This is the first installment of a four-part series which aims to help early-stage startups navigate their way through a fundraise.
Many startup founders are uncertain about how to raise funds for their early-stage ventures. Before getting into the nuts and bolts of fundraising, one of the fundamentals of corporate finance which entrepreneurs must keep in mind is the risk-return trade-off.
Higher the risk investors take, higher is the return they expect from the investment. Earlier the stage of the company, higher is the risk that it might not “succeed” i.e. it might not find the product-market fit or the market it is going after might not be large enough. Worse, the solution it is building might not address any pressing problem.
Early-stage investors - angels, seed and Series A venture capitalists - seek extraordinary returns from investments into early-stage startups. This is further compounded by the fact that most early-stage investors follow a portfolio approach in which as many as seven or eight out of 10 investments might fail, or only provide a marginal return on the investment.
The remaining two or three bets have to be hits that provide extraordinary returns to be able to compensate for the misses. Most venture capital funds have limited partners (LPs) - external investors who have committed capital and seek a return.
The right fit
The expectation of high returns has two implications. Early-stage startup investors like to be in businesses playing in a large market and have the ability scale fast with additional capital.
Some industries are better suited for scaling up than others. Infosys, a global leader in the IT services industry had around $70 million in revenue in 1997 while Amazon had around $147 million in revenue at the same time.
In 20 years, Infosys grew 145 times, garnering over $10 billion in annual revenue. During the same period, Amazon grew 925 times as it reached $136 billion in annual revenue.
This sheds some light on why early-stage investors seeking exceptional returns prefer high-growth e-commerce over IT services.
Entrepreneurs in certain industries will find it much harder to raise early-stage capital. Apart from IT services, some sectors which do not support quick scaling up include consulting and business-to-business (B2B) services, lifestyle, and local businesses such as restaurants and spas.
Other industries which are less favoured include those requiring high upfront investment, high variability in input costs or selling prices, historically sub-par performance, or low barriers to entry and poor margin.
Taking a call
This is not to suggest that businsses which fit into one of the above categories cannot raise early-stage capital. It is just that they will find it much harder to do so.
In addition, some of these businesses - particularly consumer-oriented businesses in the hospitality and services sector - could be converted into chains and built for growth.
If you are in an industry which does not require much capital to keep expanding at a healthy clip, it might be better to avoid fundraising.
Fundraising can never be a substitute for building a sustainable enterprise - it is only an enabler for the cause.
Typically, early-stage funding is used to support technology and product development, marketing and hiring key staff. Ideally it should not be deployed for high founder salaries and office space rent and is avoidable for capex and secondary transactions.
Ideally, it is better to try to do as much as possible with the resources available internally before scouting for external investors.
So before you opt to raise funds, ask yourself the following questions:
1. Have you exhausted your resources and resourcefulness?
2. Have you gone as far as you can while boot-strapping?
3. Have you completed the tasks that could be done without capital?
4. Is your team ready i.e. do you have equity-based co-founders?
5. Have you completed your branding exercise?
6. Have you spoken with potential customers?
7. Have you researched and sized your market?
8. Have you developed a product prototype?
9. Do you have evidence of product-market fit?
10. Do you have some traction?
If the answer to any of the questions above is ‘no’, it is best to evaluate ways of getting it done before seeking funding.
The author is a former investment banker, an advisor in the technology sector and currently works as a strategy professional in the telecom industry. The views and ideas expressed are personal.