What should pre-seed money be spent on?

Generally, the reason for raising funds at any stage is to be able to take the company to the next ‘phase’ of its evolution.

Most startups would go through the following phases in their journey:

  1. Concept stage – i.e. when the idea is not yet developed into a product or service, but the founders may have done a fair bit of thinking on the concept and understanding the business dynamics surrounding that idea. This is the stage where the business case is being evaluated and assumptions are made and validated – hopefully by understanding the market and speaking to customers, etc.
  2. Prototype development stage – when the concept – either a product or service – is ready for testing with a limited audience – the startup may have a few initial employees.
  3. Early-stage – when the product or service has started gaining some traction – there are a few early customers/consumers, the product and processes are being refined and fine-tuned and the building blocks for growth are being built – a small team is getting formed
  4. Growth stage – when the startup has started getting more customers, processes are getting developed, an organization structure is getting into place and the company is in an expansion mode – this is probably the time when most companies would start getting profitable

Pre-seed money would typically be raised at concept stage, and should ideally last a little beyond the prototype stage. In most cases, pre-seed stage money is used for the things that will prepare the company to attract seed capital from angel investors or from early-stage VCs i.e.

  • Understanding the business case by validating assumptions
  • In building the prototype or the first version of the product – what is called the MVP or Minimum Viable Product which will allow you to test your assumptions in the market i.e. check if your customers find the value proposition meaningful, if they feel that this product / service does fulfill their needs, etc.

At pre-seed funding stage, a startup should keep capital expenses very low – i.e. rent ACs, furniture, etc. rather than buying. Operating expenses should also be kept low – take lower salaries, work out of a shared office, multi-task, etc. This is also in your interest because the valuations are likely be very low at this stage, and hence the lower the amount you raise, the lesser your equity dilution at this stge.

 

 

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Understanding cost structures

The accuracy of your assumptions on revenues and costs will determine the business case for your startup. Hence, it is critical that all cost elements are identified, and the accompanying costs are estimated and accounted for.

In the initial phase of the startup, it is important for the entrepreneur to create an excel sheet with all possible cost categories. This should be done on a month-to-month basis to get a better view on the month-by-month cash flow needs.

Costs should be marked broadly into the following categories:

  1. Capital costs [e.g. computers, servers, furniture, etc.[
  2. Operating expenses or opex
    1. Fixed opex [e.g. rent, salaries, etc.]
    2. Variable opex [printing, marketing, travel, etc]

 

Suggestions:

  • Before starting to estimate costs, invest time in developing a good excel sheet with all possible cost heads identified. Instead of using absolute numbers, put formulae so that one change in the base figure can reflect accurately across the entire plan.
  • Break costs into as granular level as possible. E.g. while estimating capital costs, under ‘Servers’ instead of putting a number for that month, break it into “number of servers’ in one row and ‘cost per server’ into another row, with the result of that calculation into the third row. This way, you can make adjustments to the cost per unit or the number of unit without having to worry about making the change everywhere.

 

Once you start writing down the different cost heads under these three categories, often you will realize that there are many more cost heads than you had thought without putting them down in an excel sheet. Once you start putting things down on an excel sheet, you are able to get a good view of how things are going to progress. E.g. in the excel sheet once you realize that the number of people is increasing, you may realize that the office space may be inadequate and hence you may need to budget for not just new & bigger office rent but also for capital costs like brokerage, furniture, etc.

One of the highest cost units is likely to be salaries. While estimating salaries, it is important to account for hiring costs [usually I month salary or 8.33%]. If the attrition rate in your industry is high, you should account for more hiring costs.

Most entrepreneurs go wrong in estimating their people needs, and assuming that they would be able to manage the business with lesser people than practically required.

While estimating people needs, rather than putting down an amount, put down first all the designations on which you are likely to need people at the growth stage. Then  in the column section, put the number of people you would need in each designation and at what stage. E.g. while you may have identified ‘Chief Procurement Officer or CPO’ as a designation for an e-comemrce company you may not have plans for such a person for the first 18 months, in which case enter ‘0’ in the number of people column against the CPO.

In a row below each designation, enter the per month CTC or gross salary. And below that row would be the result of multiplying the number of people for that designation by the monthly salary for that person. See example below:

  January February March April
Customer support manager 1 1 1 2
CTC pm 25000 25000 25000 25000
Total 25000 25000 25000 50000

 

 

Important: In the initial phase you will be resource starved and will therefore manage with very few people than ideally needed. Even if you are able to multi-task and manage the operations with very few people, it is often not scalable beyond a point. Any case, the business case is to be made with the full cost structures as they would apply when the business is at scale.

To explain this further… your business plan should take into account all possible cost structures, even if you are not currently spending them. E.g. you may be working out of your home, or in some cases not even taking a salary. But operating without a salary or operating without an office is not really a long-term option. Hence, for getting a realistic picture of your business case and profitability, it is important to account for all possible cost structures.

Separately, when you work out your operating plan for the first phase you will eliminate or reduce the expenses as they would be actually applicable.

 

In some businesses the cost of unsold inventory, damaged goods, etc. also need to be accounted for as they can significantly impact the business case.

 

Why many startups fail to scale?

Every entrepreneur aspires to grow his company to a significant scale. However, many startups fail to scale, beyond a certain level.

For scaling up, it is essential that the startup upgrade the company’s capabilities and resources on all relevant fronts – people, technology, processes, funds, etc.

Surprisingly, operational inefficiencies is just one of the reasons for not being able to scale. Many of the other reasons are quite within the control of the entrepreneur.

Here are some reasons why entrepreneurs fail to scale their startups:

  • Low aspirations: Often many entrepreneurs lose their initial drive on reaching a certain level of success and are not then as driven to scale up to the next level. Sometimes, they tend to take lesser risks and are less hungry for glory than when they were starting out.

Suggestions: Aim higher, keep the bigger goal always in view, keep reminding yourself and the team about the bigger goal.

 

  • Fallout between the founders: One of the common reasons for issues in startups is disagreement between founders on the way forward. These issues and disagreements come up typically at two inflection points – (a) either when the startup is doing very badly and tough decisions are to be taken e.g. to further reduce the already low salary or (b) when the startup is doing really well and tough decisions are to be taken e.g. to sell out and take the cash or to stay on and grow even more.

Suggestions: Have a philosophical discussion and agreements with the co-founders on how different situations will be handled. What will be the decision in case of difficulties? What will be the decision in case there is an option to sell out? It is possible to build these agreements into the shareholder agreements or articles.

E.g. If there are 4 founders in a company with 25% shares each, they may decide that this 25% will ‘vest’ over a 5 year period. This means that if one of them leaves at the end of the 3rd year, he/she will get only 15% equity and the rest will be shared between the remaining founders. This can be documented and formalized.

 

  • No back-up team: As the startup grows, the founders have to switch roles from doers to managers. Their focus has to change from managing the day-to-day tasks to hiring the right persons to do the job. Often startups fail to do this and therefore are unable to manage the growth. They either stagnate or become inefficient and wither away.

Suggestions: Keep looking for good people. Plan for growth before you reach the growth phase. Let go. Delegate.

 

  • Absence of processes: At the startup stage, there may be no processes or some processes, which eventually will have to get firmed up. However as the team grows, the absence of processes creates inefficiencies and chaos as each team or person attempts to manage their part of the operations in a manner that they feel appropriate. Even with the most honest intentions, such chaos is never good for the organisation.

Suggestions: Once the initial challenges are out of the way, the CEO has to focus on creating the processes. It has to be someone’s key responsibility area.

Also, inadequate funding can be a significant hindrance. We have noticed some entrepreneurs shy away from raising capital for growth and attempt to scale up with the meager resources by applying the same ‘wear-many-hats’ approach during the starting up days. This is counter-productive. To scale up the organization, it needs to scale up the capabilities and competencies and hence need adequate resources, and capital.

What should startups focus on in pilot phase?

A ‘pilot program’ is an activity planned as a test or a trial. In the context of startups, a pilot is done to test the untested dynamics of the business.

In any business, especially in a startup stage, entrepreneurs have to start with certain assumptions. These assumptions could be about percentage conversations, cost of customer acquisition, repeat purchase rates, etc. They could be about processes and competencies e.g. ‘one person can handle 25 transactions in an hour’. Or the assumptions could be about the business case. E.g. We will make a gross margin of 35%. The objective of a pilot phase is to test and validate some of these assumptions, so that the final go-to-market business plan can be adjusted on the basis of validated assumptions.

Below are a few things that are tested in a concept test stage/pilot phase:

  1. The concept – the power of the idea itself: Do the consumers/customers see the value proposition in what you offer? 
  2. The business model: A business model is about ‘who will pay how much and to whom’. Each element of this should be tested in the pilot phase. i.e. are the consumers/customers seeing the value proposition as you meant it to be, how much are they willing to pay – is there price sensitivity, and if so, how much.
  3. The assumptions for your business case: As mentioned above, list all the possible assumptions you have made in your business plan and see if there is a way to validate those in your pilot. In a pilot, some of the operational outcomes may NOT be as per your plan. However, it is expected that in the initial phase your operations will be inefficient and that cost and operational efficiencies will improve as your business matures.
  4. Understanding operational challenges: Entrepreneurs often tend to underestimate the operational complexities and challenges of managing a business. While startups often manage operations with a limited number of people who are stretching themselves beyond practical limits, it is often not sustainable in the long run. A long-term business case cannot be made on the basis of the enthusiasm and give-it-all commitment of the founding team. A business case has to be based on what is practical and sustainable with an average set of people managing your larger teams.
  5. Testing processes and operational capabilities: Processes help organizations scale up. Processes are nothing but just a set of guidelines on managing activity and handling situations. Processes are usually centrally planned and locally implemented. Processes. They reduce the dependence of individual brilliance, and instill a discipline that results in operational efficiencies and consistency of experience. It also allows individuals to be clear on how a certain activity/situation is to be handled. The quality of processes can make or break an organization. Not only should processes be implemented, but they should also be measured and evaluated periodically to ensure that inefficiencies and redundancies are eliminated. In a startup, it is critical to define some processes, but yet be flexible to adjust processes quickly as soon as you see some processes becoming bottlenecks or inefficient. It is therefore important for startups to test these in the pilot phase.

What to ask customers when testing the viability of product idea?

When testing the viability of a product/service concept, you should aim to get answers to the following:

  • Does this concept address a customer need or want
  • Are customers excited about the value proposition offered by the product/service
  • Is there a business case in this concept

For the first point, you should check with customer is the problem that you are addressing is relevant. Concepts which address real and important problems have a better chance of succeeding.

Once the customer has accepted that they indeed are looking for a solution to the problem you address, then explain your concept and check if they feel that this addresses the problem well and that the price-point at which it does is fine too. You may need to test this with a few customer segments to understand which group has the highest potential for you. Be careful to check that the value proposition and your concept is easy for customers to understand. In many cases, showing them a one-page concept note is closer to how they would see / know about the product in real life. It is unlikely that they would get a chance to hear about the product from someone like you.

After the product is ready, it will be important to get customers to use it to ensure that the product, according to them, delivers on the promise. In concepts that may require repeat purchase, it will be important to test if they purchase it again. There are some interesting ways of doing research on concepts and products, including qualitative techniques and quantitative research.

From a venture creating point of view, it is important to understand if there is a real business case underlying this concept. This will mean working out a fairly detailed business plan, costing the concept right, pricing it right and then seeing if it makes commercial sense to get this product out in the market.

Understanding the concept of a business model

Simply put, if the idea is the ‘what’ part, the business model is the ‘how’ part of your plan. It is a clear statement of how you are going to make money from your venture.

In other words, it reflects your thinking on the following broad parameters. Of course, the parameters will vary by business:

  • Who is your customer
  • What are the revenue stream(s)
  • How much will they pay for the service
  • How much gross margin will you make on each sale

 

To illustrate with an example:

For an online toy store the business model can be as follows:

“We sell & deliver toys to consumers who order online from our website. Our target consumer is the affluent family with children below 7 years. Our average ticket size per transaction is INR 1000 and we expect our target customers to buy 2-3 times a year from our online store.

We have a 50%+ gross margin on our products. Thus, we expect to make about INR 1000 gross per customer per year.”

Note: Once you have your business model detailed out, you will need to check if your concept and business model has a business case. I.e. At the startup stage of low capital-intensive businesses, it will suffice to identify at what phase does the business become operationally profitable.

Business models could vary, even for the same concept different companies could follow different business models. Let us see with another example:

 

Possible business models for an outsourced HR management company:

  • One-time engagement for setting up processes
  • On-going, shared services model
  • On-going embedded employees model
  • Consulting services model

 

 

Understanding pricing or revenue models

How much to charge your customers is a critical decision for entrepreneurs. I.e. pricing is a critical component of your business strategy. While getting your pricing strategy right is no guarantee of success, getting is wrong is one sure shot route for failure. Obviously, how much consumers are willing to pay is dependent on the value they see in the solution you offer, be it a product or a service.

 

There are quite a few Revenue Models available for startups to consider:

 

Cost Plus mode: where the seller decides the price of the product based on the cost of the product. This is usually done for physical goods e.g. shoes, garments, computers, pens, etc. Doing this model for online services is not feasible because there is no real cost of the physical goods. How much premium you can charge over the cost is dependent on a number of factors including competition, alternate options, the overall value-proposition that the customers see in your offering, and often, also the personality & equity of the brand.

Value based model: For products or services that do not have an individual unit price [e.g. Microsoft Office software], the seller decides the price based on what they believe is possible to be charged from the consumer. This is the toughest part and may require some experimentation and in-market tests to arrive at the price point that you could charge.

Distribute the product free but customers pay for services: In some markets telecom companies follow this model where they give away the telephone instrument for free, and people pay for the usage. In some cases, e.g. printers, the base product is not given free but is offered at a very low price, often lower than the cost price, with the hope of recovering it through sale of related products and services e.g. cartridges and printer servicing.

Free for consumers – ad supported model: E.g. Angry Birds

Freemium: Free for basic, paid for premium services. E.g. sugarsync.com, linkedin, gmail, etc.

Portfolio pricing or package price: This strategy is applicable when the seller has a range of products and/or services and may want to engage the consumer for the entire portfolio. E.g. Insurance companies which offer for corporates a portfolio comprising of life insurance + car insurance + fire insurance + health insurance

Subscription model i.e. users pay a per month/per year e.g. book libraries, dropbox and other online storage sites, SAAS platforms, etc.

Pay-per-use model i.e. users pay as they use it e.g. Platforms like Webex have a pay per use model

One-time payment i.e. users buy a license to use e.g. Microsoft Office

Tiered or volume pricing: Typically used to group buying benefits. E.g. an enterprise software where the license fee per user reduces as more licenses get bought. The pricing in this model is often defined in slabs as relevant to the category.