05 Jan 2016 20:00 IST

When investors intervene in a start-up's business

Investors claim to be hands off, but don’t hesitate to steer a firm’s course

How and why are investors getting start-ups to close down unrelated diversifications and getting them to focus on core areas?

Let us first look at diversification of investment.

Diversification of investment, whether by an individual or a start-up company, helps reduce risk by putting resources in different investments that have different risk-reward profiles.

If one of these investments doesn’t do well, its impact on the overall portfolio will be reduced through diversification. But the downside to this strategy is that the rewards too are proportionately reduced.

Diversification or focus

In the early stages of a start-up, especially when the market itself in a growth phase, putting resources in multiple areas makes sense. However, when you are on to something that works, putting all one’s resources in that one idea and growing it, seems sensible and appropriate.

In an uncertain space, many investors, especially in the initial stages of the Internet boom, encouraged their investee companies to look at multiple opportunities. For example, a Web start-up in the retail space may look at Web stores, a larger online marketplace and other models, to begin with. But as it goes along, it makes sense to focus on the specific area where it gains the most traction.

Essentials of business

Coming up with new ideas and building new, simple products, is the easy part of start-ups. Unfortunately, developing new solutions is not what creates a lot of value — bringing it to other people is what does.

And in order to make money, after you have built a great team and found a product/market fit, you must focus and take the product or solution forward.

From this perspective, it makes sense that investors now want investee companies in the Internet space to build focussed businesses, which is where the value lies.

The early days (of diversification) are over and now reality is coming back slowly — business is not about eyeballs and footfalls but about making money through value creation.

Are investors really as hands off as they claim to be?

Looking at the Housing.com instance, where investors threw out founder and CEO Rahul Yadav, this claim seems dubious.

Investors take investment calls based on the attractiveness of the space, credentials of the promoters, their evaluation of the business plan and, finally, their evaluation of how the business can generate value, and hence, good valuations at the time of an exit.

Most investors have representations on the Board and restrict themselves to policy decisions and setting the direction of the company. They don’t interfere with the day-to-day running of the business and leave that to the promoters.

But this isn’t always the case. It depends on the investors’ individual styles and competencies. There are those investors (who have had earlier stints in operating roles) who take pride in their execution / operational abilities and are, therefore, more hands on. Then there are others who do not interfere at all.

I was lucky — all my investors haven’t interfered too much in the running of the business.

However, most times, when targets and valuation expectations are not met, investors do start poking around in operations.

Normally, the really good investors don’t do that, but play a supporting role. And just as well, because very often, the company and its employees suffer when there is a direct confrontation, as in the Housing.com case.

The exit of the promoter, as a result of a clash with the investor, took its toll, and the company lost its leadership position in the housing market. This reflects on the investment, and no investor wants that. However, in some cases, such intervention becomes inevitable, especially if the promoter starts working at cross-purposes with the original vision of the investors and the company.