Angel investors, VCs and other funding options for startups

While most entrepreneurs think of VC funding as the most obvious way of funding their startups, there are actually many different ways in which you can fund your startup.

 

Getting risk capital i.e. angel investors or Venture Capitalist – VCs

Angel investors or VCs are investors who give you capital in exchange of equity in the company.

Angels and VCs buy equity in a company for a price and expect to make a profit by selling it at a higher price. Just like it happens in the stock market, but in this case because your company is not listed, VCs make money by privately selling the stock they hold in your company to someone else.  E.g. an angel investor may ‘exit’ by selling his/her stock to a VC and later the VC could exit by selling the stock they hold to either a Private Equity firm or to a strategic investor, or in rare cases by diluting their holding during or post an IPO.

The money that angel investors give is collateral free. I.e. you do not have to mortgage your house or something to get money from angel investors of VCs. In case the company fails, investors lose their capital and entrepreneurs do not have to return the capital. This is the one and only reason why angel investors and VCs will evaluate plans thoroughly before making a decision to invest in a company. In effect, they are taking the following risks about your venture:

  • That you and your co-founders are a great team that is capable of scaling up the business
  • That your concept will work
  • That the market is large and therefore there is potential to build a large company

Because of this, funds raised from angel investors, VCs and later from Private Equity funds is called ‘Risk Capital’.

While angel investors and VCs provide capital without collaterals, and thus allow you to start up without having your own capital or collaterals for a loan, it is probably the most expensive form of capital. That’s because you are giving away equity in exchange for the capital you raise.

Let us understand this with an example. I am of course, simplifying and exaggerating for easier understanding, but the principle is correct.

Let us assume company A raises INR 10 lacs [i.e. USD 20,000] from an angel investor and gives the angel investor 10% equity in the company. Assume further that this company is able to successfully scale up and is receiving a INR 5 crore [USD 1 mn] funding from a VC for a valuation of INR 20 cr.  [USD 2 mn].  Assume that the angel investor exists at this round by selling his stake to the VC. In this scenario, the VC would get about INR 1.5 cr for his/her share holding in the company. The illustration below gives a sequential view of the capital structure of the company after every event i.e. when the angel invests, when the VC invests and finally when the angel exits by selling his/her stake to the VC.

Share holding at starting Phase
Entity

 Investment

 No. of shares

Price per share % holding
Founder

 1,00,000

 50,000

2

50%

Co-founder

 1,00,000

 50,000

2

50%

Total

 2,00,000

 1,00,000

 

100%

Share holding after angel investor invests INR 10 lacs and takes 10% equity
Entity

 Investment

 No. of shares

Price per share % holding
Founder

 1,00,000

 50,000

2

45%

Co-founder

 1,00,000

 50,000

2

45%

Angel investor

 10,00,000

 11,111

90

10%

Total

 2,00,000

 1,11,111

 

100%

Further, a VC invests INR 5 cr and takes 25% of the equity
Entity

 Investment

 No. of shares

Price per share % holding
Founder

 1,00,000

 50,000

2

34%

Co-founder

 1,00,000

 50,000

2

34%

Angel investor

 10,00,000

 11,111

90

8%

VC

 5,00,00,000

 37,037

1350

25%

Total

 2,00,000

 1,48,148

 

100%

If the angel investor sells his/her shares to the VC, then the VC would have paid the angel investor a sum of Rs.150,00,000 i.e. Rs.1.5 cr to buy the angel investors shares in the company. The capital structure of the company would be as below.
Entity

 Investment

 No. of shares

Price per share % holding
Founder

 1,00,000

 50,000

2

34%

Co-founder

 1,00,000

 50,000

2

34%

Angel investor

 10,00,000

VC

 6,50,00,000

 48,148

1350

33%

Total

 2,00,000

 1,48,148

 

100%

Bootstrapping

Bootstrapping is the art of going as far as you can without external funding. I.e. pooling together your own resources, usually at a pre-concept stage or at a prototype building stage.

Often, people bootstrap their startup while still keeping their job at some. Whether you should bootstrap or go for external funding is a factor of how much money you need, and for what. I.e. if you are building a solar micro-grid, it is unlikely to be funded through bootstrapping as it is likely to be a capital-intensive business. However, on the other hand, an e-commerce venture can most likely be bootstrapped… often by using SAAS platforms, etc.

When to bootstrap

  • When your concept is yet to be proven … and can be proven with limited capital
  • When you too are unsure if you would like this to be your lifetime career and want to give it a shot
  • When you have the resources to go past the concept proof stage

 

When not to bootstrap

  • When the capital required for the proof-of-concept stage is more than what you can garner from your current resources

Even when you don’t need the capital, it is sometimes good to pitch to investors as it gives you a good feedback on your concept. If many investors say no, it may be worthwhile evaluating the concept and pan thoroughly before diving into the game.

You may want to consider the points below before you take the decision to bootstrap:

  • Evaluate whether your idea has a good business case – speak to some experts, pay attention to those who are not excited about your idea. After all, even if it is not costing you a lot of money, your time invested has a lost opportunity cost.
  • Prioritize: to bootstrap efficiently, you need to make your limited resources go far. Take a call on what is critical and what can be put off till you receive adequate capital.
  • Keep the expenses side as low as possible. That means having a very, ver lean team. That means hiring multi-taskers rather than specialists.
  • Consider SAAS and outsourcing: Even if that is not your most preferred option, you should take a call on what is important. Is getting ‘something’ out in the market more important or getting ‘The most perfect product’ most important? SAAS platforms may not give you the customization possibilities, but often they can shave off a significant percentage of your funding needs. You can always develop your own platforms after you have proven the concept and the model.

 

Debt

In other words, taking a loan.

Institutional loans often require a collateral, which many entrepreneurs may not have. Even if you have the collateral, do a real hard evaluation if the business model and concept is fully ready for you to take an individual risk on. Often, getting other external investors gets you more parties to take strategic decisions with, and provides an invaluable group to bounce ideas with.

 

Friends & Family round

For startups which need limited capital to start up, a friends & family round may be an option worth considering.

Points to remember in a friends & family round

  • Treat the friends & family round as a formal fund raising round too – pitch to the interested investors as you would to a group of angel investors or VCs
  • Complete the paper work and other formalities too – issue equity shares
  • Manage the relationship as a professional investor relationship – send quarterly reports, have a board, etc.

 

Get strategic investors

  • Larger companies for whom your concept is an adjacent or related opportunity may find it interesting to investing as a strategic investor.
  • Adjacent opportunity – e.g. Educational content platforms could be an adjacent opportunity for a large company in the education space
  • Related opportunity – e.g. healthcare services for the poor is a related product for a microfinance company
  • A strategic investor, apart from providing capital, also helps validate the concept for external investors thus making it easier for raising the next round of funding or for getting co-investors in the current round.
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5 mistakes to avoid when pitching to investors

With most VCs, you will get just one chance to present your business case. VCs are usually a skeptical lot because they see a lot of bad presentations.

Here are some mistakes to avoid when pitching to investors

  • Poor assessment of the risks in your venture: All businesses have competition. VCs are not looking for businesses without risks… in the businesses they are in tested in, they are looking for teams who understand the risks and have a plan to manage the risks.
  • Poor assessment of the competition or assuming that there is no competition: If there is no one else doing what you are doing, how are the consumers currently solving the problem? E.g. in a online food ordering business, just because there is no other brand dos not mean that there is no competition. ‘Calling up the restaurants using menu cards available at home’ is your competition.
  • Exaggerating management strengths: Remember, most VCs will do due-diligence… and most are experienced enough to know what is practical and what is fluff. E.g. for a professional with 2-years experience to claim “In my role as Client Services Manager I was responsible for formulating strategy and operations planning for fortune 500 clients” is usually not going to be an accurate representation of your role. However, “was involved with” instead of “was responsible for” is perhaps closer to reality.

Also, giving the right picture of your current skill sets and capabilities helps investors understand what assistance they may need to bring to the table, in case they decide to invest.

Investors are not looking for ‘we know all and we have been there done that’ teams… those are rare to find. Investors are interested in honest teams who are passionate about the domain and are smart enough to learn the things that they currently don’t know.

  • Impractical and unrealistic growth projections: While aspiring for scale is important, planning ‘how’ you are going to achieve it is critical. Without a plan, aspirations of scale are merely a statement of intent. Investors invest in a team with pans… not just on statements of intent.
  • Don’t include names of ‘advisors’ if they are not genuinely involved. Plain show & tell names just because you know a few people don’t impress investors.

 

The process of pitching to investors

Often first-time entrepreneurs underestimate the time it may take to raise funds for your startup. Unless you get seriously lucky or have easy access to a number of investors, it is prudent to estimate anywhere between 3 – 6 months to get funded. And that is if you have a good plan and a great team.

 

Well, its relatively easier with angel investors and much easier with angel groups like the Angel Investors Consortium. That’s primarily because they invest smaller amounts in a wider range of companies but also because individuals are making decisions and hence do not have to go through more complex processes of VC funds.

 

Here are a few steps that are involved and approximate time it could take with institutional investors:

Step 1 Identifying the right investors 2 weeks
Step 2 Getting the first meeting, including time taken for trying to reach someone to get meetings set up 1 – 2 weeks
Step 3 Meetings with the evaluation team 1 week
Step 4 Presentation to Investment committee 2 weeks
Step 5 Term sheet 1 week
Step 6 Term sheet agreements 1 week
Step 7 Due diligence and signing of documents 1 – 2 weeks
Step 8 Funds hit your bank  

Total time

9 – 12 weeks

 

Here are a few steps that are involved and approximate time it could take with institutional investors:

Step 1 Identifying the right investors 2 weeks
Step 2 Getting the first meeting, including time taken for trying to reach someone to get meetings set up 2 – 4 weeks
Step 3 Meetings with the first layer of filtering 2 weeks
Step 4 Meetings with the senior layer 2 weeks
Step 5 Internal presentation to Investment committee 2 – 4 weeks
Step 6 Term sheet 1 week
Step 7 Term sheet agreements 2 weeks
Step 8 Due diligence 2- 4 weeks
Step 9 Signing of documents 1 week
Step 10 Funds hit your bank  

Total time

16 – 20 weeks

And these are fairly optimistic timelines with the investors who finally fund you. There will be several you would meet who may, out of genuine interest to invest, progress the discussions but may not conclude the deal for several reasons. And there will also be many who may decline to invest in the first meeting itself but still it will have taken 4 – 8 weeks to get the “No” as an answer.

 

Given the lengthy process, the entrepreneur should try to be selective about which investors they should approach. Investors, especially VC funds are clear about the kind of companies, the stage and the domains they would invest in, and that information is usually available on their websites.

 

One of the first things that entrepreneurs need to do is make a shortlist of who the ‘right’ investors would be.

  • To begin with, you need to decide if you are ready for angel investors or for VCs. Click here to know more between VCs and Angel Investors.
  • When applying to investors, check their websites and see if they have invested in businesses similar to yours and if your domain is within their interest areas. E.g. if you are a life-sciences company, there is no point in approaching investors whose focus areas are Mobile & Internet and Consumer Businesses.
  • Check if there are synergies between any of their portfolio companies and your business, and if there are, then evaluate highlighting the same during your presentation.
  • From among the many people at the VC, identify who in their team is more likely to be excited about your idea. This is easy to find because most VCs will have profiles of their team members, including details of which companies or domains that person is involved with.

 

Once you have identified the investor, and the person who you are going to connect with, try seeking an appointment by making a call to the office. Most likely, you will be asked to send the presentation to a generic mail id used for receiving business plans. Well, this is not something that you can always avoid. The truth is that investors get so many calls and mails requesting for meetings that it is almost impossible to accept all requests.

In most VC offices, business plans received will be reviewed with some level of seriousness, though most probably by the junior most executives who may not necessarily be experienced at taking a gut feel call on what seems like a good business case. If you are lucky to get past this stage, you will be asked to come and meet an associate. And that’s just fine. This is the first line of filter in a VC fund and an associate is expected to do a thorough evaluation based on their internal criteria, and then if and found suitable, are expected to move the deal up to a partner who can decide if the deal is to be presented to the investment committee.

If you pass the first line of filter in a VC fund, and this can take a few meetings, you would have to present to the next level. This round, depending on the interest of the fund, could take a few meetings with revisions and discussions on strategy, scale, funding needs, etc.

Once there is broad agreement on key areas, and if the deal fits into the internal criteria of the fund, the deal will be discussed at the investment committee meeting where the terms of the term sheet will be outlined.

After presenting the term sheet, the entrepreneur is expected to run it past someone who knows the legal stuff around term sheets…. And when you ask someone’s opinion, the person feels it obligatory to suggest a few changes. It then takes a few meetings and discussions to finalize the term sheet and sign off.

NOTE: some VCs would discuss the terms of the term sheet offline over meetings and dinners, and therefore the draft presented to the entrepreneur on which there is an informal agreement on key points like valuations, control, vesting, rights and downside protection. However, the time taken would still be approximately be the same.

Once the term sheet is signed off, the due-diligence will start. Also, the startup may have to complete some tasks as part of the ‘conditions precedent’ and that could be things like filing for patents, getting an independent director on board, getting customer contracts signed, etc.

After all this is done, the final signing of the documents and receiving the cheque are the logical next steps.

 

Why do early stage investors not invest in a company’s later stage rounds even if the company is successful?

Well, different investors participate in different stages of a venture. These stages carry different risks, apart from being different in the amount of capital consumed.

At the very beginning, which is where angel investors or seed stage investors participate, is the highest risk-stage of the venture. I.e. at this stage the venture carries a concept risk [i.e. will the concept/product/service work, will the business model work] as well as the execution risk [i.e. will the team deliver] and scaling-up risk [i.e. will this model scale and can this team scale it]. Angel Investors work closely with the entrepreneurs complementing the skill set gaps in the current team. The role of the angel investors, apart from providing capital, is to help the team prove the concept and the business model.

As the venture progresses and the concept and business model is proven, the venture needs to prepare for scale and that is when additional capital is required. At this stage, angels usually step back as the venture needs larger capital, which is usually got from institutional investors like VCs.

Institutional investors typically assist the company in building the foundations for scaling up – organization structure, processes resources, infrastructure, etc.

Post this round, capital is usually required for scaling up. This is the stage when growth stage VCs or PEs come in. At this stage, the model is proven, the teams capability to execute is proven and now the capital is required to significantly scale the operations, and perhaps explore new revenue streams, new markets, etc.

Therefore, in each of these three stages of a venture – i.e. concept stage, execution stage and scaling-up stage – different investors participate with different levels of involvement and different inputs required for these three different stages.