“KISS, the popular acronym for Keep it Simple Stupid, is an elegant concept, but it has its limitations. While complexity is not needed when simplicity can do the job, only diamond cuts a diamond. Complexity can be handled only with complexity.” This kind of summed up my discussion with Shashank, a young entrepreneur who had met me with the investment term sheets he had received from an angel investor and a pre-seed stage fund.

In both the cases, he was perplexed by the sophisticated and nuanced instruments proposed by the investors, whereas he was expecting a simple and straight investment in common equity. For young entrepreneurs, such complex investment structures containing several ‘ifs’ and ‘whens’ can be baffling.

Investment structuring in VC funding: Textbooks would say that VCs use equity or equity related instruments or a combination of both while investing. Equity related instruments would include preference shares and convertible debt, which give the VCs some additional rights that help them to protect their investment.

For example, investing in preference shares would enable the investors to receive preferential cash flows at the time of exit. Convertibles, on the other hand, are used to adjust the investment valuation based on the performance of the venture. We took the data on Indian early stage ventures for the last 17 years and analysed the relative proportion of investment in straight equity and equity related instrument in each deal. The pattern was astonishing.

As if guided by a hidden hand, the average proportion of straight equity has consistently reduced from a level of 99.12 per cent during 1998-2000 to 15.85 per cent during 2013-15. That means, in recent years, for each and every dollar invested, a higher and higher share has been through structured equity instruments such as convertibles or preference shares.

Structuring and uncertainty: A possible reason is the increasing uncertainty in business environment, which makes early stage valuation difficult. The difficulty is compounded by the fact that the average age at which ventures get funding is becoming lower, which means VCs have very little information for taking decisions.

Convertibles help to postpone the hard valuation decision to a later date, thereby avoiding derailment of the deal because of valuation.

The proportion of straight equity also differed by industry. Industries having a high degree of uncertainty and intangible assets have a higher proportion of their investment through structured equity. For example, the average straight equity in E-Commerce start-ups is only 23.23 per cent, whereas in the case of IT & ITeS sector it is 32.34 per cent. The business model of IT & ITeS is more stable and proven as compared to that of E-commerce. Manufacturing, with low uncertainty, has the highest percentage of investment in straight equity (77.86 per cent).

Why do the investors prefer structured equity? Like they say, the proof of the pudding is in the eating. Has structured equity delivered on what matters to the investors, viz., returns? To investigate this, we calculated the returns from various venture investments since 1998. Investments that have used structured equity have given better returns as compared to that of straight equity.

In summary, my message to young entrepreneurs is this. Asking for simple and straight equity from VCs would be akin to swimming against the tide. Having tasted blood in terms of better returns, the VCs are going to increasingly deploy sophisticated structures in their investments. Industries with higher uncertainty would have a higher degree of structuring. Rather than being confounded by the complexity, entrepreneurs should turn it to their advantage. To quote Paulo Coelho, “When you want something, all the universe conspires in helping you achieve it.”

The writer is Professor, Department of Management Studies, IIT-M

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