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Alok Mittal
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March 19, 2009

These days, it can often be impolite to ask someone how business is doing. What, then, are the traditional long-term thinkers, the venture capitalists, up to now?

Venture capital firms, as it happens, are still investing. While the pace of investments has slowed down on an industry-wide basis, firms that have recently raised capital see this as a great opportunity to make some serious long-term bets. The fact is that now is a much less distracting time than 12 months back -- lesser noise, lesser competition and lesser irrationality.

This is especially true in areas where the customer demand is unaffected -- for technology-oriented businesses, this means more of consumer internet, mobile VAS, education and healthcare businesses. And perhaps less of software products and offshore services, even though specific industries there continue to do well.

Needless to say, the bar for start-ups to raise capital has gone up. Capital is more selective today than it was few months back. Besides a stricter industry selection as mentioned above, the premium on capital efficiency of businesses has gone up as a selection criterion.

The good news is that start-ups that deserve to get capital will still find it -- if earlier the success rate was 5 per cent, now it might be 4 per cent; if earlier 95 out of 100 start-ups were not finding capital, now it might be 96 -- not a whole lot of difference in odds! VCs also do not want to under-finance companies and are ensuring that the current capital infusion takes them through at least 18-24 months, which is the expected time when the outside fundraising environment starts to recover.

Interestingly, valuation is less critical a criterion in early stage investing. In early stage ventures, valuations are a means of balancing and aligning interests of all stakeholders, and are not based on revenue or profit multiples.

To that extent, while there is a mild softening in the first rounds of investment, the larger impact of declining valuations is only visible in later stage companies. Investors who have invested through such cycles before realise the importance of not squeezing too hard because this can have a detrimental effect on the entrepreneurs' incentives over time.

Equally, in later stage investments, there is still a delay on the part of the entrepreneurs in accepting the new reality and adjusting to it -- some of them continue to quote peak valuation multiples as fair basis of valuation. In my mind, this will adjust over the next few months, and enable more transactions in that segment.

The great part is that, so far, the deal flow volumes and quality have not suffered. This is really the lifeblood of venture investing, and collectively venture capital firms must continue to foster an environment in which high quality entrepreneurs continue to create companies.

This means not only the financing element, but also engagement, advice, coaching and everything else that goes into enabling entrepreneurship. Similarly, entrepreneurship-oriented organisations, like TiE, NEN and others must continue to energise the ecosystem by being more effective matchmakers and guides to the aspiring talent in India.

This is also a time when VCs in India will get tested for the first time. First, they will get tested in how they support their portfolio companies -- are they sitting on the same side of the table as the entrepreneur or the opposite? Are they able to roll up their sleeves and help their companies implement the right decisions?

Over the past three years of resurgence of venture capital in India, all of us in the business have had the luxury to claim high level of empathy and operating knowhow -- now is the time when those attitudes and skills will get tested. As much as for entrepreneurs, these are the times that will separate men from the boys in venture capital business.

Second, venture firms will be able to test their syndicate partners on how they perform under adversity. As is the trend globally, many co-investments have happened in India as well, and so far the choice of partners has been based on little else than a shared view on the investee company. This downturn will provide us with the first opportunity to gain experience on these partnerships, and improve our own selection process for syndicates going forward.

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