Catching Dragons

An LP who had read AVF’s monthly newsletter inquired why we had rejected one of the deals based on the fact that the founders were raising 12 crores. He asked why we didn’t co-invest or take a small chunk of a larger round if the deal was good. This is a common and frequently asked question not only by our LPs but also by founders, their advisors, our advisors, our investment committee and almost every employee. Despite the overwhelming number of times we reject deals based on their valuation or the size of their raise, I continue to stick my neck out on the line for our investment strategy. It has been devised with an important mathematical, strategic and logical reason.

While later stage funds invest at a time when the business has achieved a product market fit, positive unit economics, solid revenue streams, etc. we, as an early stage fund invest when the founder is still contemplating the answers to these questions. Therefore, I stay grounded to reality in expecting that 90% of the early investments we make will fail and return nothing, and the remaining 10% should:

  • Return the total corpus of the fund
  • Deliver a return to the fund’s investors

This is difficult unless there is a clear strategy and discipline while investing.

A fund makes money for its investors by selling its ownership stake in what is called a ‘liquidity event’. This liquidity event can take place in many ways; by selling our ownership to buyout funds, to an acquirer or to the public during an IPO. But how much we make from a liquidity event is decided by two numbers

how much stake we own * how much the company is valued at = size of exit

Considering the small percentage of successes I expect, it is important for each successful investment to have the capacity to return the whole corpus of the fund or be what Kanwal Rekhi calls a “dragon” exit. To figure out at what valuation an investment becomes a dragon for the fund, you can use the same formula

20% X 1000 crore valuation = 200 crores

10% X 2000 crore valuation = 200 crores

5% X 4000 crore valuation = 200 crores

2.5% X 8000 crore valuation = 200 crores

The chances of an early stage fund getting an 8,000-crore exit are slim but if the fund team has picked and worked on such a winner, they should ensure that the exit will have a significant return i.e. multiple times the fund’s corpus and not just the corpus. Therefore, holding a 2.5% stake in such a winner will only return the corpus and I would need 4 such investments to return 4X of my fund – the odds of which are far and wide.

I have modelled our portfolio on an exit ownership between 15-20% with exit scenarios of 1,000 to 2,000 crores over 4-6 years. One such exit will return the fund’s corpus and the rest is just the icing on the cake.

Such a portfolio construct is good for the founders as well. Chasing $1 billion exits promotes behaviour like excessive marketing spends, massive hiring, multiple (and massive) fundraises, lots of founder dilution and an overall impatience to deliver results which cause long term issues. It is simply not sustainable.

Therefore, while I regularly review our investment strategy and thesis, changing the portfolio construct to have lower average ownership just doesn’t make mathematical sense to me. And while numbers can tell a story, they cannot lie.

33/2019

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