Overview
The year 2021 was a golden year for start-ups to get venture funding in India where the total funds raised by start-ups hit a record level of $42 Bn across 1,583 deals resulting in as many as 100 start-ups entering the unicorn valuation club. Even with the stellar public stock exchange debuts for start-ups like FSN- Ecommerce (Nykaa), Zomato, and Policy Bazaar among others in India, VCs witnessed a high rating value exits to VCs.All of this indicates a positive trend for start-ups and an assurance of greater returns for VC investors.
For ages, venture capital funds have been one of the most stable & favored sources of funding to nurture Startups from an early stage. Since venture capitalists offer more than just funds for business success, entrepreneurs rely on them even at the cost of parting with a chunk of the company equity. In this article, we will discuss how venture capital firms are helpful to start-ups as a source of funding and how start-ups could raise funding from VCs effectively.
Venture Capital is a form of funding raised by any start-up or a business in exchange for a percentage of a share in the capital of the company. Venture Capital comes from venture capital firms that invest their funds in businesses for various purposes such as expansion, scaling up, product development, etc., depending on the stage of the business. Giant Corporations such as Apple, Google, and Facebook, all were once start-ups that were supported by venture capital firms. Likewise, start-ups like Nykaa, Paytm, and Zomato were only able to reach higher with the support of venture capital investments.
Who are VCs? Why they are the most preferred investors for start-ups?
Venture capital firms are a kind of investment firm founded by a group of wealthy investors and bigger enterprises, and pensioner’s funds who find it profitable to come together, and invest their money in either early-stage start-ups or late start-ups to mentor start-ups or other young, often tech-focused companies.
Like private equity, VCs also have limited partners (LP) at the highest level who offer funds and intend to earn returns from their investments made in promising start-ups. There are also General partners (GP) at the next level who are responsible to manage the funds so accumulated and create a portfolio of investments by finalizing deals with chosen start-ups and have a say in the business strategies of the start-ups where the fund has been invested. For this, they earn management fees along with a carried interest from the share of profits made by the startup. However, unlike PE firms, VC firms generally take a minority stake lesser than 50% ownership or less invested in companies. Sequoia Capital, Blume Ventures, Andreessen Horowitz, etc. are some famous VC firms in the world.
Benefits of VC funding- VCs have multiple benefits to offer to start-ups which include-
- Expansion Opportunities–With funds raised from VCs, start-ups could utilize the funds received from a VC for helping expand to new markets beyond national boundaries or could diversify their product lines depending on the stage of the business.
- Industry Expertise- Most venture capital firms offer funding along with a lot of hands-on guidance for any particular focus area such as marketing, technology, building networks, etc which could help start-ups to make the right business decisions and grow in the future.
- Support-Start-ups get support from VCs in various arenas such as legal compliance, taxes, human resources, etc. which could be very useful for them in the early stages.
- Network Expansion-Founders of the start-up could benefit from the vast network of VC investors which could be hugely helpful for the business after receiving funding.
Challenging Aspect of VC Funding
It is understood that unlike traditional sources of financing such as banks or financial institutions which rely on the hard assets of the business to offer loans, VCs focus on the scalability & commercial viability of the business idea, and have so much more to offer to start-ups rather than just funds. But, for the same reason, it is not easy to raise funds from VC firms as they may have higher return expectations from the deal. There may be other challenges for VC funding such as-
- Negotiations with VCs may take longer than expected.
- Unlike Angel investors, any entrepreneur will have to convince multiple people to close a deal.
- As most of the VCs may have too many deals on their plates, they may prioritize those start-ups that have already joined them, as compared to accepting newer ones.
How to raise funding from VCs for my start-up?
In case you are an entrepreneur looking to close a funding deal with any VC for the first time, most of the founders will tell you, that raising venture capital takes time, commitment, and a thick skin and maybe you will hear ‘No’ frequently far more than you will hear “yes.” But, if you simply do not want to quit, you should have a clear strategy that could guide you throughout the process. Here are some of the steps which should be religiously followed to reach a good deal for your start-up-
Pick a VC Firm That Aligns With Your Values
The foremost concern in raising funds for a start-up faced by any entrepreneur is to pick the right VC Firm. For this, an Entrepreneur needs to make proper research, check the options available, and find a firm with expertise in his/her sector, which can provide the right kind of mentorship to him/her.
For instance, in cases where founders of a tech start-up are looking to raise funds, they need to stay fully updated on the latest happenings in the sector, the emergence of new technologies and emerging innovations, and the status of the industry.In such a case, it would be better for the tech start-up to look for a VC firm with ample knowledge and experience in the field and thus will help guide the startup towards growth.
Additionally, as the VC Firm is going to administer the utilization of funds by the start-up, they will also have a say in the key business strategies of the startup, so it would be easier to make decisions in case the investors have a clear understanding and vast knowledge of the sector. Thus, it would be advisable to approach a VC Firm only after gauging all these abilities of the concerned VC Firm by the founders of the start-up.
Likewise, there are certain questions needed to be considered by a start-up while looking for a VC to raise funds-
- Which are the businesses the VCs have invested in before? Are such businesses similar to your start-up? Have they already invested in a straight competitor business?
- What stage of funding do they prefer to invest in? If they are primarily interested in Series A, it would not be a wise decision to approach them for seed funding.
- Does your business qualifies the definition of a start-up or is it a smaller business? Generally, VCs are interested in exponential growth. If your start-up cannot offer exponential growth, it would be a good idea to consider other funding sources.
- Is the long-term vision of your start-up in line with the long-term goals of the concerned VC? For instance, while some VCs look for a quick exit after getting their expected returns, others might be interested in building value over time. This could be understood by carefully looking at their prior exits.
Focus on relationship building
Once you carefully pick the right VCs to raise capital, it is necessary to develop a warm connection with the same, since most Venture capitalists rely heavily on trusted connections to vet deals. There may be some VCs who will take pitches from unsolicited sources, its best bet to find an introduction through a credible reference.
Typically, the process starts with an introduction to an associate, and then you can work your way up to the full partnership, which helps to know the exact profile of the venture capitalists to find out which level of introduction makes sense.
Do Your Homework before Approaching Investors
There may be instances, when the entrepreneur or founders may not find any connection. Then, your next alternative would be to make the warmest possible introduction for any connection you can make to the venture capitalist so that you can establish you’ve done some actual homework and not just send out plain-form letters.
Try to look for any background information related to the previous deals signed by the VC, which is similar to your pitch and will help you to create a bit of warmth.
Showing that you have done some homework will go a long way to make sure that you create a lasting impression. Luckily, most VC firms have a documented process that should be followed to guide their approach.
Craft and Send an Elevator Pitch
To pitch to an investor for the first time, a founder needs to send an elevator pitch to the venture Capital the first time. For those unknown, an elevator pitch isn’t a sales pitch. It’s a short and well-crafted explanation of a problem a start-up is solving, how are they solving it and how commercially viable the product/services are or going to be. Instead of sharing a lengthy pitch document, the founder should send a link to his pitch profile, which is an online profile that briefly explains the proposed deal and even provides a way for the investor to request more information.
Assess your Start-up valuation correctly
Despite years of experience in the business, most businesses fail to correctly assess the valuation of their start-up. However, it is crucial to correctly assess the value of the start-up and identify the correct valuation in case the founders are seeking equity financing for their start-up. Failure to make the correct assessment of start-up valuation may have consequences of its own.
While over-valuing your start-up may deter the investors, under-valuing it may lead to a large chunk of your shares going out of your hands. But, if the founders of the start-up are able to put a fair valuation for the start-up on the table, it can help them during the negotiations with VCs, since there are certain factors that depend highly on your startup valuation, such as equity shares terms.
Keep your business plans well prepared
Irrespective of the commercial viability & scale prospects of a business, if a start-up is lacking appropriate business plan which sets its priorities and financial objectives straight could undermine its fundraising efforts. Further, having a well–prepared funding plan could help founders to-
- Identify the right type of sources of funding
- Setting the roles of your team.
- Identify the total sum required as investment from investors
- the equity needed to be given up in exchange for funds
However, it is to be noted that the founders of the start-up must be transparent from the beginning and should come with multiple options for raising funds. They should also be flexible about the amount of money to be raised and the manner of its utilization.
Creating the Right First Impression
In order to ensure the funds are coming your way, founders need to ensure everything is in line for the presentation. The entrepreneurs will need to convince the investors about the business potential, clear business strategies, growth path, business goals, and the estimated period to earn profits and returns — all of which must be established within the business plan.
Thus, in order to create the first impression, the business presentation to be placed in front of the investors needs to be clear and concise, well-structured, and supported by sufficient data to create a strong appeal to them.
Timing of Investor Approach
Once the business pitch is ready, it will be required to be presented before the analysts and associates of the VC firms to fix a meeting with the General Partners in order to convince them interested to invest in the start-up.
In the next step, the start-up will have to give a final presentation to the General & Limited Partners with a clear and transparent business plan and the ultimate business goal to be reached after getting the venture capital funding for the startup.
Undertaking Negotiations
Once the founders find a potential VC to partner with, the process of negotiations takes place. Upon these negotiations, a preliminary legal agreement is signed between parties that contains the major terms of a venture capital investment, before finally signing an actual share purchase or equity agreement, also known as a Term Sheet. Primarily, there are two sets of terms – economic & control issues which are generally negotiated as part of the term sheet.
While economic issues include matters such as pre-money & post-money business valuation, type of investment, and the stock-option pool. On the other hand, control issues include liquidation, anti-dilution provisions, and protection provisions.
Due Diligence by the Investors
Finally, when you get the nod from the General & Limited Partners who are interested to make a deal with your start-up. The next and final step will be closing the deal and discovering the actual position of the start-up through what is known as due diligence.
After agreeing to a term sheet, VC usually undertakes a lengthy process of due diligence on the start-up, for which the start-up should be well-prepared from the beginning. While the process of due diligence may vary slightly depending on the type of the business, however, generally the questions may be regarding –
- Relevant Market & Competition;
- Team & Business culture
- Finance & Human Resources (HR) systems
- Current &Potential Customers
- Product development plans
- Sales and marketing plans
- Any previous legal contracts start-up has entered
Close the Deal
Finally, when the terms of the deal have been negotiated between parties and the start-up has passed the process of due diligence, the deal will be closed. The closing of the deal will involve the preparation of many legal documents such as an investment agreement, stock purchase agreement, Indemnification & Confidentiality agreement, etc. Once all these documents are executed, the founders will receive funding from venture capital investors.
Bottom Line
It is to be understood that the process of raising funds from a VC is not any sprint, it’s a marathon, especially for new Startups and founders. It may be an emotional topsy-turvy ride, where eventually the founders may have to go through hundreds of rejections throughout the process before one acceptance. Thus, it is important to be resilient and learn from every rejection and try to obtain the feedback you receive and apply it constructively to improve your business pitch but without having to change the very basic structure of your business. However, always take extra caution while preparing a business pitch, locating an investor whose interest is similar to your business, negotiating the terms, and closing the deal which will ultimately help your business to get the funding it needs to reach its full potential.
