Everything you need to know to get funded – for beginners (Part 5)

Funding is a continuous process - not a discrete event

I have heard entrepreneurs say that we will do this or that post funding. Many believe that the round of funding they will raise will be the last they will ever raise. In my view, this is like saying that he next customer we will sell to will be the last we will sell to, or the next employee we will hire will be the last, or the next innovation we will do will be the last.

Raising capital for a business is not separate one-time function for any company. It’s an ongoing process like all other processes such as sales, marketing, engineering, R&D and so on.

Going public is just another large fund-raising process. Raising debt as a company becomes bigger another way of raising capital. Apple Computers, the most valuable company on the planet with over $600B in equity, and one of the most cash rich companies with over $100 billion in cash pile, has another $50B in debt. They continue to raise pile on cash, and they continue to re-finance and raise more debt.

In MBA-speak, there is something called WACC – “weighted average cost of capital”. All businesses need capital and they have different ways of raising capital and they all come at different costs. The more risk you subject your investor to, the more expensive this capital is going to be for the business. Not surprisingly, early stage equity capital (angel, seed, venture etc.) is the most expensive form of capital you can ever raise. These guys are looking for 10X (or more) returns! However, you are also subjecting them to a lot of risk, and many of their investments die an early death. Hence, they look for very large returns on the ones that succeed so that as a portfolio, they can make a good return.

I want to make sure that I am conveying the right message, so I am not lamenting about the high cost nature of this kind of investment, just stating a fact. It’s absolutely fantastic as entrepreneurs that this option is available. Only because such capital is available, we have seen some outstanding innovations and companies become big. Google, Apple, Youtube, Cisco, WhatsApp to name a few.

Imagine a world where such risk capital was not available, it would dramatically slow down the entrepreneurial eco-system. In fact, the dramatic growth in the entrepreneurial eco-system in the last 15 years can be attributed to the availability of this risk capital. Kids coming out of college in 1995 were no thinking of being entrepreneurs, today they are. Successful investors in this category deserve every success they get. You should also know that venture capital as an industry is filled with pain too. As a class of investment, over 80% venture funds don’t even return par. Which means if they invest $100 in total in different companies, they return less than $100 in total. Of course, some investments and some funds have done exceedingly well over a period of time through their ability to gauge the market and pick winners.

As an entrepreneur, your job is to minimize your WACC over a period of time. At an early stage of business, you raise high-risk, high cost capital. As the business starts succeeding and risk reduces, you have the ability to raise lower cost capital both as equity and debt. As you become more and more stable as a business, you start re-financing your older liabilities and they all get cheaper and cheaper. You are always solving to a healthier balance sheet and a lower and lower WACC. Capital itself as a resource de-risks you more and more. Lets look more closely at some of the early forms of capital.

Seed Capital

As a new entrepreneur, you are at your riskiest at this point and hence raising seed capital gives you confidence and dramatically improves chances of success. Seed Capital in India can range from $10-20K to as much as $1M depending on the track record of the entrepreneur, the nature of the venture and so on. The source of this capital can be individuals, also known as “Angel Investors”, or Incubators, usually run by individuals / corporations (Like GSF, T-Labs etc.) or Institutional Funds, like India Quotient, Seedfund, Blume and so on. There are also some collections of angels who invest together some times in a structured way, and sometimes in an informal way. For example, IAN (Indian Angel Network) is a structured format and so is Mumbai Angels, Hyderabad Angels and Chennai Angels. I think there is also something called Chandigarh Angels now.

The stage at which you can raise Seed Capital can vary a lot. In “hot” spaces, with solid teams, you can sometimes raise it very early. In other cases, you have to really demonstrate some traction, early signs of product market fit to raise this capital.

My guess is that over 500 such investments would have happened in India over 2015. A good friend of mine, a prolific investor, makes 8-10 such investments every year for the last 4-5 years. Lot of them are not even announced. Some of these are joined in by family offices, corporates, foreign individuals, family and friends.

For the 500 investments that must have gotten made, there must be at last 10- 20x pitches so there must be 5,000-10,000 companies that would have made pitches in 2015.

Series A Capital

Series A capital is usually the first large institutional round of capital that entrepreneurs raise. In India, it ranges from $1.5M – 5M. There are about a dozen funds which invest this kind of capital. On the more prolific side are funds like Sequoia capital, SAIF capital, Accel Partners etc. and then there are several others such as Nexus, Helion, Kalaari, Orios, Lightspeed and so on. There must be around 20 such funds who are making these investments at any point of time and my guess is that over 50 such investments would have happened in 2015. Some of these funds also make Seed investments in addition to Series A investments.

So if you do the math, my guess is that only 1 in 10 companies that raised Seed Investment would have raised Series A investment. This does not mean that the rest would have failed. Some of them must have raised other forms of capital, some may not have needed capital, some of them may have gotten merged into other companies. My guess is that at least 50% of them would have shut down or will eventually shut down.

While there are always exceptions, Series A investors generally look for very solid product – market fit and some validation of business model / unit economics. Many times unit economics may not be favorable at the time of investment but its viewed that it will turn favorable at scale.

Growth Capital

As businesses look to scale, they look for growth capital and this is in form of Series B / Series C investments. Private investments these days can keep going for a long time driven by the large availability of capital. At this stage the businesses are expected to have a solid business model / unit economics and some may have even reached profitability as a business. The expectations of these investors as a return also reflect the lower risk in the business. These investors generally look for 25% IRR on their investments. May services companies which don’t get interest at Seed and Series A level start getting interest here because of their interesting margins and continue abaility to grow at 20-30%.

My guess is that from the 50 that would have raised Series A investment, 15 would eventually go on to raise Growth Capital. Some would raise follow-on internal rounds, some would get acquired and there would be a few which would not make it. However the mortality rate post Series A is significantly less than pre-Series A.

The use of this capital is usually to capture market share. Your business model is proven out and you want to acquire as may customers as possible in as less time as possible. Elbow out any competition and establish a solid position.

Public Market Capital

Only 3-4 out of this set would eventually be expected to “go public”, i.e. raise public money. This indicates that the business has reached a certain size. Many others will get acquired by larger players. This is a relatively newer phenomenon in India but well-established in more developed markets. A fertile acquisition eco-system is critical to the success of an entrepreneurial eco- system.

Very little mortality is expected at this stage, though there can be a few. This money is used many times to retire existing investors, provide liquidity to promoters and also for large scale market development.

Debt

They say that you can only really raise debt when you need it the least. You need a strong balance sheet, collaterals and what not. Thankfully, there is some innovation in debt now a well and companies are able to raise something called “Venture Debt” after Series A investments and it becomes more and more available after Series B and do on. As a company becomes bigger and bigger, debt becomes a serious option since it significantly brings down the WACC. Equity of any kind expects north of 20% as return while debt, even in India can go as low as 10%.

For entrepreneurs, at early stages of business, fund-raising is not just about funds, but also about validation. The way you constantly valid your products with customers, you also validate your business with investors. Investors get to take a look at a lot of different businesses and have some sense of businesses that are more likely to succeed. Of course, this also has a big problem that some entrepreneurs start “playing to the gallery”, basically only work on stuff that investors are funding and stop applying their own mind. So like everything else, there is also a balancing act here. Same same but different. You can’t be too same but its also risky to be too different. You have to heed to the sensibilities of the market but you also have to apply the first principles to make sure you solving real needs. Did I ever say that entrepreneurship was easy?

By Rajul Garg

Rajul is Co-founder and Director of Sunstone Business School. Previously, Rajul co-founded GlobalLogic, sold for $420M in 2013 to Apax partners in the largest deal of the year in India. Rajul built the operations of GlobalLogic from ground up in India and then expanded through global acquisitions, until 2008. He also consulted with top tier venture capital firms such as Sequoia Capital and Aavishkaar, where he got exposed to the education sector. Fresh out of college, Rajul founded Pine Labs, a leader in the Indian market in credit card transactions. Rajul serves on several Boards, including publicly traded S Mobility, a leader in digital mobility. He is an active mentor to several startups, a sought after angel investor and a participant in several industry bodies such as TiE, NASSCOM, IIT Mentors and others. Rajul is a 1998 Computer Science graduate from IIT, Delhi.

This article is part of a 5 story series. Click here to read the previous parts.

This article was originally published here