Why would a startup choose VC funding and what's the right approach
Do VCs in India invest at every stage and how to identify the right venture capital investor for the right stage
Before choosing the VC route, every founder must know how VC firms function
No matter how unique an idea seems, developing it into a flourishing business with good returns is not a child’s play. The strategies have to be correct; the execution has to be right and the revenue has to be channelised properly. But for all these to happen smoothly, the foremost thing that needs to be ensured is the flow of money into the business, right from the stage of its ideation. If bootstrapping or angel investments are not coming through then startups have to turn to VC funding for capital. Thus, it’s usually a practice to source funding from external sources, and venture capital (VC) funding is one of the most popular ways to do that for startups.
The question that pops up first is – why would one choose VC funding for their business? The answer might be simple – VC funding doesn’t require repayment of the fund to the investor. But in reality, there’s a lot more to this simple statement and clauses far deeper that need to be considered. To understand this well before choosing the VC route, every founder must know what venture capital funding is and how it functions, as well as its pros and cons and things that need to be analysed before decision-making.
What Is VC Funding?
Definition of venture capital is a fund sourced from wealthy people, big companies and pension funds that are invested into various businesses so that they can grow and make a profit and provide returns in multiple terms of the initial investment. The aim of the investors here is to support the startups to grow, upscale and reach a point of IPO offering, acquisition by bigger companies or buying of smaller ones so that they can make a successful exit, cashing out a good amount of return from the VC money invested. The motto of the entrepreneur, on the other hand, is to sustain stable and fruitful growth, ensuring profits so that the investors don’t make a quick exit.
There can be individual investors who can put their money into the business or a venture capital company that invests the total fund accumulated into a portfolio of several businesses. Startups have the highest probability to fail due to the inexperience of founders and negligible track record of the startup ecosystem in India. Thus, often individual investors are not convinced and stay away from funding startups. Here, funding deals are mostly done by venture capital firms who balance losses from a startup’s failure by returns from other deals of the investment portfolio.
The Right Time To Raise VC Funding For Startups
These days venture capital is a lot more flexible than it was a few years ago. VC money is invested at all stages of startup growth, starting from seed and early-stage funding to growth-stage, and late-stage ventures. The good thing about the Indian startup ecosystem is that VC investors have not shied away from backing startups early.
Venture capital firms invest in startups, seeking good returns and in India, there’s plenty of opportunity for the right service considering the untapped market. In exchange for the investment, they get equities or company shares from the startup, thus earning the right to be on the board of directors and participate in all the business decisions. While on the one hand, this gives investors a scope to secure potential returns, on the other hand, it takes away the entrepreneur’s complete autonomy over their business. With investors on board, founders will feel some pressure to deliver the returns — but that largely depends on the investor itself.
This is an important thing to consider from the founder’s point of view while deciding whether to raise VC funding for the business.
But, in a situation where the founder has got an exclusive idea that is first of its kind in the operating sector and is certainly going to succeed as a business. Here, instead of them approaching investors or VC firms, it might be the case that investors come to their door. Here the founder has the leverage and can get good funding for lower equity — while in the case of a founder pitching their idea to many investors, this demand-supply dynamic is reversed.
So in a sense, a startup should ideally go for VC funding when it doesn’t need the money — but that’s high-brow talk as any founder would tell their peers to take the money when it comes. So the timing of VC fundraising has always been a debate.
However, to raise a VC fund, it is essential to know the stages when venture capital is invested. Because, based on that, it would be easy to understand how VC fund works. Venture capital investment in startups follows a series funding method, which is staged by stage funding. Types of venture capital are thus identified according to the stage it has been invested in the business.
Stages of VC Funding
Venture capital firms in India have recently entered the scene from early rounds including seed rounds. Sequoia, for example, has an early-stage accelerator named Surge which provides seed funding to startups.
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But the prevalence of VCs is higher in Series A funding rounds and beyond. At this stage, the funding is used to develop the business and product, raising efficiency and productivity, thereby satisfying the existing customers. From Series B onwards, it’s about increasing the production capacity and widening the market base leading to higher profit margins.
Series C funding means the startup has already gained momentum, and here it’s about scaling up get even higher profits and perhaps look for an exit — through the startup’s IPO or perhaps even an acquisition by a rival or another company. Unlike founders, investors are nearly always in favour of exit when there are returns to be had, but it all depends on the stage of the startup, and whether exiting in the future would give them more returns.
From the investor’s point of view, seed and Series A funding are the riskiest bets as there’s still no profit in sight in most cases, and there’s every chance of the business failing.
Hence to combat the losses, VCs tend to invest together in a startup. Here, the task for the founder is to pick a credible VC firm that can attract other investors as well. VCs also diversify their portfolio, investing in startups at various stages to hedge their risk.
But for all these to happen, the first thing that is needed is a good deal of VC funding between founders and investors. This requires not only the investors to pick a startup with potentially high returns, but the founder to choose the right venture capitalist too.
How VCs Select Startups And Access Deals
From the investor’s perspective, the task is to choose the entrepreneur, who is clear about their business idea, has strategies well placed and planned to develop it into a business, sustain, grow and upscale to successfully secure big returns, in multiples of the VC funding. To have a clear idea of how VC funding works and the expectations of investors, one first needs to understand the structure of a VC firm and its working process.
The topmost layer of a VC firm is formed by the individuals who pool in their money for funding. These people are termed as limited partners (LP), who are important to finalising deals with startups. Limited partners don’t interfere with how the fund is invested or the money is managed and earn returns from the money they had provided to the VC firm.
Some of the key responsibilities of the general partners (GP) at a VC firm include management of money, investment decisions and strategising the business for portfolio startups. Partners earn fees for managing the venture capital fund, by smartly investing it to earn returns and profits after paying out returns to fund investors. GPs also get a share of the profit the VC firm makes after providing returns to LPs.
A VC investor, thus, chooses a portfolio of startups of a specific sector and invests in them, after judging the business model and roadmap. To ensure good returns, the company also acquires rights in a startup’s business decisions.
How To Choose The Right VC Investor?
Smooth execution of this entire process depends largely on the quality and strength of the business pitch and the marketing skills of the entrepreneur. To make a good quality pitch, they need to have clarity of their business idea, its applicability and thereafter a clear vision of how to develop it to a business, address gaps and requirements well and utilise funds to take it ahead with well-defined strategies towards profit and good returns. For this, they need to conduct extensive market research, observe the sector of operation, analyse its trends and future. Based on that, the founder will now need to make a list of good investors and make the right choice from the list.
To find the option of investors, the entrepreneur needs to further research and find people or venture capital firms with good experience and a track record in their sector. This is a prime concern because the investors will have control in the startup’s functioning and business decisions. So, to run the business successfully with investors in the decision-making, they too need a thorough knowledge of the sector. For example, think of a startup that provides co-living spaces to students and working people. Here, the business owner needs to find investors who have extensive knowledge of the residential sector, habitat systems, co-living practices and customer preferences based on age-group, income level and standard of living.
Done with the selection and ready with a list of good investors, it’s time for the background check again. This is because the startup founder now needs to gauge the investor’s credibility, flexibility in terms of smooth and timely flow of funding, nature of dealing when it comes to initiating and finalising the deal, the structure of venture capital companies, terms and conditions placed, behavioural pattern of the investor in terms of finalising the deal, continuing with it, interference in company decisions, year of experience in the sector and their track record of successful, unsuccessful deals and tendency to exit. This background and credibility check of the investors’ list will help the startup make the right choice of the investor and strike a deal. This step is of foremost priority when the VC funding is raised online, where there is no scope of meeting investors face to face at every step.
Making the right pick, it’s time to approach the investor or the venture capital firm. In the case of individual or angel investors, it’s easier because it depends on the conviction of the startup and their persuading powers. But in the case of venture capital firms, especially a multi-layered VC firm in India, startups have to cross every step successfully, convincing each layer with their business pitch, their conviction and a detailed, well-researched business plan, supported by strategies, data and documents. It would thus lead to a successful deal and thereby the start of VC funding for the startup.
VC Funding In India: The Ongoing Trends
VC funding in India has earned much popularity over the last few years with quite a few startups taking resort to this and becoming unicorns successfully. This is a good sign though, considering that the startup ecosystem in India is still relatively new, gradually expanding and generating income as well as providing employment. With startup’s general tendency to fail in business strategies leading to huge losses, bankruptcy or closure of the company, here the Indian startups lack ideals, track records and examples to follow. Thus, it is not difficult to understand that startup funding would be a risky project. Adding to the woes, the Indian economy is in the middle of a bad liquidity crisis and the consequent slowdown in every sector.
Despite this, success stories of startups such as Paytm, Uber, Urbanclap, OYO, Flipkart, Myntra, Instamojo has encouraged the youth of India to take the plunge with startups.
Debt funding or loans are surely other good sources of funding for startups in India. The government too is coming up with several favourable loan schemes for budding entrepreneurs. But, here definitely venture capital has got the edge as a preferred source of funding. This is because debt funding requires repayment of the funds along with interest payment, irrespective of the success of a startup and also keeps the company or the entrepreneur’s assets as collateral. At the same time, it’s less risky for the investor. Debt funding is growing in the Indian ecosystem and this trend could harm long-term growth prospects of the startups. This is why VC funding plays a crucial role, not only in terms of funding but also in terms of enablement and nurturing innovation.