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I have often been asked about startup funding by entrepreneurs. There seems to be a lot of myths surrounding the subject, so let me pen down some of my experience.
Pre-requisites of startup funding
Gone are the days where you can get funded based on an idea. In order to secure funding you must establish the feasibility of your idea through proper planning and implementation. You must have a prototype or a minimum viable product. You should also establish the proof of concept of your business before you qualify for funding.
The ground rules of startup funding
- Firstly, not all businesses are fundable – A business must satisfy a certain set of criteria before it qualifies for funding. A business is only fundable from an investor’s point of view if it has the potential to scale up and give exponential returns.
- Secondly, you must remember that funding is not an indicator of success – Irrespective of the impression that you might get from the news and media. Funding is just a stepping stone. Many businesses around us have grown without any funding. So funding might be a need in some cases, but it’s not an absolute necessity.
- The business should be self-sustainable – The primary source of your funds should be your paying customers i.e. your business should generate enough revenues and profits to fund the growth and expansion. Only in the case that this is not possible or there is a specific need for additional funds then should you look for funding.
Reasons why you should look for funding
- Scale up your operations – One of the most prominent reasons for funding is to scale up your operations, for expansion and achieve economies of scale. For example, you have already started a business and successfully implemented your idea, and it’s running well. Now you may want to scale up your operations or expand your presence. This is the point you should definitely consider funding.
- Establish a competitive advantage – The next reason is to establish a competitive advantage over your competition and quickly acquire a substantial market share. Let’s take an example – in the case of an internet or app business, the user traction and market penetration is a must. Getting users organically might take a lot of time and your competitors may take advantage of the situation. So, to get a large number of users quickly, you would need funding. You must have seen a lot of startups giving out promotions, discounts, and incentives at the early phase of their business. This is primarily to gain market share and a dominant market position.
- Fund your short term operational expenses – The third reason is to fund your short term operational expenses or working capital. For example – a small manufacturing firm suddenly receives a large order. To fund the sudden spike in production, funds will be required for additional inventory and wages. Once the order is fulfilled and paid for, the funds can be paid back.
- Research and development – In very few specific cases, depending on the nature of the business, the business model might demand a large gestation period or extensive research and development. For these businesses, it is imperative to get funding from the start without which the business cannot be set up. For example – any custom manufactured IoT device would require software development as well as hardware customization. Both of which are expensive and time-consuming. It is going to cost a lot of money just to get the initial batch of products to test the market and would definitely require external funding. This kind of funding is only applicable if the product is unique and innovative.
Apart from these reasons and leaving very few special-case exceptions, you would struggle to justify your funding need. Do not get funding because it is cool or it’s fashionable. Ensure that you create a strong foundation for the business before looking for funding. Seeking funds for the wrong reasons is clearly a recipe for disaster.
Forms startup funding
- Equity investment – This is definitely the most popular and most talked-about avenue for startup funding. These investments are done in lieu of shares or equity in your startup. The shares given out can either be common stocks or preferred stocks.
- Debt investment – This would have a repayment timeline and incur an interest rate. Debt investments are primarily in the form of long term loans (personal or commercial) and short term loans in the form of invoice debts and working capital loans.
- Royalty based investment – This is a very interesting mode of funding. In lieu of financial funding, you pay the investors a structured royalty which is a portion of the sales. The royalty may be of a limited timeline, variable rate, or perpetuity based on the investment agreement.
- Convertible bonds and convertible equity – This is another form of funding. Under this model, the stakeholders would have an option to interchange between debt and equity investment based on pre-agreed terms and timelines.
In reality, investments can either be purely in one of these forms or may be structured as a combination of multiple forms. It is important to understand the funding structure stated in your term sheet and the advantages and disadvantages it may have for your business. For example, in the case of royalties and debt investment you will have a regular cash outflow which might be a hindrance to future growth. In the case of equity, you must be prepared to give out a substantial portion of the equity over several phases of funding to the extent that you might not have the controlling share in your own company.
Sources of funding
- Bootstrapping – I always recommend that you start with bootstrapping. Bootstrapping is when you put your own money or borrow from friends and family to set up your business. Bootstrapping inculcates the entrepreneurial discipline and financial responsibility to run a lean business.
- Crowdfunding – Crowdfunding is also an option where you can raise funds through crowdfunding platforms like Kickstarter.
- Startup competitions – Participating and winning Startup competitions can also help you to accumulate some funds along with gaining some credentials and as well as getting some media mentions.
- Incubators and accelerators – Then we have startup platforms like incubators and accelerators. These usually play a role in the very early stage of your business primarily pre-revenue. Accelerators and incubators support the startups with a small amount of funding, mentorship, networking opportunities, resources, and workspaces.
- Government programs – You should also research the government programs like subsidies and grants that are available for your business sector and ensure you understand the parameters to qualify for these.
- Equity investors – The third source of funding is from equity investors. Under this category, you have angel investors who invest their own money and Venture Capital firms, who manage funds aimed towards specific startup sectors and stages. For mature businesses there are Private Equity or PE firms.
- Debt investors – The fourth source of funding is debt investors which are usually banks and commercial institutions. The crudest form of debt funding is through credit cards. I have interacted with a lot of founders who actually funded their initial business expenses through credit cards. I would not suggest this unless it’s a dire necessity. Because credit cards tend to have extremely high-interest rates along with the personal liability to pay back. The second form of debt funding is personal loans. You can get a personal loan without a business plan. Personal loans would also have a personal liability to pay back and interest rates are comparatively higher than commercial loans. This brings me to the next form of debt i.e. commercial loans. This is the most popular form of debt investment for businesses. Unfortunately, commercial loans from banks and lending institutions are very difficult for a startup and usually require collateral.
The different stages of equity-based funding
- Inception stage – The inception stage is primarily focused on building the prototype or the minimum viable product and validating the business concept. It is almost impossible to raise funds at this stage unless you have a proven entrepreneurial record of creating a large business. So, I would suggest that you bootstrap during the inception stage.
- Seed stage – Once you have established the feasibility of the business concept and created considerable traction for your business, it is now suitable for the seed stage. At this stage, the investors would be expecting a return of 15 to 20 times their investment over a period of 5 to 7 years. The seed stage is focused on building the core team, product optimization, and exploring avenues for monetization.
- Early-stage – Once you have created the footprint in the market the business qualifies for early-stage investment. An early-stage investor usually looks at a return of 10 to 15 times. Early-stage startup funding is primarily focused on business expansion and increasing customer traction.
- Growth and expansion stages – Once the business has established a solid market position, and is at a point of influx, the investment stages that follow are growth and expansion stages. The core focus of these phases is the business expansion and scaling up. For these phases, investors usually expect 5 to 10 times returns.
- Bridge or exit stage – The bridge or exit stage is usually of very large transactions and for companies with substantial valuation. These phases are focused on inorganic growth, mergers, buyouts, acquisitions, and exit preparation for the business. During this phase investors usually look for a 3 to 5 times return on the capital invested.
As you can see the expected return for the investment gets lower as the business grows. This is primarily because the risk is reduced as the business matures. As the business grows bigger it becomes more stable and sustainable. So the earlier you raise funding the more equity you would need to shell out.
Let’s have a look at the investment ranges for different categories of investors. This chart will give you an indication of the quantum of funds invested by each category of equity investors. Please note these numbers are just an approximation and may vary case to case.
The process of startup funding
Before we dive into the process of funding, let us understand what investors look for before investing. What are the investment criteria from the investors’ point of view that drives an investment?
- Idea and its potential – The starting point is definitely the idea and its potential. The idea must be feasible, scalable, unique, and innovative and must have a market opportunity.
- Business – The investors also focus on the business including the credibility and credential of the core team and their ability to execute the idea. The business model and revenue model along with your positioning, pricing, and cost structures are equally important.
- Future potential – Investors not only focus on the present but also the future potential of the business which can be showcased through a well-drafted business plan which includes the business strategies, the usage of funds, value proposition, and the exit strategy.
- Return on investment – Along with all of these, the most important point that the investors look for is the return on investment. It is important that the investors feel confident in the investment proposition and are convinced that they will be able to earn back their investment.
The essential components of your pitch
Before approaching investors for funding, you must prepare your pitch.
The essential components of your pitch include a comprehensive business plan with projections of 5 years, along with investment offerings and estimated valuations.
You can see a video about creating a business plan from my YouTube channel below:
Along with the business plan, you must have a well-designed investor deck which is a presentation of around 15 to 25 slides summarizing the business plan. The investor presentation comes in handy when you present in front of the investors.
Your pitch also needs to have a well-crafted executive summary also called a teaser summary. This is a 2-page document summarizing the overall business plan. Teaser documents are usually used to initiate formal communication with investors.
You should also prepare an elevator pitch which is a 5 minute verbal summary of your business idea and the plan. It is called an elevator pitch because you should be able to pitch to someone over an elevator ride. The elevator pitch comes in very handy to pitch to investors when you meet them at events or conferences.
Essential Components of a Startup Pitch
You must spend adequate time and effort researching, creating and preparing the components of the pitch before approaching the investors.
If you need any professional help to create your business plan and pitch documents feel free to contact the team at BplanExperts.com. They have the experience of helping over 1600 startups across 80 countries. They will surely help you.
How do you approach investors?
Once you have the pitch along with its components ready you should start approaching investors. You can meet investors at startup events or competitions. You can also proactively reach out to investors by sending them emails with the teaser document and follow up for a meeting. You can also reach out to investment forums or investment networks or get referrals from mentors.
The fund seeking process can be time-consuming, difficult and challenging. You must understand that you will face a lot of rejection, but you will have to be relentless. Also, ensure that you balance your time between fund seeking and running your business because without a running business there is no chance of funding.
Understanding the investor’s psychology
It is also very important that you understand the investor psychology.
First is the investability of your business. Entrepreneurs are passionate as they want to change the world or solve a problem but don’t expect the investors to be as passionate as you are about your business. The investors would invest in your startup primarily to make money. So, it is important that your business offers a lucrative investment opportunity.
Investors usually carry a portfolio of startups. So, it is natural for them to fund companies that are complementary to the startups already in their portfolio. This is because the startups can complement each other’s businesses. For example, if I have an eCommerce venture in my portfolio, investing in a logistic startup or a payment gateway startup would make a lot of sense as they can be integrated. Plus, there is always a possibility of a future merger and consolidation. So do your research into the investor’s portfolio before pitching.
Investors tend to invest in a hot trend. You will see whenever an innovative business pops up, a lot of similar businesses come up within a short period of time. This is based on the phenomenon called the economic pendulum.
So why do investors invest in similar businesses? If a major investor invests in a type of business, the other investor looks for their competition to fund. Primarily because the market is nascent so whoever executes properly gains the market share. Plus, similar businesses of scale with varied market reach are easy targets for acquisition which ensures an exit for the investor. For example Uber, Ola and TaxiforSure, which was acquired by Ola and then you have Oyo, Fab Hotels, and Treebo. If you know other such examples, mention them in the comments. I would love to know about them.
Investors look for a balance, a sweet spot on the competition scale. They avoid businesses that aim to create a completely new category. Because then the business would need to create awareness for the category, educate people, and then create awareness of the product. This in turn makes the job very difficult. They also avoid a highly saturated market, full of competition. The sweet spot lies in between. They look for an untapped market within an existing business category.
One of the things the investors hate to hear is the “market share syndrome”. Often entrepreneurs pitch from the viewpoint of market share. They say “The market is X billion and if we manage to get 1% market share we will have a company worth x million.” But, in reality, things don’t quite work that way. So, you should always avoid going down the market share route. The research you do for the market and its growth is solely to substantiate the business case.
Once you understand the psyche of the investor, you can optimize your pitch accordingly.
Things investors won’t tell you
Now here are some of the things that investors won’t tell you.
- You must understand that funding is a business transaction between the investors and the startup founders. Just like a startup would need funds from the investors, the investors are also eager to invest in lucrative startups. It is a symbiotic relationship. It has to be the right fit. So, you must ensure that you do your due diligence on the investors, their sources of funds, their management style, and the support system they offer before signing the deal.
- Do not raise more startup funding than what you require. Capital is expensive. Raising higher capital at an early stage means more equity to be diluted to the investors. And also, additional funds often result in unwise spending.
- Never raise money with an increased valuation. It might be tempting to do so. But, in subsequent rounds of funding inflated valuation will be normalized resulting in a down round. This makes the existing investors extremely unhappy and tarnishes the market reputation of the company. You might have seen that valuations of several unicorns were suddenly slashed down. If you remember, Flipkart was valued at 15 billion dollars in June 2015 but Morgan Stanley slashed its valuation to 5.37 billion dollars in 2017.
- When you raise funds, you are literally married to the investor. In subsequent rounds, if your existing investors do not re-invest, it gives out an indication that something is wrong. Other investors might think that the existing investors might know something which they don’t, so they are very cautious about investing in such a scenario.
- It’s not just about the money. You must understand that you as a founder must gel with the investor. Your vision and goals must be aligned. A lot of funded startups fail due to expectation mismatch between the founders and the investors.
- You must understand the responsibilities that come with startup funding. Managing investor relations, compliance, and reporting. All of these require additional time and effort. So, it is extremely important that you manage investor expectations and maintain transparent communication with your investors at any point in time.
I hope this article has helped you get an overview of startup funding. Feel free to check out my blog Arnab Ray’s Blog if you would like to know more about the startup ecosystem.
If you need any help with your business planning and funding, feel free to contact the team at Bplan Experts.
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Guest author: Arnab is an entrepreneur, management consultant, mentor and an early-stage investor, deeply involved in the startup ecosystem. Arnab is the CEO & Managing Director at Array Innovative Services Pvt. Ltd. His portfolio of ventures includes BPlan Experts, PresentationGFX, CrazyAboutStartups.com, Vezume, Array Consultancy Services, and Array MediaGraphics & Systems Apart from work he is a music enthusiast, avid traveler, foodie and out & out crazy about startups.