When, from whom and how to raise funds are common questions which many first time entrepreneurs grapple with. I will be writing a series of posts on this topic. To begin with, entrepreneurs should know when they should choose to NOT raise money from a Venture Capital (VC) fund and just continue to build their businesses by generating cash flows or to just bootstrap, as an unglamorous label.
This article is more relevant to Indian startup ecosystem as on 2018 with the visibility for the next 5 years.
The VC’s No
At India Quotient, I meet many founders who are passionately building exciting services/product businesses. Most of these startups leverage technology to differentiate or use the internet to distribute, and some of them use neither. These startups are in the range of 0.25–1 Cr. monthly revenue. They have found their early customer validation or Product-Market Fit (PMF). Some of them are profitable as well.
I still politely say NO to a lot of them in my first meeting itself. I know founders do not like to hear NO. Some of them are very capable and have the potential to be successful entrepreneurs. The business makes opportunity cost sense to them , but here is the catch — they do not make sense to my business of investing (VC investing) in startups. I am an entrepreneur first and then a VC. I can understand their view but they need to understand our logic and business too.
I will explain the VC business math later, lets first look at No Businesses.
Typical No Businesses are as follows:
The above examples of businesses are good opportunities which can potentially reach net revenues of 20–100 Crs in 5–10 years with healthy 10–15% profits or more. Its difficult go beyond this scale either due to the target market being small or limitation in scaling via an existing distribution channel.
Among these businesses, sometimes I also come across a founder whose business has potential to grow by either investing in the brand, creating own distribution or by changing the business model a bit. Unfortunately, the founder’s vision is limited, not ambitious enough or he/she isn’t a risk taker.
Net result-these businesses can’t/won’t exponentially scale in the VC fund’s time horizon of 8–10 years
VC Math — NO reason
Let’s do simple math - valuation multiples are generally in the range of 1x to 10x depending on the sector, net margin, growth rate etc. (10x possible for SAAS companies, i.e., recurring revenue software businesses), so maximum valuation potential for such a company is 100 Cr. x 10 = 1000 Cr. i.e. 150Mn USD . This does not excite VC’s and that's the reason of NO because the potential outcome for a VC fund is low.
Reason for no excitement is the VC fund business model* — to get a disproportionate return from their winners and they do this via putting a bet on 20–30 such theoretically possible potential unicorns (1+Billion$ value companies).
If you look from the Indian VC fund size perspective, the winner should be an at least 3500 Cr. value company. If a VC fund holds 10-20% at the time of the exit, they can make 350-700 Cr. i.e., 50-100Mn$ outcome for a fund which equals to 0.5-1x times for a 50-200Mn$ fund.
Looking from another perspective, a No Business can generate 2-10 Cr. of annual profits. If there are 2–3 founders then each one can take 50L to 3 Cr. profit home — a very good personal outcome. Hence the founders should grow the business organically or by using debt from banks/NBFC. There is also a good chance that at 80–100 Cr. revenue a large strategic player may acquire and each founder can take home 50–500 Cr. cash.
This path is not easy for sure, bit long also, but it is both financially and mentally rewarding. And this is a real SUCCESS for a founder!
Avoiding the VC Trap
When No Business founders meet VCs, many of them engage, ask for more data and after multiple meetings say No or give vague directions like — I will put if someone else comes, show me that particular metric, etc. This creates belief in entrepreneurs mind to raise money from a VC and he ends up chasing them or chasing unsustainable business growth. He loses focus on fundamental of his business. In the end, neither they become a viable business for themselves nor for VCs.
Many founders do not know that good business can be built without going via the VC funding route.