The how and why of early-stage investments

I received an email from a former student a couple of weeks ago requesting for a meeting. He had founded a start-up and wanted to discuss the funding proposal for his early-stage venture. It is a joy to meet former students, particularly when one has ventured on an un-trodden path.

Over a cup of tea, he quickly told me that some investors have expressed interest in funding his venture and he wanted to know whether the valuation they had arrived at and the shareholding they are seeking were appropriate. If not anything else, he at least wanted to ensure that he was not making any mistake by accepting the proposal.

I told him the general 2 and 20 thumb rule that prevailed in early-stage deals. That is, investors look for a 20 per cent shareholding for a $2 million (approximately ₹12-13 crore) investment.

However, I wanted to check if the trend in India was any different and whether there have been any changes in the overall pattern of early-stage investments in recent years.

The results that we got from analysing a dataset of more than 700 deals during 1998–2015 were remarkable.

First, we found that the average shareholding acquired in early-stage deals in India was close to 30 per cent, which was a tad higher than the global averages. Did it differ between sectors? A bit.

The average stake acquired was the highest in the Healthcare and Life-sciences sector (33.65 per cent) and lowest in the manufacturing sector (19.58 per cent). Has the average shareholding changed over the years? Not really.

Over the years, the average shareholding has remained within a narrow band, between 25 per cent and 30 per cent.

Second, we looked at the average investment size. Here, we are on par with the global average.

The average investment in early-stage rounds has been around ₹12 crore.

This, interestingly, did not change significantly over the years. Did it differ between sectors? Marginally.

The lowest average investment was in the IT&ITeS sector (₹10.16 crore) and the highest was in the Healthcare and Life-sciences sector (₹16.31 crore). What we found was a great degree of homogeneity in average investment and shareholding across companies.

Third, we looked at the age of the company at which it received early-stage funding. Figure 1 shows the results. In the last 16 years, the average age has reduced by two-thirds.

For example, companies that were incorporated during 1995-97, received early-stage funding at an average age of 5.45 years, whereas companies that were incorporated during 2010-12 received early-stage funding at an average age of 1.76 years. It is difficult to miss the consistent downward trend.

This is music to the ears of entrepreneurs — they have been able to raise funding earlier in the firm lifecycle than in the past.

Fourth, we looked at the companies that received investment in terms of the lifecycle. Figure 2 shows the trends. While close to half of the deals have been in early-stage in recent years, we can also see that the funding environment for early-stage deals is highly volatile as compared to that of growth-stage or late-stage.

Tail winds can quickly become head winds. What matters is that early-stage ventures should seize the funding moment when it arrives. While it is important that they partner with the right investor, bothering too much about the valuation and the shareholding at that stage is unnecessary.

What the Bard of Avon put it nicely in Julius Caesar more than 400 years ago, is relevant in this age: “There is a tide in the affairs of men, Which, taken at the flood, leads on to fortune; Omitted, all the voyage of their life, Is bound in shallows and in miseries… And we must take the current when it serves, Or lose our ventures.”

The writer is Professor, Department of Management Studies, IIT Madras

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