Improving the VC capital structure

The venture capital scene raises funds from private investors that expect their investments to be returned with capital gains after between about eight to twelve years. But many entrepreneurs and some venture capitalists criticise this capital structure as it may cause VCs to rush into projects and in the worst case, sell investments premature and thereby hinder the start-up’s development. 

Among the many reasons that venture capitalist state for the failure of their investments, most put the blame on start-ups. However, Mahesh Murthy, co-founder of Seedfund, Indias best-performing VC fund, notes that “the VC fund structure simply isn’t good for startups – especially in emerging economies like India.”

Venture capitalists raising money have about three years to invest it in start-ups and then another five to eight years to grow the companies and exit them, potentially via an IPO. However, going public within such a short time frame after a start-up’s launch is challenging. All tech giants that exist today required much longer than eight years to go public.

“So if you’re a fund that comes in at the start of a business and does all the hard work of finding the opportunity and promoters, helping them build their team and business, guiding them through thick and thin, and then growing them past their rivals to profitability and leadership – then you simply can’t get the benefit of staying till the end,” says Murthy on techinasia.com.

When investors start to expect identifiable results in about the fifth year, they might force companies to invest in not required activities such as a TV marketing campaigns or an undesired merger with another portfolio company. They may also force the sale of the firm to anyone paying a decent price or demand the VC fund to provide an up-round to increase the start-up’s valuation.

While the limited partners believe that their investments are doing well, ventures may, in fact, be left with new masters, an inappropriate valuation, and higher expenses. In the worst case, companies not ready for an exit may just be dropped and cannot achieve their full potential.

Mahesh Murthy says that the eight and ten-year structure should be dropped and replaced by 20-year plus fund structures that suit the development of business more. Investors are required to be more patient and investors that demand quick returns should see that early stage VC is not the right investment for them.