By Dr Suresh Srinivasan, Distinguished Professor (Strategy & Accounting), Great Lakes Institute of Management
Start-ups identify a customer ‘pain point’ or an ‘unmet’ customer need, find a solution for such pain points, for which the ‘potential’ customer is willing to pay, and fold the overall offering around a ‘business model’ such that the costs of delivering the solution to the customer are more than compensated by potential ‘revenue streams’ leaving a surplus for the founders.
One would see the primary focus here is the idea, the scalability of such an idea, the ability of the start-ups in executing the idea, and the importance of orchestrating resources, primarily skill sets and money, in the pursuit of delivering value to potential customers. In the above definition, one sees a number of keywords like ‘potential customer’, ‘unmet need’, ‘potential’ revenue streams, etc., all of which signify the magnitude of uncertainties and risks involved with any start-up agenda.
Until it is executed and the potential customer pays for it, the start-up idea merely remains on paper and the probability of its failure and the resultant loss of investment remains high!!
Further, in start-ups the resources are assembled by the founders by spending first; there is always a time lag between such spending and for such spending to translate into revenue streams, being the investor returns on such spending! There is hence a requirement for funding at all stages!
While it may seem that a traditional business also has such an issue and what’s so different in a start-up backdrop; the difference is the level of risk involved in the start-up arena as the business model is yet to be vetted and remains on paper while business models of traditional established companies are smoothly functioning well-oiled machines with well-established customers and revenue streams!
This is where cash flow and funding, more importantly, the timing of such funding, become crucial in start-ups; at every stage, the start-up sucks cash and needs fund infusion. While most start-ups ideally prefer to bootstrap their venture to remain self-sufficient, in reality resorting to external
funding becomes a necessary evil to grow and scale. Recognition by the founders that funding, at some stage, is inevitable, helps; it will then be a question of merely how funding needs to be managed!
Early-stage funding, also known as seed capital or angel investor funding, comes with higher levels of risk-taking by the investor while subsequent rounds of funding, where the clarity in the business model of the start-ups start emerging (also known as Series A, B, and C funding), generally have a lower risk for the external investors like venture capitalists, hedge funds and investment bankers.
Investors fund the start-up at various stages, in its pursuit of establishing a proven business model, and securing equity shares and ownership in the start-up in return for their fund infusion. The Share of the overall ownership such investors will secure will depend on the stage of the start-up at which they are infusing funds (which denotes the risk they are taking) and the resultant valuation of the start-up at that stage.
Funding is a double-edged sword; on one hand, it helps the start-up progress swiftly towards achieving scale, and on the other hand, it dilutes the promotor’s shareholding (and consequently the level of profit he receives from the start-up) and control (with respect to crucial decisions) over the start-up! The level of such dilution depends on the stage and quantum of funding.
While the central idea of the start-up may seem to be the most important attribute in a start-up’s success with funding merely being a complementarity, it turns out that funding, and its timing, can make or break a start-up’s success! Some ventures can be scaled in a shorter span while others may take inherently a longer time frame to grow and attain scale, but such growth (and the value surrounding it) can be sharp. So, what should be the timing of funding?
Understanding the fundamental underlying conflict between the founders and external investors is important; without a doubt, both are equally interested in the start-up succeeding, no questions! However, the interest of the external investors lies in securing their return in the short-run (say to exit the start-up with 3x or 4x returns in the next 5 years, say) while founders have a more long-term view of the venture, resulting in tension in their viewpoints and decisions!
On top of it, the founders amongst themselves could have misalignment on the long-term aspirations for the start-up!
Recognizing such tension, founders need to be realistic in their aspirations for bootstrapping and running the start-up without diluting control vs. raising funds and diluting ownership and control. At the same time, raising funds too early even before the business model is gaining shape can bring
investor interference is too difficult to handle at such early stages!
Funding can take time, effort, and energy, as it involves tight negotiations between the founders and the investors, clubbed with information asymmetry, the need for a realistic ‘shared’ view on the strength of the business model, the founder team’s execution capabilities to scale and cash-flow estimates in the short to medium term.
As the start-up travels through its different stages of evolution, however well planned, cash burn can aggravate the need for funding at short notice; it is crucial for founders to have on their radar, access to ‘like-minded’ investors aligned with the founder’s philosophy. This is more important than merely deciding on a higher financial offer, or scrambling for investors when crisis strikes and cash-flow shrinks!
As founders are diluting their stake, the investor is here to seek returns in the midst of available alternative investing options with a range of risk and return profiles! It is imperative that both needs each other! Founders need to be sensible in their demands, thereby indulging in realistic and value-creating negotiations, if not the very start-up can derail!