by Mark Sherman, San Mateo, CA
and Carl Stjernfeldt, Wellesley, MA

Introduction

At Battery we are firm believers that many creative, entrepreneurial, and driven people reside in locations other than Boston and San Francisco. Early in our history we went on airplanes and traveled to locations less frequented by other VCs. This strategy turned out well, with some of our most successful deals being based in locations such as Austin (SigmaTel public in 2003) Pittsburgh (FORE public in 1994), Boca Raton (Qtera sold to Nortel for $3B in 1999). Battery has also made a number of investments in Europe and Israel.

During the last couple of years this theory has been further extended to the two leading emerging markets in the world, China and India. Besides having two very large home markets, companies in India and China have shown themselves to be able to effectively compete in the international marketplace. In many ways we can compare what Israel did for security and wireless to what we are seeing from India (software and services) and China (semiconductors and components). In addition, we are moving towards a global marketplace where the location of manufacturing and design can be separated from the customer location, supported by more efficient communications methods.

It’s also interesting to look specifically at the end consumer requirements around wireless. Not only are the Asian and European customers in general significantly more advanced cell phone users, but the Indian and Chinese markets are also exploding. Overall we firmly believe that in order to be a significant VC in the next decade, you will have to create and execute a strategy towards China and India.

Background

India GDP has been on a very impressive growth curve in the last decade, and this even though the population continues to increase. Even more impressive is the government’s focus on information technology infrastructure, especially telecom. India clearly views telecom infrastructure as a competitive weapon in the global marketplace. Today there are approximately 50 million wireless subscribers in India, and most people predict this number to be close to 100 million within two years, and most likely to reach 200 million before the growth curve will level off. In addition, the Indian government has a very ambitious broadband initiative that is designed to yield 20 million broadband subscribers before the year 2010.

India also has an advanced educational system, graduating 100,000 IT professionals each year, and with a very large number of elite level students. A graduate from one of the IIT schools can easily compete in, if not dominate, the global market place. In addition to academic schooling, the last decade of foreign investment has also created a large, well educated middle management group. The combination of increasing GDP, an expanding middle class, a successful service oriented business market, and a desire to adopt new technology has led to a significant domestic market for Indian software and communications equipment manufacturers.

Specifically, there are two markets Battery has focused on. The first is outsourced services. While the umbrella term for the business process outsourcing (BPO) market is “hot,” we believe that there are many subsegments within BPO that are worthy of this attention. An example is the outsourced software development services model. As in many India services related companies, labor arbitrage creates pricing opportunities to get customers’ attention. However, we strongly believe that compelling USA or European go-to-market teams and a commitment to operational excellence are the key determinants of long-term success. In the case of outsourced software development services, it has been deep domain knowledge and engineering processes that have allowed these vendors (Aztec, Persistent, Symphony and many others) to develop sizable sustainable businesses. Additionally, they have been able to grow up the value chain from lower level software engineering tasks (documentation, testing, localization) to sustaining engineering, designing planning and potentially into product management planning.

The second area is telecommunications infrastructure gear. We are in a very interesting position where the requirements in India are significantly more stringent than for most US based carriers. Because India has the luxury of skipping a whole generation of equipment by going right to the IP centric, converged network architecture, there is little legacy equipment with which to contend. Therefore, if you can satisfy an Indian carrier's requirements it’s highly likely you can compete very aggressively in the global market. Large tier-one equipment providers have caught on to this trend, and they are actively pursuing OEM relationships with equipment providers in India. In addition, these OEMs are in a bind. They are being asked by their customers (the carriers) to have a complete product line and provide ever more integration and architectural work. These broad product lines are very expensive to develop and keep up to date. As such, the OEMs can work with Indian telecommunications infrastructure companies, which can satisfy the carriers’ requirements at prices not possible with US-based engineers.

The Indian entrepreneurial market and challenges of investing into it

In order to have a vibrant entrepreneurial market (either a regional cluster like Silicon Valley or Route 128, or a whole country), a few things have to be in place:

1. Willingness to invest capital in risky businesses,
2. rule of law to support validity of contracts,
3. an entrepreneurial mindset with the population (which mainly means the stigma of failure is not too severe),
4. an educational infrastructure to teach basic concepts as well as to spark creative new ideas,
5. large incumbent organizations (to develop younger managers and create an employment backstop for failed entrepreneurs),
6. a supportive capital market or interest from Global 2000 organizations to buy these companies, a way for investors to exit their investments in a liquid currency, and
7. sufficient infrastructure in the form of technology and service providers, and entrepreneurial role models.

India traditionally had all of the above except the role models. Recently the combination of domestic successes (the ~$10B market capitalized Wipro is said to have created 30 other CEOs) and returning successful entrepreneurs primarily from the US have combined to create a group of risk takers who are very familiar with the start-up environment and how to be successful in it. Therefore we feel comfortable that the entrepreneurial scene is India is rapidly expanding and will soon rival that of the US or Israel in technology.

There are a number of challenges to be addressed by a US VC firm entering India. We will not discuss these in detail since there have been many papers written about this subject, but here are some of the highlights:

Corporate governance: Slowly the Indian market is becoming comfortable with the notion of corporate governance with majority voting provisions. Previously most investor agreements were written so that all investors had blocking rights to all material transactions. In addition, it was until recently very complicated to put a company into bankruptcy.

Legal infrastructure: Many of the legal issues we resolved long ago in the US are still open for debate in India, especially around founder equity agreements and control provisions. India’s legal system is based on the British case system, so the legal recourse process is very similar to that in the US or the UK. However, the actual court process is significantly slower than in the US, and the applicable library of cases relevant to entrepreneurial companies is significantly smaller. In order to provide an additional layer of protection, many investors are choosing to create an intermediate entity in a third country, such as Mauritius or Cayman Islands. This may also have significant tax benefits.

Preferred Shares: The notion of Preferred shares is not acceptable according to Indian law. However, many law firms have agreed upon the OCCPS (Optionally Convertible Cumulative Preference Shares) as a structure that provides an investor with many of the same benefits of Preferred shares while adhering to Indian law.

Exit limitations: The Indian stock market is quite active, many would even say too active. That is, it is fairly “easy” to go public, but it’s quite hard to get analyst coverage and remain a valid public company with significant trading volume. One advantage is the ability to create an ADR (Alternative Depository Record), which is an instrument that can be easily traded on a US stock exchange.

Currency hedging: An additional level of complexity when making direct investments into India that is not encountered in US based deals is the fluctuation of the Indian Rupee. Most VC investors are not used to, nor have extensive knowledge of and experience in currency hedging and protection.

Accounting: As in any non-GAAP based economy, it is hard to make an investment without a deep understanding of the local accounting standards. However, one advantage of the Indian market is that many management team members have worked in the US or for US companies, and hence have a good understanding of GAAP accounting rules.

Battery’s plans to enter into India

Based on the above discussion, we are committed to participating in the Indian economy in an aggressive way. Currently we have established a consulting relationship with Silicon Valley Bank and are working with them closely, particularly in their Bangalore operation. We are in the process of establishing an advisory board, and we are actively involved with The Indus Entrepreneurs (TiE) and Indian Venture Capital Association (IVCA). In addition, we have recently recruited a Senior Associate who will be focused on deal generation in India. Lastly, since nothing beats first hand interactions with the entrepreneurs and the marketplace, Battery is committed to be on the ground in India on a regular basis.

Late last year we also closed our first Indian investment, Tejas Networks, a Bangalore-based telecommunications infrastructure equipment provider that is pioneering a new business model. They will sell direct within India and compete internationally through OEM relationships. Besides having a very strong product line and a proven solution with more than 2,500 deployed boxes in customer networks, Tejas has an experienced management team. Many of the team members have also worked in the US, worked for US companies in India, or been educated in the US. Lastly, the original founder of the company was Desh Deshpande, founder and CEO of Cascade and Sycamore. Both were very successful companies and extraordinary investments. We are very excited to have our first deal in India be such a strong performer.

Please do not hesitate to contact us if you are an Indian entrepreneur and are looking for venture capital from a firm that is committed to India and the tremendous opportunities that exist there. If you have a more software and services centric business, please contact Mark Sherman, and if your plan is more communications or components centric business, please contact Carl Stjernfeldt .