Colour of the Capital

It is the season of IPOs in our capital markets. I hope you guys have made some good gains on the listing pops that IPOs have been witnessing. However, do be cautious during such frenzied times. Because rationally which company insider (who are also being advised by savvy Investment Bankers) would want to leave such high returns on the table for new incoming investors. But let’s leave this discussion for another day when the music would have stopped, and we would have some time off from making this quick buck! For today I want to draw a parallel out of the IPO deal making process and share some observations for founders who are considering raising PE/VC capital.

During my investment banking days when we were running IPO deals, we used to often discuss about what is the ‘Colour of the Book’. This was a common phrase used by bankers to understand the nature of investors who were subscribing to an IPO deal (Called a book as technically it’s a ‘Book Building’ exercise). It enabled the bankers to get a sense of the quality and stability of the shareholding pattern. For example: Commitments from long term investors broadly indicated good support for the stock price post listing, higher participation from foreign hedge funds denoted something else whereas subscription from bank treasuries provided an altogether different outlook. Similarly, in the private capital markets, PE/VC investors exhibit a variety of nuanced colours that need to be understood by Founders before they partner with these investors on their enterprise building journey. So here are a few prominent hues that one would generally encounter:

• Growth at all costs

These are investors who seek growth irrespective of what costs get incurred to achieve that growth. They want a company to focus on hyper growth traction, viral user adoption or any kind of land grab strategy even if it requires overlooking short term aspects of business model sustainability or building faulty company culture while blitzscaling. The premise is to capture the market and then fine tune the commercial and softer aspects eventually. The hope being that the company has a better luck than this gentleman below :)

• Build optionality for the future

These are investors who believe in laying the foundation and building the rails for multiple products/services to flow over it to the customers in the future. Platform businesses that need to expand horizontally before going deeper vertically are well suited for this type of investor. However, Founders should find the right balance between growing the horizontal network and optimizing on unit economics so as to ensure business sustainability and longevity. This type of play also augments valuations positively as you can see below:

• Profits and cashflow is a must

Being a Chartered Accountant, I have grown up with the saying ‘Revenue is vanity, profit is sanity and cash is reality’ which would connect with this type of an investor. Here the emphasis is on sustainability of business model via free cash flow generation. This involves a plain vanilla approach towards business building with a focus on revenue generation, margin expansion and cash flow conversion to reinvest it back in the business for future growth. This approach is so boring that I didn’t even find a humorous graphic to support the point :p

• Focus and interest in particular sectors

These investors have multiple interests other than just financial parameters for making an investment. For a strategic investor it could be possible operational synergies with its existing business lines whereas for a Development Finance Institution it could be the mandate to support a particular strata or geography of the society. This also includes sector specialists who bring deep domain expertise to the table and get actively involved with portfolio companies. Something like this :)

To sum, there is no right or wrong type of capital. All of these types and many more have their role to play in the overall ecosystem. Each one’s prominence fluctuates based on market and business cycles. The point which is imperative is for founders to be clear on how they want to build their business and accordingly choose the appropriate colour of capital for it, rather than raise capital first and then face the song and dance of that particular type of capital. The perfect alignment between these colours of capital and the interests of the business is what should be a founder’s target north star!

Source of graphics: Lyrique Private Equity, Unsplash and the web in general.