The India startup story has had as many highs as it has had lows. While the boom truly began in 2013, it was only over the next two years that investors poured money into entrepreneurs, products, and ideas. But, as it is at the beginning of every success story, for Indian entrepreneurs, historically it has never been easy to raise the initial round of funding or seed funding.
Seed funding, for the uninitiated, is a form of securities offering in which an investor invests capital in exchange for an equity stake in the company. The term ‘seed’ suggests that this is a very early investment, meant to support the business until it can generate cash of its own (see cash flow), or until it is ready for further investments. There are various options to raise seed investments via friends and family funding, angel funding, and crowdfunding.
It is with this thought in mind, that we, at Inc42, have decided to break down the seed funding scenario in India – already explored in our seed funding report. This time, investors’ opinions have been taken into account in order to give a holistic perspective on seed funding and the way startups can and should leverage the initial money they’re given.
Managing Funds/Investors Expectations/Returns
“I usually advise founders to invest in areas that would directly benefit the customer and customer experience. So things like comfortable office space, shiny new laptops, too many parallel engineering projects, staff welfare, air travel, hiring a PR agency, paid content writers, SEM and Facebook ads [other than for testing] are out. Borrowing or sharing work space, developing direct relationships with the media, hiring techies and customer experience executives – all good,” says Ravi Kiran, co-founder, VentureNursery.
The seed fund is mainly raised to establish minimum viable product and build initial traction. While funding exists, it can’t support luxury expenses, hence it is advisable to plan the business’ expense in a way that one can last till the next round of funding or till the startup achieves breakeven.
Adding to this, Abhishek Rungta, CEO, Indus Net Technologies says, “Austerity is the key. Do not spend on too many diverse ideas and use cases. Get one use case right. Get the user to pay and repeat the habit. Spend on what is key and critical to business. Even when you are funded, operate as if you are bootstrapped.”
The majority of expense happens on the salary and administrative side, hence, during seed stage, it advisable to keep these expenses under control and spend only where necessary. Because whenever investors infuse their money in any business idea, they expect the startup to meet defined milestones.
“With $500K funding, I expect a startup to sort out product-market issues and get to decent customer traction within a year. A good team with a robust product and a visible, addressable, and demonstrable market should be able to raise a series A round within 12-18 months of the seed round,” adds Rajesh Sawhney, founder, GSF Accelerator.
Furthermore, Anil Joshi, Managing Partner, Unicorn India Ventures said: “The seed round is done with the perspective of having a minimum viable product which results into a paid customer. The expectation is to start building a good traction line and then scale up.”
Investors expect startups to build a strong second layer team beyond the founders. They are also expected to reach a stable product which is ready to scale with some sense of metrics in place for the future growth pipe like CAC, gross margins, repeat rates etc.
On asking when angel investors expect returns, Anirudh Damani, Partner, Artha India Ventures says, “In terms of returns, a seed-funded startup should ideally give an exit at Series C which is 48-60 months from the seed round.”
Seed funds generally have a holding period of 5-6 years and they expect returns in 5-6 years. “A good seed investor should plan for 5-10 years for an exit. Exits usually happen in India due to secondary exits (at series B and beyond), M&A (5-8 years) and rarely through IPO (8-10 years),” adds Rajesh.
Low Ticket Size Is The Major Concern
If we look at the investments made in 2015, angel and VC investors have closed as many as 1,096 deals. Out of these, angel and seed investors funded 632 deals while VC investors backed the remaining. On a standalone basis, angel funding picked up speed in 2015, breaching the $300Mn mark for the first time, from $196 Mn in 2014.
Comparing these stats with 2016 data, the year has witnessed over 877 deals with a combined amount of $3.9 Bn being invested till October 2016.
The aforementioned report further states that a total of 537 (about 61% of total deals) startups grossed $161.5 Mn in seed funding in 2016 until October. Moreover, around 1,200 unique investors participated in Seed rounds, with the majority of them being angels. Healthtech and ecommerce have been the most favoured sector for investment followed by SaaS, fintech, edtech, and hyperlocal.
With more than 50% of the deals being seed rounds, what needs to be noticed is the ticket size of the deal. As per the data available, most of the ticket sizes are less than $500K.
Commenting on this development, Madhukar Sinha, co-founder and Partner, India Quotient says, “The seed round is used to reach product market fit (PMF) and involves multiple iterations around the product and build a good team of 20-25 people. It usually takes anything between 10-12 months to reach this milestone. Keeping a buffer of around 3 months for fund raising and any other delays, raising capital for 15 to 18 months in a seed round is recommended. That number today stands around $500 K (will again vary from business to business but more of a thumb rule).”
Indian investors believes that the more money entrepreneurs raise early without solid tangible results, the more equity they lose, as their valuation and attractiveness only starts growing once they have the product-market fit and traction.
“This is just a thumb rule for the Indian ecosystem. This ($500K) is the amount of money angels can afford to lose without losing any sleep. It should give the founder enough time to run experiments to show us he can be successful. We would give the money in tranches and track his progress,” states Dr. Aniruddha Malpani, Director, Solidarity Investment Advisors.
With the seed round of funding, entrepreneurs need to demonstrate that with that $500K (or similar amount) they can develop a viable and sustainable product. Although it might look like a small amount compared to the $5 Mn or $10 Mn tickets, but, without a complete product, the startup has nothing of value at that moment.
When Is The Right Time to Raise The Second Round
After raising a seed round, startups usually get confused as to when to raise their second round. Investors believe that once the product is complete and functional, valuation will increase multifold and the startup could raise funds of bigger tickets without parting with a sizeable section of the equity.
“The right time to raise funds is when you have four-five months of money in the bank, you have a good hold on the operational metrics and you have started growing anything between 30%-50 % MOM (at least for 3 consecutive months). All of this is, of course, assuming that the product market fit is achieved,” adds Madhukar.
There is no one formula that entrepreneurs can use to raise a second round when they raise a decent amount at a respectable valuation. “As things stand today, I would say a founder should approach Series A with about six-nine months of current burn in the bank. Hopefully, the business model should be looking scale friendly. Too early and you won’t have much to show. Too late and you would be walking into the hands of the VC; not able to hide your desperation,” says Ravi.
Whereas, Aniruddha believes that the best source of funding is via customers. If entrepreneurs can get their customers to pay for their product/ services, investors will line up to give you more money.
“Is VC Funding The Best Option For Startups?
There is a belief that it is always in the startup’s best interest to opt for VC funding over other means of raising capital. But Madhukar opines, “No, We do not believe that VC funding is the only or best way of raising capital. Startups should look at other forms of capital available depending on the kind of business, stage of business etc. For example, if there is fintech startup which is in the lending business, it should try to raise some debt along with equity for book building while the equity is used for product development and operational expenses. If a startup is pre-product and at the market research stage, it should look for capital from angels or industry enthusiasts in that space.’
Ravi, however, differs.
“Startups should worry less about funding and more about finding a real customer problem that can be solved meaningfully and, ideally, cheaply. Where funding should come from would depend on the founders’ belief, conviction and approach to business. VCs can help in more ways than just funds, but it depends, a lot, on who the VC is.”
It is seen that VCs always look to get returns in a 7-10 year timeframe. Therefore, entrepreneurs must only raise money when they are in a state of giving them a cash-out in this time period. And be pessimistic. Fortunately and unfortunately, entrepreneurs are over-optimistic and hence, time things wrongly. In building a business, timing cannot be under-estimated.
“It would not be correct to say that VC money is best compared to other options but one can certainly say that it comes with a lot of wisdom attached to it. Most of the VCs have done entrepreneurial stints and are well-versed with growth or startup challenges hence they could shorten the learning curve apart from opening up a lot of doors. One may not have a choice to choose the investors. However, one should always look for an investor who can add beyond money during the early days. Or else, take the money and build a pool of advisors or mentors who can guide during the early days,” adds Anil.
In every startup’s growth journey, seed funding will always be the most important round as it is a stepping stone to turn dreams into concrete reality. Also, one needs to understand, the seed stage is the most critical stage as most startups die during this phase.
2016 can be considered the year of seed/angel funding. Many new startups came, raised their first round and soon exited from the market, too. There were also other startups that charmed angel investors with their business models, raised funds, and are now looking for the next round while scaling up.
In short, 2016 was a year of surprise in terms of deals signed, the coming up of a new bunch of angel investors, exits etc. Now we have to wait to see what 2017 holds for angel investors and the budding startups that are planning to raise money in the ‘New Year!’
(With inputs from Ankan Das)