Ram Narayan

Emerging VC trends and what they mean for Canada?

By Ram Narayan

If Nike could outsource sneaker manufacturing to China, the same can be done with computer code. It’s a strategy that ensures venture capitalists (VCs) build and operate start-ups at a fraction of the cost of building them in the US, setting the stage for higher operating margins to be hardwired into their balance sheets from the start. The strategy is so powerful that a business plan requiring 40 US-based employees to develop a product and speed it to market can be re-written with just five employees in the US and the other 35 in India.

This trend started when the VCs began to outsource software development to access cheap engineering talent in countries like India. US start-ups are now being built entirely abroad — from product design to product development to quality control, and even, in some cases, to sales and marketing. For every employee in the US, you can have five in India and still maintain total control over the company’s intellectual property. With a strong CEO, CFO and a fistful of frequent fliers, an entire startup’s back-end operations can be located elsewhere, while the roots of the firm’s entrepreneurship, vision, funding and exit potential can remain within the US.

The timing of this shift toward building the bulk of tech start-ups abroad should not be underestimated. Not only has the world changed on a global geo-political and economic basis, but the economics of building companies, as opposed to just products, has changed as well. A company that requires $10-15 million in series ‘A’ funding in the US requires just $2-3 million in first-round funding in India. It’s not that products themselves can be built more cheaply abroad - the Nike argument for manufacturing internationally. It’s that entire companies can be shaped from the ground up to scale faster, reach international markets more quickly and ultimately improve operating margins in ways that traditional competitors never could.

In one year alone, new General Electric back-end operations were able to scale from zero employees to 18,000 based in India. The talent is that good, that available and that cheap! The location is significant for more than cost alone. As a jumping off point to sell into the Asian and European markets, India now represents a far more central location for product design, quality control and customer service than the US.

Many top-tier US and European VC firms are already funding such companies, often locating them in Bangalore, India. My discussion with CEOs of top tier VCs and investment banks in the US tells me several more VCs from the US are planning to enter India in the near future.

INDIA BOUND…..

LET’S LOOK AT HARD FACTS

It’s no longer just a matter of software development labs belonging to Microsoft, Motorola and Oracle sprouting up in these markets. July Systems, a wireless startup developing software for mobile operators, UTStarcom Inc and Xalted Networks, are perfect examples of how start-ups are flourishing in India. July — a private company funded with $8 million from Acer Technology Ventures, JumpstartUp Venture Fund, NeoCarta Ventures and Westbridge Capital Partners — is headquartered in Santa Clara, CA, but that is just in name only.

While US telecom spending has declined by more than 30% over the last two years, India’s spending has seen a remarkable increase, as has the spending of other countries in Asia. India’s capital expenditures are expected to soar to more than $100 billion in the next five years. Indian telcos are projected to spend $5 billion in 2003 alone, upgrading their networks with next-generation technology — the same technology that has already been oversold in the US.

NOT JUST EQUAL

Yet, this argument goes far beyond getting more bang for your buck, and the technologies go far beyond mere software. The engineering talent in India and China has now reached a level that’s on par with, if not better than, US engineering talent and the quality of the technologies being developed abroad is among the world’s best. In the software sector, for example, the highest standard that can be achieved is CMM Level 5. Of the 50 companies certified at this level, 37 are located in India. No wonder that Charter Venture Capital has located a large chunk of Cradle Technologies in India. Cradle, a next-generation chipless semiconductor company, has its headquarters in Mountain View CA, but it has built its technology development centre from the ground up in Pune, Maharashtra, India.

This experience has highlighted the fact that building a company entirely in the US is no longer pragmatic. It’s a hard lesson for VCs to learn, as they realize their own portfolio companies cannot compete with the UTStarcoms of the world. But it’s a lesson we must absorb as we fund and plan the next cycle of investments. Once certain hurdles in the Asian markets, especially India — such as transparency, market efficiency and exit hassles — are removed through legislation, the flight of tech start-ups from North America and Europe will be more pronounced. Even in the current environment, well-advised VCs are legally circumventing these obstacles through treaty shopping and structuring. Although repatriation of capital and capital appreciation by way of dividends, interest and royalties are freely allowed in most Asian countries including India, VCs would have to take some amount of local currency risk.

Now, what does this all mean for Canada? The bulk of VC funding for Canadian start-ups comes from the US. Given the goal of VCs to maximize their return on investment, it won’t be long before Canadian start-ups move their operations to Asia. In such an environment, how do we ensure that the R&D is carried out in Canada so that the benefit of this technology exploitation such as jobs and sustainable development remains in Canada?

The answer is simple. Timely availability of research money will be critical to ensure Canada maintains its competitive edge in the fast changing tech world. Governments therefore, will have to allocate a lot more research money to fuel the growth of tech start-ups in North America. Scientific R&D tax credits as a funding mechanism is of limited value in the initial stages of a start-up, which needs direct funding to meet operating costs. An effective mechanism would be to increase the allocations for agencies such as Technology Partnerships Canada and the Industrial Research Assistance Plan that specialize in financing start-ups engaged in R&D.

Ram Narayan is risk manager at Technology Partnerships Canada, an agency of Industry Canada.

The views and opinions in this article are those of its author and do not purport to convey in any manner whatsoever the views of any organization.