corporates

Angels

Banks

Mutual Funds

Pension Funds

Insurance Cos

Hedge Funds

Venture Capital Funds

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Angels

Hedge Funds

Banks

Mutual Funds

Pension Funds

Insurance Cos

VC Funds

Fixed Income

Securities

Forex

Commodities

Startups & Private Equity

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Nature of these investors

Unconventional

Make highly risky investments

Deal with difficult Asset Pricing and Valuation

Are free of regulatory issues

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Target CompaniesStartupsEarly stage companiesPrivate companies in the scale-up phasePre IPO financing rounds

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Sources of FinanceEquity (common stock, preferred

stock)Loans: long term, short termLease financeInter corporate depositsBank cash credit and overdraft limitsDebenturesFixed depositsGrants from government agenciesSupplier credit and deferred

paymentsCredit cards

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Modes of AcquisitionPrimary market:public issue, rights issue

(flotation costs)Secondary market (listing costs)Private placement (individual or

institution)Banks and mutual fundsPension funds, insurance companiesDebenture issueFixed deposits

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How to compare various sources ? Holding period (Duration)

Repayment terms

Interest rate

Other strings attached

Pledges and collaterals

Finance marketing costs and lead time

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Net Present Value (NPV) of an Investment Horizon of interest: Typically 4 –5 years

Expected future cash flows: Dividends, interests

Residual value at the end of horizon: Market price

Risk-free rate of return: Government bonds

Risk premium: Investor dependent

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Example: Angel Investment Three to five year horizon

No dividend / interest

IPO Price is the residual value

Risk-free rate of return: 5 % (Bonds, Treasury bills)

Risk premium: 20-40% (Early stage investment)

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NPV = CF1 / (1.0 + r) + CF2 / (1.0 + r) 2 + CF3 / (1.0+r) 3

+ RV / (1.0 + r) 3

r = Expected rate of returnCF i = Cash flow at the end of i th year

RV = Residual value of the asset

Discounting is the reverse of compounding

Where

Funds RequirementsIdea / Concept: USD 10KPrototype: USD 50KProduct development: USD 0.5M – 2MOrganization building: USD 8M-10MScale up: USD 50M IPO: Initial Public Offer

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Sources of Funds

Idea / Concept: Personal savingsPrototype: Loan from friends and

relativesIncubation: Angel / Early stage fundOrganization building: VC, first roundScale up: Second round / growth/ scale

up funds IPO: Investment bankers, underwriters

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Cost of Equity

Angels would expect higher rate of returns than VCs

Typical VC expectations is 40-50% compounded annual return

Risk-return curve: New venture increasingly reduces its risk as it goes through stages

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Angel InvestorsHigh Net Worth IndividualsSuccessful serial entrepreneurs (also

parallel entrepreneurs)Good knowledge of technology and

business acumenHave country-specific preferences (NRI,

NRC)

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Examples…James Clark (SGI to Netscape)Prakash Bhalerao (Alopa Networks)Kanwal Rekhi (Exodus Communications)K.Chandrasekhar, B.V. JagdeeshSabeer Bhatia (Hotmail Arzoo Navinmail)Rakesh Mathur (Junglee to Purple Yogi)Suhas Patil (Cirrus Logic)

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Made In India and Served from IndiaN.S. Raghavan

InfosysIIM BangaloreStrand Genomics

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Made in USA and Served from IndiaMahesh Murthy

Passionfund TiE Angel Forum

Romesh Wadhwani Indian School of Business (ISB) Wadhwani Foundation

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Peculiarities of Angel Investment

Quick decision-making

Low level of funds

One-two days a week of commitment – after all they are putting their own money on the table!!

Uncle-nephew relationship

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Venture Capital Firms

VCs look for private equity for young companies

Mezzanine VC firmsScale-up VC firmsTechnology / “Space” specific

Biotechnology Networking Chips and hardware E Commerce

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Structure of a VC Firm General partners 3-5 (themselves successful

entrepreneurs): put about 2-3% of the corpus Limited partners (Pension funds, Retirement

plans): Put 97% corpus Corpus = Fund, typically ranges between USD

50M to 2B Management fee is about 2-3 % per year Funds about 5-30 new companies per year Employs junior managers for due

diligence(associates) After IPO/Acquisition, general partners keep

20% of gains, limited partners get Principal+80%

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VC Firm’s Annual Throughput10,000 qualified business plans

1000 meetings

400 company visits

25 new investments

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Role of the VC in the Portfolio CompanyNegotiate aggressive termsSelect strong co-investorHelp in constituting the Board of DirectorsAssist in

Recruitment Market validation Strategic relationships

Pursue liquidity aggressively

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Valuation: Bargaining PointCauses of mismatch

Asymmetry of information Ego Greed

Factors that drive the valuationTechnology, ESOP rates, managementOrders in hand, scalability, brand strengthPatents and copyrights

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Difficulties in Valuing Start-up Companies

Immediate earnings are negative

No past history

No comparable companies

No market prices

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VC Fund Raising ProcessIntroduction (phone call, e-mail, referral)Submit business plan / executive summaryPresentationCompany visitDue diligence (management reference

checks, customer calls, market analysis)More meeting(s)Term sheetLegal / Closing

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Innovations in Financing Terms

Third party collaterals SIDBI USA Small Business Administration

Flexible, milestone-based equity conversion options and release of funds in tranches

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Some big names in India and USA

Silicon Valley --Sand Hill Road AddressesKleiner PerkinsSequoia CapitalBattery Ventures

IndiaChrysalis CapitalAcer Technology VenturesWestbridge Capital Jump Startups

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Hedge FundsHottest and most talked about in the

business press

Started by ex-Wall Streeters

Quantum Fund : George Soros

LTCM: Long Term Capital Management (Myron Scholes and Robert Merton, 1997 Economics Nobel)

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Hedge Funds: Privileges and PromisesNot scrutinized by SECAsk for long term commitment from

investors : 6 months to 2 yearsTake simultaneous positions in securities,

commodities, Forex and Bond marketsGlobal (Transnational operations)Promise absolute return irrespective of

market trends and movements

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Hedge Fund StrategiesFixed Income ArbitrageEquity market-neutral statistical arbitrageConvertible ArbitrageMerger ArbitrageDistressed securitiesEvent-driven strategiesMacro investorsSector-specific positioning

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Who can invest?Accredited investors

Income of USD 200K/year Net worth of USD 1 Million exclusive of

house, automobiles and other consumer durables

Hedge fund typically limits to 99 investors and has minimum investment of USD 100K – 500K

Fund of Funds

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Private Equity Investment

Large, profitable private limited or deemed public companies who need finance but don’t want to do an IPO

Examples: Patni Computers, Persistent Systems Limited

Deal is usually in tens of crores

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Some deals in the last 6 monthsCompany Investor Investment

USD millApprox

Valuation

Progeon Citigroup 20 100

Glenmark Pharma

CDC Capital 10.3 74

TV Today ICICI Ventures, GE Capital

1.5 25

Patni Computers General Atlantic Partners, GE Capital

108 530

Strand Genomics Westbridge Capital Partners

4.6 9.5

References

Google!!

Indian Venture Capitalist Association http://www.indiavca.org/

Joseph G. Nicholas, “ Investing in Hedge Funds”, Bloomberg Press, 2000

http://www.hedgefund.net http://www.hedgefundmarketing.org/

Cheat_Sheet.htm

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