Understanding the Start-up Funding Dynamics

The following column by U. Mahesh Prabhu was first published by Business Goa.

There was once a widely shared belief among business fraternity: “You are worth nothing until you’re profitable”. Today this mantra doesn’t hold any water. For good, or for bad, media today is abuzz with stories of startups being valued and invested in handsomely.

As per recent news a great many startups claim atrocious sums of investment. If media reports are to be believed Flipkart has $2.45 billion, SnapDeal has $1 billion, PayTM has $610 million, Ola has $276.9 million and Quikr has $196 million in investments. What’s actually baffling to many is the fact is that these startups are far from being profitable – in other words, they are loss making money guzzlers. So why do these loss making units receive such constant supply of investments?

As a thumb rule, ‘valuation’ is the fundamental basis on which investors determine the share of company that entrepreneurs would have to give them in exchange for money. Let’s assume that an entrepreneur is looking for a seed investment for around $100,000 in exchange for about 10% of the company that he wishes to invest in. In a typical deal, the pre-money valuation of the company should be $1 million. This, however, does not mean that the target company is worth $1 million now. Valuation at the early stage is more about growth potential as opposed to present value. Drew Housten went to Y-Combinator who paid a seed capital of $20,000 in exchange for 5% of Dropbox; since they valued the startup at $400,000. Similarly Kevin Systrom was paid by Baseline Ventures $500,000 in exchange for about 20% of Instagram since they valued this company then at $2.5 million. Today the company is being valued over $1 billion!

In new age startups, the key to success is all about bringing in the right idea to life by getting right people to work for you. Since startups are low on capital, the obvious way to woo employees is by offering them a stake in the company in addition to a nominal salary. These stocks are set aside for offering to future employees much in advance and are called Option Pool (OP). Normally OP is around 10-20% of stakeholding. What is also interesting is that larger the OP, lower the valuation of a startup. Why? Because OP is valuation of future employees which startups don’t have when they are starting their ventures.

The following factors play a pivotal role in evaluating startups, namely: Market forces, the comparative analysis and size of exits in similar startups, willingness of an investor to pay a premium and, also, level of desperation for being funded in an entrepreneur.

The question many entrepreneurs ask is “How do I get huge valuation?” The right question, however, is to ask “Do I need a high valuation?” The answer is most definitely – “not really!” This is because when you get a high valuation for a seed round, for the next round you’d need even higher evaluation. This means that you’d need to grow phenomenally between two rounds. Generally as a rule, it’s anywhere between a year and two that you go for the next round of funding. Should you fail to register 10 times growth in this period, your investors are bound to lose interest in your venture.

There are two strategies often deployed by entrepreneurs:

Thrive or Die: This is about raising as much sum possible by getting a high valuation before spending all the money to attain exponential growth in terms of market capitalisation. Should this gamble payoff, your next valuation is higher; so high that your seed round pays for itself. The assumption here is that if a slower-growing startup experiences 55% dilution, the faster growing startup will only be diluted 30%. So you save yourself 25% that you spend in the seed round. This is the strategy that is being adopted by the likes of Flipkart, SnapDeal etc. So far their gamble seems to be paying well; yet their accumulated risk is way too high. Not too many business analysts seem to be speaking about this.

Get as you go: Raise only so much amount as you need. Spend as little as possible and aim for a steady growth rate. There’s nothing wrong with steady growing startups. It’s just that your evaluation will grow steadily. This might not get you in the news, but you will raise your next round. This is the more sensible way but is infamous since you are deprived of media glare.

Of all the things, it’s crucial for an entrepreneur to understand that an investor’s perspective is always the key. What an investor understands and assumes will finally determine the fate of your startup. In the end you have to earn the trust of your investor

 

 

August 24, 2017

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