Funding - when should startups take it, and what makes for 'smart money'

Each startup decision is governed by two questions – How Big and How Fast? That is, how big do we want the startup to become, and how fast do we want get there?

Not all startups are meant to grow big, or need to play the VC game, but founders need to have clarity on these questions early on.

Having worked with over 100 early-stage startups, I see most of them eager to raise funding from angel networks and VCs without having the right machinery in place, i.e. they look to raise funding too soon.

Venture Capital to grow Big and get there Fast

Before we go into when to raise funding, let us understand why should a startup raise external funding. Venture capital funding is suited for those looking to grow very big and get there as soon as possible. Startups generating profits may also need VC money to fuel their growth and capture a large market.

Ownership and control come secondary for the founders of such high growth startups as the belief is to own a small piece of a big outcome – potentially resulting in billions of dollars.

While many businesses have the potential to become big, not all types of businesses are suited for venture capitalists.

For example, a services business that delivers latest technology solutions such as Machine Learning (ML) is unlikely to receive VC funding to grow because of linearity of revenue growth.

On the other hand, there are many recently-funded startups that use ML as a part of their product to cater to a wider audience worldwide. VCs are looking for multi-fold returns from each startup within five to 10 years, thereby making speed of execution the most important factor.

When should startups raise funding?

Founders should fundraise as late as possible to give the startup a chance to survive the initial state of flux, and to know themselves and the business better. While this is not always possible due to financial constraints, I strongly urge founders to self-finance atleast the first three stages of achieving a product-market fit. Prasanna Krishnamoorthy outlines the four stages of product-market fit in this article.

The first two stages – founder-market fit and problem-value fit should be achieved without the need of external funding. Once the problem is identified along with a probable solution, founders can approach angel investors to build the product team, and validate the product-solution fit with initial set of customers.

Ideally, if the founding team can pool in finances, it would be suitable to avoid funding at the Seed / Pre-Series A / early stage, and go directly for a Series A round to have more equity, flexibility and control over the direction of the startup. I’ve seen a startup change its direction on advice from angel investors and fold up – all because the founder raised capital too early. In case of B2C startups, venture capital may be necessary right from the get-go to achieve 5-7 percent week-on-week growth rate.

One could use OKRs to know when to fundraise. For example, at a pre product-market fit startup, one needs to clearly articulate the objective of the fundraise followed by key results or milestones that will be achieved over an 18-24-month period.

The objective for an angel round could be to achieve a product-solution fit.

Following could be the key results:

• Build a product team that defines the problem and delivers a solution
• Acquire 5-10 customers in the same segment that face similar or the same problem
• Achieve NPS of ‘X’ or higher
• Calculate, deliver and showcase RoI to customers (this needs to be quantified)

Investors continuously monitor the progress of each startup to identify and separate the ‘best’ startups within their portfolio to concentrate their efforts on. Hence, meeting or exceeding the milestones for the round is crucial for the next round of funding.

Choosing the Investor

Over the last few years, the Indian startup ecosystem has seen more and more funds being invested (over $13 billion was invested in 2018), and I expect this trend to continue in the foreseeable future. As funds become available, valuations tend to increase at the early stages / Pre-Series A rounds, and this can potentially cause an issue for startups looking to raising next round of funding at higher valuations. In this article, I will not discuss valuations, but how much time it takes to fundraise and how much to fundraise.

Choosing an investor can be tricky – after all, a founder needs money to achieve milestones, but doesn’t want to add people (with certain powers) who don’t align with the founding team.

In the early stages, I’ve seen founders need money plus customer leads, while others who only want the money and minimum interference. I’ve seen many friends of founders come in as angel investors and subsequently join the team to grow the business.

I’ve also seen some founders take money from people who don’t understand the risk involved in investing in startups. These are risky investors who can get unreasonable overtime, and founders should avoid them at all costs. In all of this, it is worthy to note that money comes with strings attached. It is crucial to have clarity on the role of early-stage or angel investors along with expected financial returns and timeline as many startups have been exploited at this stage making them ‘un-fundable’ at a later stage.

The job of a startup investor – be it an angel or VC – is to pick winners. The job of the founder is to build a scalable business and is ultimately responsible for all decisions, including cash flow management, building a capable team, choosing the right investor, among others. Each founder must do due diligence on the investor including track record, domain expertise, strengths, limitations and alignment (ability to get along with the founders and the vision) before taking the money.

I believe founders who have scaled and exited startups are potentially good investors as they have gone through the journey as an entrepreneur and can provide valuable advice to the founder during challenging times, if the founder so desires. Founders who have built scalable businesses in the same domain/sector could be great investors to bring on board as they can help identifying areas where your product can be differentiated, hiring the team, and even closing customers or partners. Note that these are all value-add and a founder should look at an investor primarily to get money at the best possible terms in a minimum amount of time.

While there are many types of investors, one should look for an investor who can be trusted, shares the vision, and knows what it takes to build a scalable startup. Vaibhav Domkundwar from Better Capital says, “I’m a problem-solving investor and I don’t believe in telling the founder what to do and how to do it, but I’m available and actively involved to help the founder if she/he comes to me with a specific problem”.  

The founders need to have clarity and conviction on the type of startup they are building and onboard investors who believe in them and their vision.

(Disclaimer: The views and opinions expressed in this article are those of the author and do not necessarily reflect the views of YourStory.)