Economic activities are important for the economy of any nation. These activities may include starting a new business, creating employment opportunities or becoming an entrepreneur. A new refined and renewed term has been coined for all these activities — startup. In terms of numbers, India now has over 60,000 startups and they are working across around 55 industry sectors. Data provided by startupindia.gov.in shows that around 4.7 lakh jobs were created by startups during the Jan 2016 - Dec 2020 period. In order to promote startups, India celebrated January 16 as National Startup Day. Also, Prime Minister Narendra Modi has said that startups are the 'backbone' of new India. But these startups face a lot of uncertainties during the initial phase and this is where incubators or investors play a key role. Incubators or investors not only extend monetary but moral support as well to these startups. One such platform is Shark Tank India - which provides opportunities for budding entrepreneurs to make their ideas big. Shark Tank India will soon be coming with its second edition. Here in this article, we will try to elucidate how much risk investors take while funding a startup and how they make money out of it.

What role do incubators or investors play in startups?

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Coping with extreme uncertainty in the initial stages of a startup can be onerous. According to Dr Apoorva Ranjan Sharma - Co-founder, Venture Catalysts Group - incubators and investors help entrepreneurs manage uncertain times and play a key role in the development of a startup’s business.

"A revolutionary idea or product can face several challenges before it reaches customers, and incubators help develop a business strategy that ensures growth. Incubators often provide a range of services for startups, providing validation for ideas and identifying market needs, carrying out market research and building a prototype product," Dr Apoorva Ranjan Sharma told Zee Business.

Incubators enable startups with mentorship. New entrepreneurs often need guidance to understand and strategise the various aspects of business, like marketing, sales, business development, operations, and so on. A startup may even need to pivot from its original course, and a good mentor can provide the right guidance and direction.

"One of the most crucial contributions of incubators involves fund-raising. A good idea or product with validated potential garners investor interest, and a bootstrapped business can achieve financial support via the incubator route. Incubators are able to provide access to a network of investors and experts for startups, availing new opportunities for growth and impelling the company towards realising its vision," Dr Sharma added.

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What are the different stages of funding?

 

Following its inception, a startup initially is a high-cost and low-revenue business. "Startups can avail funding from a number of sources, and entrepreneurs often self-fund their startups when starting out with their idea. There are about eight stages of funding for a startup. These include pre-seed, seed, Series A, B, C & D, mezzanine funding, and acquiring funds through the release of the company’s IPO," the Cofounder Venture Catalysts Group said.

● The pre-seed stage - This is a stage where a business concept is developed. Also, working on any kind of partnership agreements, getting any patents or copyrights and creating a pitch deck are parts of this stage. Funding source in this state is usually self, family, friends, and micro VCs.

● The seed stage - Getting a product or prototype and getting the business running are part of this stage. Angel investors and early VCs can give funding at this stage.

● The Series A stage - From researching industry and markets to planning to scale into new markets, startups do all these things in this stage. Among those who fund startups in Series A are accelerators, super angel investors and venture capitalists.

● The Series B stage - This is the stage when a startup tries to establish a commercially viable product or service and also focuses on scaling the business. Those who fund startups at this stage are venture capitalists or late-stage venture capitalists.

● The expansion stage (Series C and beyond) - From building new products and markets to acquiring other companies, all are part of this stage. Among those who fund startups at this stage are late-stage venture capitalists, private equity firms, hedge funds and banks.

● The mezzanine stage - Either a startup is acquired by another company or special purpose acquisition company (SPAC) or it remains private using VC funds. Hedge funds and private equity firms are among the investors.

● Going public — The IPO - At the pinnacle of a startup’s success is its IPO. This is when a startup offers its shares for public purchase for the first time, and it involves execution through elaborate teams of SEC experts, lawyers, accountants and underwriters. In this stage, a startup must compile its financials, clearly outlining anticipated future operations, audit financial statements, and completing governmental IPO requirements such as filing of prospectuses and formalising the date of the IPO launch.

Key points incubators or investors keep in mind while funding a startup?

 

Investment in a startup has potentially higher risk as compared to other traditional avenues. Depending on the stage of the startup, investors and incubators adopt different approaches when it comes to funding it. According to Rajiv Srivatsa - Partner at Antler India - early stage funding is the toughest task as there are very few signals about the future prospects of the startup.

"For our pre-seed investments, we evaluate startups at the earliest stages - usually when the startup is at the idea stage, or pre-product stage, or pre-traction stage. There are very few signals at these stages, which also makes early-stage investing much harder. We primarily focus on identifying outlier founders - those with the ambition, speed and ability to build a large business. Besides the founders, we take into consideration the size and growth of the particular market and other factors such as how much value their product can capture in the value chain. We zoom in a lot on their unique insight or product differentiation angle, and want to keep taking bigger risks even if they are super early on an emerging market trend, or are trying to create a new user behaviour that has the potential to become big," Rajiv Srivatsa said.

On the other hand Deepak Menaria - CEO and founder of Lemon Ideas - feels that founders are the main focus when it comes to funding.

"I would want to look at Startup founders more than the idea because as a jockey, he/she has to ride the horse (idea-startup). The skills, commitment, experience, and past achievements of the founder are a few indicators to mitigate the risk. It’s more like putting money on a founder/jockey but other stuff also matters like validation, market opportunity, potential to grow, innovation or uniqueness among others," Deepak Menaria told Zee Biz.

However, some investors feel that it is not the founder or idea that matters.

"The most important factor dictating startup success is not the idea, not the founder's caliber, not the size of the market but the timing. Is the market ready to be served by the idea? An easy way to judge this is when consumers are saying 'I'm going to pay double for this'," said Suman Bannerjee, CIO, Hedonova.

Important Factors Venture Capitalists Consider Before Investing

 

● Character of the Founders

● Scalability

● Product Market Fit

● Financial outlook & projections

● Target Market size & target audience

● Competitive landscape

● Previous investors

● Valuation multiples

How easy or difficult is it for startups to get funding?

 

An entrepreneurial journey is typically a rollercoaster ride full of ups and downs. Growing a business demands considerable time and capital. Most businesses fail because they cannot obtain funds at the right time. According to Gaurav Singh - Founder, JPIN - it is also common for start-ups to hit a roadblock; therefore, they cannot raise funds beyond a Series A. This can be due to many reasons, but often it is because the startups fail to reach their agreed milestones.

"Despite the risks, a growing awareness of VC returns is attracting investors into the market. Many traditional investors currently dominating the public wealth market are warming up to VC investments. Since the pandemic, a massive surge in unicorn companies was created, with many going public. This brought in a new wave of investors looking to be part of the historic gains seen during the pandemic. Unfortunately, with ongoing volatility in the equity market, investors have become more cautious about spending their money on risky asset classes such as VC investments. Therefore funding has become more challenging to obtain. The slowdown in funding has resulted in only the ‘best’ receiving capital. It is essential for startups to focus on their fundamentals and road to profitability. Despite the slowdown, there is no doubt that the VC ecosystem is still thriving and will continue to invest throughout the volatility," Gaurav Singh added.

According to Priyanka Kothari, Director of Arvog - it is very difficult for startups to raise funding in the current funding scenario as multiple startups have raised funding at exorbitantly high valuations and later on neither the founders nor the investors were able to justify these valuations.

"This has led to multiple startups having to lay off employees and startups that have gone to raise funding through IPOs have seen their valuations drop tremendously post the listing. This flow of events as iterated above along with global macro events has led to a restricted flow of capital to startups and has also made investors more risk-averse. This being said, there are many startups with amazing business models that have been able to attract investors and raise millions of dollars," Kothari added.

On the other hand, Soubir Bose - Co-founder EasyInherit - feels that current times are perhaps the best ever for start-ups and there are a large number of options for funding.

"The Start-up India initiative by the Modi Govt has really accelerated the process for all startups whether they are at just the idea stage or have started generating revenues. But it's important that the start-ups do their homework on the market, consumer, ecosystem and financials. Equally critical is to think of all possible pitfalls and combat strategy," Bose said.

What happens when a startup fails or becomes a unicorn?

 

Startup failures are extremely common in the age of information. It is said that almost 90 per cent of all startup companies fail while becoming a unicorn —that is, achieving a valuation of $1 billion — which reflects a successful venture. It is also important to mention that not every successful startup must attain unicorn status. When investing in a company, investors take on the risk of losing their money in case a startup fails. However, if a startup succeeds, investors who bet big win big.

"How well an entrepreneur has managed his company, and how they worked with previous investors is also an important aspect viewed by investors. Overall, companies that are not backed by venture capital fail more often in the first four or five years from the company’s inception," said Dr Sharma.

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How do incubators or investors make money when they fund startups?

 

Investors provide capital in various stages of funding for a startup in exchange of equity. This avails a portion of ownership in the company for investors, while ensuring a share in future profits. By developing a partnership with a startup, investors make money proportionate to their share of equity when the company begins to make a profit, whereas, in case of its failure, investors lose the money they invested. Startup investors make a profit from their investment by selling parts of their ownership in times of a liquidity event, such as an IPO or acquisition.

Investing in startup equity is very risky, given the average rate of failure displayed by startups. However, the increased risk and illiquidity in investing in startups are juxtaposed by the potential for a very large return if the startup succeeds.