Advisory on how start-ups should raise capital

Start-ups generally do not get money from banks (lending), only from shareholders (equity). Banks don’t lend money to finance projects

Start-ups generally do not get money from banks (lending), only from shareholders (equity). Banks don’t lend money to finance projects with no short term revenue generation. So we would focus on shareholders.

Over the last few years, the Indian start-up ecosystem has seen more and more funds being invested (over $13 billion was invested in 2018), and we expect this trend to continue in the foreseeable future.

The lifeline of any start-up is accessibility to a consistent flow of capital. Throughout a company’s life, they raise multiple rounds of funding to grow into a thriving, profitable business.

The Covid-19 crisis

Although the year started off well for startups and investors alike, the outbreak of novel coronavirus or COVID-19 soon dampened their spirits. With many sectors coming to a near halt, budding ventures began anticipating the worst – a severe liquidity crunch. As it turns out, their fears were justified. Public markets are crashing and venture capital funds have become extremely cautious towards their spending. Deep-pocketed global investors, too, have decided to put off some large deals for the deals for the time being. But while the overall scenario looks grim right now, let us see how the pandemic is impacting India’s startup funding scenario.

The need for financing and how the present scenario has impacted it

External funding is suited for start-ups looking to grow at a rapid pace. Start-ups generating profits may also need external funding to fuel their growth, as they are generally bootstrapping, funding is required to capture mass market. In this process, ownership and control come secondary for the founders, the investors of early stage companies would generally ask for majority stake, the belief is to own a small piece of a big outcome. This kind of funding also bring in a lot of experience from the investors and also the discipline in the company, which a lot of start-ups lack.

However, Startup funding for March 2020 dropped by over 50% as compared to the previous month, reveals data from Venture Intelligence. The startup data tracker reported that Indian startups managed to raise only $354 million across 34 deals, down from $714 million secured in February across 46 deals. At $1.74 billion (across 126 deals), startups also saw a 22% year-on-year decline in investments for the first quarter of 2020. The numbers reflect a significant slowdown in funding activities, primarily caused by a sluggish economy coupled with the ongoing nationwide lockdown.

India’s revised FDI policy likely to hurt startup investments The Government of India has recently tweaked its Foreign Direct Investment (FDI) policy in a bid to limit “opportunistic takeovers/acquisitions of Indian companies” amidst the pandemic. As per the revised guidelines, any investor of a nation that shares land borders with India will now require government approval for making any investment in India.

Opportunities amid Covid crisis

The COVID-19 crisis has brought about a significant change within the startup investment patterns. Venture capital firms are shifting their focus from tech-centric startups to the ones operating in sectors such as FMCG, online grocery delivery, home entertainment, healthcare etc. Apart from that, startups in EdTech, FinTech and cyber security have witnessed a huge surge in user demand, which in turn is luring investors. Also, the government itself is offering Indian startups $130K to develop an encrypted video conferencing solution which is capable of working on multiple platforms.

The pandemic has undoubtedly affected the startup funding scenario in India, but it has also created new opportunities for startups that can adapt to the current environment. Some companies are already showing trend-defying growth, which is giving a ray of hope to VCs and angel investors.

While it is too early to gauge the long-term impact of coronavirus, we can expect a positive turn towards the end of the year. However, in order to achieve that, a concerted effort is required from the government along with VCs and corporates.

How the present scenario has presented new opportunities

There are a large number of companies which are making significant product pivots or adapting their engagement model, successfully, to account for the new scale of remote work. In contrast, IT Services, consumer electronics, and advertising are facing extremely difficult times for raising capital as demand for their products falters in the coronavirus economy.

Most companies are now opting to partner with accelerators, universities and venture incubators, in addition to applying for certain government schemes like the U.S. government-backed Paycheck Protection Program loans (a component of the March 2020 CARES Act) implemented in the United States with a view to protecting companies from such downfalls. By taking advantage of investors such as accelerators, founders receive more than just money. They often get legal, finance, HR, PR, and recruiting help for free. This not only helps extend their cash flow but also allows them to focus on selling the existing solutions or pivoting their products to reach new customers and bring them on board remotely instead of face-to-face.

Successful founders have rearranged their company’s story to demonstrate exactly how they have extended the runway, managed productivity and closed sales with a relevant product during such trying economic times. They are leading the conversation with a common narrative, which is that ”Our product is now a critical must-have in the new normal” and have the sales to back this claim by necessitating the undeniable nee for their product. Annual recurring revenue, annual contract value and customer referrals are still very important, but they are not the leading indicator for VCs today.

Finally, these founders understand that funding rounds are historically discounted by 10%-25% during economic downturns and are adjusting valuations and expectations from the start. This only accelerates the investment conversation further.


So when should a start-up raise capital?

Start-ups should go for funding when they are confident about their product and about their business model. Once the start-up is clear on its offerings and the target market, it is much easier to convince investors. Start-ups should run their business on a bootstrap model for as long as they can, so the valuation is as high as possible with the limited internal funding available from promoters / friends / family. Moreover, this gives the founding team the sense of discipline the investors would like to see once they are willing to invest in the company.

Once the offering is identified along with a sustainable business model, founders can approach angel investors to build the product team, and validate the product-solution fit with initial set of customers. Sometimes, a start-up changes its direction on advice from angel investors and is forced to fold up, only because the founder raised capital too early.

What does an investor expect from a start-up?

The general criteria of investment: team + opportunity + business model

Team: risk of execution

One of the most important indicators of a start up’s success is the founding team.
Investors, when making a judgement call about a founding team, look at the following:
  • Size of the founder team
  • Balance of different skillsets, personalities and backgrounds among the founders
  • Alignment of interests and incentives among the parties involved and
  • Previous experience building a business - including failures
Investors want to make sure that the team has complementary skill sets which would give the start-up a platform to succeed. An ideal team would have three to four members and specialists in their respective fields.

Moreover, investors like to focus on teams rather than ideas because a good team can pivot. Investing in a good team can yield better returns than a ground-breaking idea with a weak team. Twitter is one example of a successful pivot. Originally, the company was Odeo, focusing on podcasts. As soon as Odeo realized that iTunes is their biggest competitor and they would not be able to compete against a giant like Apple, they pivoted to micro-blogging and became what we know today as Twitter.

Opportunity: vision and promise
  • Investors want the start-up to demonstrate that there’s a big market for their offering, and big money being spent by the consumers. It is necessary to make sure that the market has potential to support multiple players and cannot be turned into a monopoly.
  • Investors want to see how the start-up’s offering is different from prevailing in the market, a product or service that would be attractive to the end consumers. A business should have an element that is unique to the company, like an idea or vendors or the data bank etc.
  • Keeping emerging megatrends in mind is very necessary as investors want to see that the company is ready for the future, with a good lifetime, like adoption of new technologies / pivoting to align with customer preferences.
Business Model: smart and wise
  • Investors want to see how the company is a good fit for their investment philosophy.
  • Start-ups with good opportunities to achieve future profits in the range of 30% annually are preferred.
  • A good business model should address the following:
  1. Targeted audience: Targeting a wide audience won’t allow business to hone in on customers who truly need and want the product or service. Instead, when creating the business model, narrow the audience down to two or three detailed buyer personas. Outline each persona’s demographics, common challenges and the solutions the start-up will offer.
  2. Established business processes: A start-up needs to have an understanding of the activities required to make the business model work.
  3. Key business resources: Resources needed to carry out daily processes, finding new customers and reaching business goals should be clear and well established.
  4. A strong value proposition: An innovative service, revolutionary product or a new twist on an old favourites.
  5. Key business partners: No business can function properly without key partners that contribute to the business’s ability to serve customers.
  6. A robust demand generation strategy: A strategy that builds interest in the business, generates leads and is designed to close sales.
  7. Leave room for innovation: When launching a company and developing a business model, the business plan is based on many assumptions. For this reason, it’s important to leave room for future innovations and the ability to pivot.


Different stages of start-ups investors typically invest at:

Start-ups raise funding in different phases. Each round attracts different types of investors, with different expectations and expertise, and each subsequent round generally raises a higher amount. 

Angel investors: Early stages companies who need external funding support to create a commercially viable product / service out of an idea go for such kind of funding.

Pre-seed / Seed: Investors at this stage are often the first institutional capital into companies. At this stage companies are using the investment to build a product and team, launch the offering in the market and find match the product with the right end consumers.

Series A / Series B: Companies at this stage have a commercially viable offering ready, which has been launched in the market, and the target audience has been identified. Companies have a clearly defined roadmap and strategy at this stage, and are looking for exponential growth.

Series C and later: Scaling of the business is the main objective of Series C and later. Companies wanting to take their business international or invest in a new range of offerings go for this stage of funding.

Conclusion

Companies need market intelligence if they need to stay ahead and remain competitive in the industry. From unicorns such as Bigbasket, Swiggy, and Zomato, to some of the early-stage ones, startups from various sectors have managed to get the attention of investors and raised funds under the present scenario. The thing to keep in mind is to focus on making their new existing product or service best in the market and not losing focus from the end goal. This is what has determined the success of many FMCG and healthcare startups under the present situation. The market is still very much open if the startup simply does not lose track of where the demand has shifted at present.