Startup Fundraising - How it works?

An intro to startup equity fundraising & why anyone invests in startups

Recent advances in computer technology, infrastructure, and cheap data costs have made it more accessible and cheaper to start a new business than at any other point in human history, which in turn has increased funding opportunities for startups.

An important thing to note is that every other newly formed business need not be a startup nor do they have to be. There are lots of great companies that aren’t startups. In the words of Steve Blank, a startup is “a temporary organization designed to look for a business model that is repeatable and scalable.”

The reason behind any kind of investment is an expectation of return, with startups; investors expect returns above the market. In simple terms startup equity/venture is an alternative asset class, which investors consider for its favorable returns despite being a very high-risk one.

This is a very fundamental element for any startup founder to understand and come to terms with as any potential investor they speak with is going to look at them through the lens of - 'What kind of returns can I expect to get from investing in this venture?', 'How long will I have to wait to see returns?', and 'How does this investment opportunity potential when compared to others I have?'.

8 Out Of 10 Startups Fail

Founders might overlook this, but most investors know this very well. That's the reason venture investors always use a portfolio approach to reduce risk. Venture deals and venture capital fund returns follow an extreme power law distribution. The characteristics of this fat tail curve mean that a tiny number of startups result in giving extremely huge returns, but the overwhelming majority are unspectacular (the tail).

But the good thing about startup investments is that investors can only lose their investment, but could stand a chance to gain a multiple of it.

An angel investor who would have written a cheque of $5,000 into Uber would have made nearly $25 million in its IPO. A 5000X return over a 9-year period.

Who are these people who put money into startups and what are they called?

Angel Investors & Venture Capitalists [There are Micro VCs, Solo Capitalists, Corporate VCs, Angle Syndicates, etc. but for a 101 we will be looking at these 2 classes of investors alone]

Angels are affluent individuals who invest their own money into a startup. On the other hand Venture Capitalists (VCs) invest other people’s [Limited Partners or LPs] money.

Angels can range from friends and family members investing based on a relationship to sophisticated investors with strong business backgrounds or domain expertise. In many instances an Angel might not have the benchmarks and economics of a VC, meaning they can invest much smaller amounts in earlier-stage [idea] companies, unlike a typical VC investment.

In addition to investing their capital, Angels/VCs also invest their time and resources [market access, partner connects, and more] to help the founders grow the company and make it successful — with the ultimate goal of an exit event such as an IPO or acquisition.

To many in India, startup fundraising is an opaque process that most only know through episodes of Shark Tank India. For most founders without connections in the startup ecosystem seeking investment, raising funding from investors is often a daunting task, with the odds stacked against them.

A sample deal flow funnel of VC

For you to raise funding for your startup, you need to know 'What do investors look for in a startup?'

Investors lookout for a Kickass Product, Bigass Market & Slickass Team

Why? And do they only consider these broader 3 aspects?

We will be looking at the 'Why' in a bit more detailed manner. Are these the only 3 investment criteria - the answer is a big 'NO'. Venture investing involves not only a process of choosing the opportunities in which to invest; but also the art of monitoring and eventually exiting those investments. Not all venture investors are the same. Like startups in which they invest, VCs/Angles often try to differentiate themselves by developing a unique culture, specific sector focus, stage preference, or geographic preference.

Product, Market & Team matter the most when an investor is evaluating your startup

We invest in smart people solving difficult problems, often difficult scientific or engineering problems. - Founders Fund

Product

“Competition is For Losers” - Peter Thiel

What is the likelihood that the product, being developed by the startup is going to emerge as a clear winner when it comes to solving the problem? And is the product something the market really needs?

Market

''Great Markets Make Great Companies'' - Don Valentine, Grandfather of Silicon Valley

A great company solving a critical problem can still be a bad venture investment if the market size is very small, as it would mean the potential return multiple is as well too small. For a VC kind of return, the expectation is to have a market large enough that can generate $1 billion or more in revenue.

Team

When a great team meets a lousy market, market wins. When a lousy team meets a great market, market wins. When a great team meets a great market, something special happens. - Andy Rachleff, Co-founder and Executive Chairman of Wealthfront

The only differentiating factor between early-stage startups -- is the founders. In the very early stages, a company is nothing more than the collective efforts of the founding team. Therefore, how talented and able the founding team, is a major contributing factor to success. The team is something that could make or break the startup despite all odds being against the startup.

Most times when a VC/Angel is rejecting your startup they need not necessarily reject your idea alone; it might be your team or market in which you operate as well.

And as mentioned earlier and not to be repetitive Product, Market and Team are not the only factors an investor will consider while evaluating your venture; depending on the stage of your startup and the funding ask the evaluation criteria are bound to differ subject to various other factors [having personal connect with Angels/VCs might alter the entire investment evaluation process].

But, most founders who would have approached investors for raising funding would have heard one version of this innocuous-sounding rejection -'Interesting startup; but the scale is too small for us to evaluate. Best to connect for the next stage.'

The investor is signaling here to come back when you have more traction. Any investor would like to have evidence that the "dogs are eating the dog food," and your startup's financial projections are not just an imagination.

Having read through all this you might need to question yourself if your startup would be attractive enough for equity investors. Your startup needs to have enormous growth potential to secure growth capital from investors who have a high-risk appetite.

If your venture doesn't fit the bill you would be better off bootstrapping your venture with some support in the form of debt [bank overdraft, business loans, etc] or grants.

However, if you have decided that venture money is the route for your startup success the very thing you also need to decide is 'How Much to Raise? And at what terms?', any investor is going to ask you this and you need to figure this out using your startup's financial goals and capabilities over the next 12 to 18 months. The terms of the funding [equity dilution, valuation, etc] are something that you might have to figure out by having a conversation with your investor(s) during the negotiation of the term sheet if you reach to that stage.

How do I reach out to investors?

• Start by activating your network, getting warm introductions to Angels/VCs is the fastest way to get on a call with them.

• Ask your network to introduce you to people whom they think can help you connect with an investor.

• Write cold messages to investors over mail, LinkedIn, Twitter, and more.

• Network with potential investors in startup events.

These might look simple/plain but, these are the easiest way to reach out to investors. There are also startup investment advisors who connect you with an investor(s) over a success fee [terms are bound to differ].

And what do I need to reach out to investors?

Investment Pitch/Memo

Your investment pitch deck/memo should possess a powerful fundraising narrative and importantly articulate the key components of your venture with a rationale for investing in it.

Raising funds is not the end goal of a startup. Growth, Scale, and Profibality must be the goals of any startup.