Raising the first funding isn’t the destination, it’s just the start of the journey
Every founder goes through the dilemma of ‘to raise or not to raise funds’. There are several examples in the industry where founders have chosen not to raise external funds and have still managed to do well, and there are businesses which have raised enormous amounts of funds to scale faster.
With a thriving start-up ecosystem in the country, founders today have much better access to funds than a decade ago. I am often asked by entrepreneurs about the different cycles of funding for a venture. While there are no hard and fast definitions, in my view, the funding paths of a start-up can be defined as self-funding/bootstrapping, friends and family funding, seed stage, early-stage, expansion stages, mezzaninepre-IPO leading onto an exit or an IPO.
Self-funding/bootstrapping is the first phase of the investment stages, when the founders invest their money to begin the start-up journey. On an average, I typically see that a founder has contributed at least Rs 10-15 lakh to their idea (around $ 25,000 in global context) before going to the next stage of investment. However, if you are a second-time entrepreneur or someone who has had a long professional career with high salary, you should be expected to put in at least Rs 50 lakhs and above (US$ 100,000). It is important for a founder to have ‘skin in the game’ if they plan on raising money from investors later. For this reason, it is important to have this round and keep it well documented, so the money put in by the investor is clearly shown as equity in the balance sheet.
During the friends and family phase of investing, you are reaching out to people close to you and asking them to put a portion of their life savings in your idea. Be careful. Many founders have burned bridges as they raised money from friends and family. Some of the common mistakes founders commit in this phase are to sell too much equity or sell the wrong kind of equity. Typically, this is the first external round of funding being raised by the founder and the size is around Rs 1–2 crore.
Checking out the investors
The seed stage of investing is the first phase of raising institutional capital. Usually, this round is sourced from professionals, angel investors, either individually or in an angel group. In most cases, angel investors were or still are founders of companies. Since angels have experience being a previous founder of a business, they can provide more than just capital. You should look for three things in an angel investor: wisdom (done it before), wealth (can help you in future rounds) and the will to work (make sales intros, spend time and be your bouncing board). This round generally allows one to raise around Rs 2–5 crore. Early-stage investing is your first round of venture capital. Usually, this begins and ends with a Series A. During this stage, you should expect to have a much more formal board, and your leadership team becomes more ‘professionalized’. Professionalization is a fancy word that means that your buddy, whom you hired as VP, could get fired and be replaced with a seasoned executive. A classic Series A raises between Rs 20–Rs 40 crore. If you made it to the expansion phase, which is post-Series A and into later rounds (Series B onwards), you have done well.
Very few companies make it to this stage. The expansion stage is where you are growing month over month. You have proven that you can scale your business. Valuations and committed capital vary wildly in this phase and are heavily negotiated. Your chances of survival are much higher, and you are on the path of success and achieving your dreams. However, the markets can change any time, especially in technology businesses, and you can easily become an acquisition target by a larger player in the same segment.
The mezzanine or pre-IPO round is the final raise before going public. In the mezzanine round, a company is valued over several hundred million. At this point, the company has hundreds of employees and is operating in more than one country. The company is starting to speak with investment banks, and the leadership team is working on filing documentation. Usually, if you were an early investor, you have been waiting for over 10 years to get to this stage and are more than ready to have a liquidity event—in this case, an IPO. As an early stage investor and founder, I think it is advisable to sell out before reaching this stage, unless, very early on, you realize that the company will be a unicorn, and assiduously work on to keep your stake in the business.
Banking on family and friends
In India, from 2014 to 2019, about 8,900–9,000 start-ups have been incepted, an overall base growing at 12–15 per cent year-on-year, as per Nasscom-Zinnov: Indian Tech Start-up Ecosystem6. The total funding received by start-ups in 2019 (Jan–Sep) was $4.4 billion. According to a Reserve Bank of India survey on start-ups, families and friends emerged as the primary source of funding. Of the 1,246 startups surveyed between November 2018 and April 2019, nearly 43 per cent of respondents said that families and friends were the largest source of funding, apart from own funds7.
Early investors don’t bet on ideas but on you, the founder. The first money you will raise especially if you are a first-time entrepreneur will be most likely from friends and family. The chance of your idea being a success is slim. Without a track-record, it would be difficult to convince an unknown investor to back you. Friends and family on the other hand, are the people who know you, trust you and believe in you. Make no mistakes—they aren’t backing your idea but backing you. Raising any amount of money is a challenge and huge responsibility but this becomes fraught with complications when you raise it from friends and family.
The start-up world is replete with unfortunate horror stories of friendships and families broken over bad investments. However, there are stories which are the anti-theses of this as well. If you have friends and family who will back your start-up, consider yourself fortunate. But be clear to them about the risks of the same. Explain to them the risk in detail. Unlike professional VCs, who should be left to find the risks, to friends and family you must be upfront. Explain to them that in this asset class, most fail and while you will do everything possible to do justice to their faith and investments, nothing is guaranteed.
People also invest because of trust. They see that the company is moving, that it’s growing and overall, their value is increasing. This model of taking small amounts of money from family and friends often works well. If one takes large sums from a few individuals, one would not have been able to extend the timeline so much and would have been forced to take decisions so that we could return the money faster.
Only raise money from those who can afford to lose that capital. This is the most vital rule. Often, friends and family, either out of emotional attachment or thinking it could be a jackpot, put in more capital than they should and when they lose big, the relationship is marred forever. Keep deal structures simple and despite it being a close relationship, employ lawyers to draft legal documentation. This is essential. during friends and family rounds, entrepreneurs try to avoid paying legal costs but it comes to haunt them later. And most importantly, you must be aware of what you are entering into and what having an outside investor means.
Who do you trust? Angels or demons?
As a founder, closing an angel investment is the first hurdle in the steeplechase of entrepreneurial life that you are looking to cross. You are naturally circumspect, tense and desperate to close the round, and move on. But you need to be aware of the type of angel to go with. Once the round is closed, you will need to co-exist with these angel investors. There are a several examples of companies that are unable to scale up because of the wrong types of angels. Entrepreneurs need to be aware of ‘real’ angel investors.
The world is fraught with folks who pretend to be angel investors but are not actually so—they look for start-ups that they can jump on board with, either as an employee or consultant. There is another class of angel investor who are the unscrupulous types. They will come across as if they have a pile of cash to invest and will offer to put together a half-million-dollar round for you, of which they will commit substantial capital of their own! So far, so good. However, once the round starts coming together, they start backing off their personal investment (usually all the way down to zero) and instead ride the momentum into a job.
Instead of investing, they will pitch for an advisory role, and will take a bunch of equity to boot. Then there are angel investors who drive a hard bargain. They will put in substantial capital and spark the round for you. But they will ultimately want about 75 per cent of the company to do it. These are new to angel investment business and think that driving a hard bargain is the name of the game. They do not realize that by doing so, they will kill the company and your motivation to be an entrepreneur. Then there are those who had no intention ever to invest but will take you down the garden path asking due diligence questions and waste your time, in the hope that you see the value they bring to them and offer them some free equity.
As an entrepreneur you need to have the guts to ask some of the prospective angel investors some serious questions. Such as, how long the person has been an investor, check with known reputable angel investors and local venture capitalists on both the person and the companies they have been involved in to get a sense of how ‘real’ the prospective investor is, research their background and find out if they are likely to have the type of liquidity necessary to make angel investments.
None of these questions or tactics will be offensive to real angel investors. In fact, they will give the real ones more confidence in you. These tactics might offend the fake ones, driving them away. The hunt for the angel round is time consuming and could take up to six months to a year. It is all-subsuming and draws the time, energy and effort of the entrepreneur. This is in addition to running and growing the business, as during the times of funding, the business needs to show growth and positive metrics.
Founders are up to the brim with stress, anxiety and exhaustion as they come to the closure of the angel rounds. But they cannot afford any short-cuts. They need to remember that closing the angel round is an important milestone in the journey, but not the destination.