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The ultimate guide to raising funding for startups

Nupur Parik
18th May 2016
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India is witnessing the emergence of a very exciting and never-seen-before startup ecosystem. The growing number of players, increased focus on the sector and the heavy funding have increased the challenges for the startup world even further.

Therefore, it is pertinent for startups to be focussed and strategic in their approach and be equipped with a deeper understanding of market dynamics and economics of competition. In general, any new business has to face entry barriers like government policies, competition, and economies of scale to control fixed costs, product differentiation to withhold market etc.

But there are a few formidable obstacles that a budding entrepreneur has to face even before getting started. If we look around, most startups are owned by college graduates who, we can assume, would not have much capital to invest. For example, Housing.com was started by a group of IIT graduates, while Notesgen was started by Manak Gulati during his engineering days. As soon as plans are finalised on paper, funds are needed to turn them into reality. Also, these are brilliant minds with brilliant ideas, but not necessarily people with business sense or needed expertise.

Entry Barriers for start ups_YS

In the nascent stage of the business, every entrepreneur wonders about these questions:

When to raise money

There is no specific period after which a business needs to raise funds. The founders need to have set foot on the ground, figured out their plans and its feasibility, and spent some time in the market, studying trends and profiles. They should have a clear picture of the position of their product and identified their set of customers.

What is most important to raise funds is to be able to persuade the investors and convince them about the market fit and show actual growth.

Whom to raise money from

A company can raise finance in two forms – debt or equity.

Debt (convertible) – This kind of financing protects the investor. It is like a loan offered to the business with a principal amount, interest rate, and a maturity date at which principal and interest have to be repaid. The intention of this kind of funding is that it converts into equity when company does equity financing.

Equity – This kind of financing includes evaluating the company and fixing a share price and selling these shares to investors. This kind of financing involves more legal complexities and is thus not very popular in the initial rounds of funding.

Financing methods can be

Angel investors – Angel investors provide funding at initial stages of business. These investors operate in a friendlier way and provide smaller amount of funding. They would mostly not get very technical, and invest in the business if they have a good gut-feeling about it.

Venture capitalists – These investors come in when business grows beyond the innocent startup phase and starts generating revenues. These investors fund in huge amounts if convinced by business models, valuations and growth trends.

They come with expertise and vast industry knowledge and mostly invest for smaller windows with expectations of high returns.

Business incubators and accelerators - These programmes assist hundreds of startup businesses every year, giving a platform to make good connections with mentors, investors and other fellow startups. Incubators nurture the business, providing shelter tools and training and network to a business. Accelerators helps a stagnant business to run or take a giant leap.

Friends and family – This is the most reliable and least troublesome source of financing. If friends and family have spare cash, it can be taken at a low or no-interest-rate loan or even equity. This source of financing allows freedom of operation.

Crowdfunding – This type of funding is gaining popularity wherein the website allows businesses to pool small investments from a number of investors instead of forcing companies to look for a single investment. Examples are Wishberry and Ketto.

SME lending – Businesses can opt for unsecured or secured working capital loan offered by numerous micro-financing firms in market today. However, this option comes with a fixed monthly obligation and relatively higher interest rates.

 Grants – Businesses in certain lines of operation such as research and development should approach and enquire for government grants or aids. Various schemes are run by the government to promote these industries.

 Raising the first set of funds – the basics

This is the major hurdle startups comes cross. Businesses start generating costs way before revenues. Funds are required to set up office, pay rents, remunerations, bills etc. Finding investors is like finding water in a desert. An incredible idea or an extraordinary solution does not guarantee investor’s attention. What can be most frustrating is that investors hold the reins and have all the negotiating power.

When presenting their business plan to seed investors, it’s important for founders to make them feel very comfortable parking funds with the business. Startups need to focus and address these risk points

  1. Strong founder team – The founder team is the backbone to the idea execution. Any investor will have a lot of comfort if the business has a strong, qualified, and energetic founder team.
  2. Tested MVP (minimal viable product) – If the business idea requires additional technology or innovation to be commercialised, it adds an additional layer of risk to the project. Gathering insights from an MVP is often less expensive than using a product with more features which increase costs and risk in the case where the product fails, for example due to incorrect assumptions.
  3. Statuary compliances in place – All statuary requirement like patents, trademarks, needed licences etc., which might lead to delays or complications in future must be taken care of before approaching the investors to provide more comfort on this front.
  4. Opting for crowdfunding – This method of raising funds provides comfort to investors, and startups can leverage on the proof-of-concept mindset of investors.
  5. Realistic plans – Investors are mostly people holding industry experience and operating in the markets. It is important that the growth plans and exit plans are realistic and backed by authentic data and trends.
  6. Considering all funding channels – Crowdfunding, SME loans, venture capitalists, family and friends – all channels of funding should be well explored before making a decision.
  7. Exhaustive business strategy – The business plan should have covered all aspects including sales, marketing, legal, accounting, design, branding, management, recruitment etc.

How much funds to raise

Though any entrepreneur would want to raise as much money as possible, excess funds can have their own drawbacks. The business plan should be well-thought-out and calculated. The roadmap should have pre-decided milestones and fund requirement should be envisaged accordingly.

Excess funds come with higher restrictions, due diligence and investment terms. Also, if a company is seeking for more investments, it tends to inflate its valuations. This can get investments initially, but ends with a lot of pressure later when it is unable to meet its inflated valuation numbers. This can lead to a) either a cut down in valuations in the later stage, which can cause more damage to the business or b) not finding investors in next round of funding as the valuations might be 'too expensive' for them.

This is what happened in the case of Flipkart. In late February, Morgan Stanley, an investor in Flipkart, disclosed in a regulatory filing that it slashed the value of its holding in the online retailer by as much as 27 percent. This implies that Morgan Stanley currently now values Flipkart at $11 billion instead of $15 billion when it last raised cash. This was followed by Fidelity Strategic Advisors Growth and Valic Co (which also own Flipkart shares) marking down their holdings in the company by 27 percent and 13 percent, respectively. Such a negative market emotion is something no startup would want when it ventures out for funds.

Conclusion

A business needs to have a sound business model and realistic future plans ready before it plunges into the market. At this stage the business is most vulnerable. According to market statistics, nine out of 10 startups fail, because of not being able to withstand one or the other factors mentioned above.

It might appear fascinating to bootstrap and be the boss, but remaining without external funding for too long might lead to missing market opportunities. If a business wants to grow really fast, it would probably need outside sources of capital.

While the plethora of lending options may make it easier than ever to get started, responsible business owners should advance very cautiously and make wise financial decisions.

 

 

 

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