Funding the Next Big Thing: A Startup’s Guide to Venture Capital
Maximize growth opportunities by understanding how venture capital works.
Indian startups raised over $3 billion by the time the second quarter of 2022 ended, per a report. While this number might sound huge, it is actually 80% down from the previous year and 57% down from the previous quarter. One of the major reasons for this is that startups are finding it difficult to get funds. Some funding mediums available to startups are loans, angel investors, and venture capital for small businesses.
However, the availability and appropriateness of funding sources vary based on the unique characteristics of a company. For startups, the stage of investment also plays a role in determining the most viable options.
For instance, venture capital funding is typically more suitable after a startup has demonstrated market validation. As such, it is crucial to carefully evaluate the terms and conditions of each funding source and align them with the company’s goals and objectives.
In this article, we’ll help you with that. So let’s begin with explaining the stages of investment for startups.
Idea: It involves ideating, writing the business plan, and forming a legal entity. Startups require minimal funding at this stage.
Minimal Viable Product: This is where funds are required for product development, marketing and sales, and registering patents. These are the basic things to get the startup off the ground. It is also time when founders consider leaving their full-time jobs, so capital becomes even more important.
Market test: For market testing, startups may require substantial funding — in the order of millions. That’s a lot of money for a commercially untested product.
Commercial product: The startup requires funding at this stage as well since the revenue might not be enough to reinvest.
Friends and family: Many entrepreneurs turn to friends and family for their first round of funding. This can be a good option because the terms are usually more flexible, and the people you’re borrowing from are likely to be more understanding if you’re not able to pay them back right away.
Crowdfunding: Crowdfunding platforms like Kickstarter and Indiegogo allow entrepreneurs to raise money from a large number of people, typically in exchange for a reward or product. This can be a good option for small markets, as it allows entrepreneurs to reach a global audience and raise money from people who believe in their idea.
Loans: Loans from banks and other financial institutions can be a good option for small market entrepreneurs. There are a variety of loan options available, such as small business loans and microloans, which can be a good way to access capital when you can’t qualify for traditional bank loans.
Angel investors: Angel investors are individuals who provide capital in exchange for equity in a company. They can be a good option for small market entrepreneurs because they’re often more willing to invest in early-stage companies than venture capitalists are.
Venture capital: Venture capital firms invest money in exchange for equity in a company. They typically invest in late-stage companies that have already demonstrated traction. Even though it is not as common as in well-developed markets, one can find venture capital firms willing to invest in startups from small markets.
2. What is Venture Capital?
Venture capital (VC) is a form of investment that is provided to startups and early-stage companies that have high growth potential but lack the necessary capital to scale their operations. It is typically provided by investment firms, wealthy individuals, and other investors who are willing to take on high levels of risk in exchange for the potential of significant returns.
2.1. Types of Venture Capital
There are several different types of venture capital that small businesses can tap into, each with its own set of advantages and disadvantages. Some common types are:
Seed Capital: Seed capital is the earliest stage of venture capital funding, and it is usually used to help a startup develop its business plan and build a prototype of its product or service. This type of funding is typically provided in the form of a small investment, such as a few hundred thousand dollars, and it is typically used to cover the costs of research and development.
Early-Stage Capital: Early-stage capital is used to help a startup scale its operations and bring its product or service to market. VCs invest a few million dollars in covering the costs of marketing, sales, and other expenses.
Growth Capital: Growth capital is lent to businesses already generating revenue — they must have a proven track record of success. It is typically provided in the form of a large investment, and it is used to help a business expand its operations to new markets.
Late-Stage Capital: Late-stage capital is typically provided to businesses nearing an initial public offering (IPO) or acquisition. It is used to help a business scale its operations and prepare for a major exit.
All the above venture capital options serve a different purpose and help small businesses in different ways:
Seed capital is for getting the business off the ground
Early-stage capital for scaling the business
Growth capital for expanding the business
Late-stage capital for scaling and preparing for major exits
3. How Can Small Businesses Obtain Venture Capital? Top 5 Tips
Here are some tips to help optimize your startup’s chances of success when seeking venture capital:
Develop a clear and compelling pitch: Before you start reaching out to venture capitalists, make sure you have a clear and compelling pitch. It should explain the following:
problem your company is solving;
the size of the market opportunity; and
how your company is uniquely positioned to capture that opportunity.
Your pitch should be concise and easy to understand, and it should leave potential investors wanting to know more.
Have a clear go-to-market (GTM) strategy: Investors want to know how you plan to acquire customers and generate revenue. It convinces them that your company is a must-back.
Show traction: VCs want to see your startup is making progress. If you’ve launched your product, show how many users you have, how much revenue you’re generating, and any other metrics that demonstrate traction. If you haven’t launched yet, show how you plan to acquire customers and generate revenue in the future.
Understand the venture capital market: Understand the venture capital market, what stage of funding the company is in and what investors are looking for at that stage, and do your homework on the venture capital firms you’re approaching. Get to know the partners and their investment focus, understand their current portfolio, and look for commonalities in the companies they’ve previously invested in.
Be prepared to negotiate: Be prepared to negotiate the investment terms. Make sure you clearly understand what you’re and what you are not willing to accept.
Network and build relationships: Building relationships with venture capitalists can take time, so starting networking and building relationships long before you need funding is crucial. Attend events, join relevant groups or clubs, and connect with industry people.
Remember, raising venture capital is a process that can take time and requires persistence. However, you can increase your chances of success by following all the tips we mentioned above - from developing a clear and compelling pitch to team building, adopting a robust GTM strategy, and more!
4. How Venture Capitals Make the Final Decision
Once a VC firm has identified a startup they are interested in investing in, it will typically conduct due diligence to evaluate its business model, management team, competitive landscape, and financials. This process typically includes meeting with the company’s management team, customers, and partners, including reviewing the company’s financial projections and intellectual property.
After completing due diligence, the VC will decide whether or not to invest. If the VC decides to invest, it will negotiate the terms of the investment, including the amount of funding, the valuation of the company, and the ownership stake the VC will receive.
The partnership makes the final decision on the investment. VC firms use a variety of criteria in determining whether or not to invest, including the strength of the management team, the potential for the market, and the fit with the firm’s investment strategy.
However, it is worth noting that venture capital is one of the most competitive forms of investment wherein the selection process is rigorous, and competition, fierce.
4.1 What Are Venture Capitalists Looking For?
As per data from National Bureau for Economic Research, venture capitalists expect over ten times the return of capital over five years. So how do they ensure they invest in a startup that has potential? VCs consider some of the following factors while evaluating startups:
A strong management team: VCs want to invest in startups with a talented and experienced management team with the skills and experience necessary to build a successful business. This includes a clear vision and strategy and the ability to execute that vision.
A large, growing market: VCs want to invest in startups operating in large, growing markets that have the potential to become even bigger. This is important because it gives the startup the potential for significant growth and a large return on investment.
A unique value proposition: VCs want to invest in startups that have a unique product or service that solves a real problem and has the potential to disrupt existing markets. This could include a unique technology, business model, or approach to solving a problem.
Traction: VCs want to see that the startup has already demonstrated traction, whether that’s in the form of revenue, user growth, or other metrics. This helps to show that the startup is on a path to success and that there is a real demand for the product or service.
Alignment with the firm’s investment thesis: VCs usually have a specific investment thesis and will typically focus on startups that fit within that thesis.
Synergy with the team: VCs may look at the startups that can benefit from the experience and network of the investors, where the investor can add value, help to scale the startup, and bring additional resources.
Scalability: VCs look for startups that have the potential to scale their business. They want to invest in startups that can grow at a significant rate and generate high revenue. They want to see that the business model can handle many customers and is prepared for expansion.
Exit potential: Ultimately, a VC is looking for a return on their investment, and one of the key ways they can achieve this is through an exit event such as an IPO or an acquisition. They will look for startups with a clear path to an exit and are likely to attract strategic acquirers or go public.
However, it’s important to note that not all startups will have all of these characteristics, and some startups may have strengths in certain areas while being weaker in others. As a result, VCs will often take a holistic approach, considering the overall potential of the startup and the team’s ability to execute their plan.
4.2 Documents That Venture Capitalists Need
When you are finally pitching your ideas to the venture capitalists, here are some documents you should have handy:
Pitch Deck: A pitch deck is a small document written to capture the attention of the VCs. It should summarize the problem you are trying to solve and how you can make money from it.
Executive Summary: It is a one–two-page summary of your startup idea. It should include all important elements related to your business and accurately summarise your business plan.
Business Plan: A business plan is a much more detailed executive summary. It should include the following aspects:
Sales and marketing strategy
Appendices (additional information like resumes, legal documents, market research reports, and intellectual property rights statements)
Note: It’s not recommended to ask VCs to sign a non-disclosure agreement (NDA). NDAs are typically used to protect confidential or proprietary information.
While it’s important to be thoughtful about what you share with potential investors, most VCs will not sign an NDA because they need to be able to talk openly with other investors and potential portfolio companies. It is much better to have an open and honest discussion with potential investors about what information you’re comfortable sharing and what information you’d prefer to keep confidential.
5. Pros and Cons of Venture Capital Funding
It’s worth noting that venture capital is not suitable for every startup, and some startups may be better off seeking other types of funding. It’s important for startups to carefully consider the pros and cons of venture capital and determine if it is the right fit for their business.
Significant funding potential
Valuable industry connections and networking opportunities
Experience and guidance from experienced investors
Increased visibility and credibility
Potential for additional rounds of funding
Increased chances of successful exits
Loss of control and equity dilution
Short-term focus by investors
High expectations and pressure to deliver
Legal and accounting costs, paperwork, and ongoing reporting and governance requirements
The difficulty of being accepted to a VC firm due to the high competition
Potential cultural mismatch with the investors.
Venture capital is a form of investment provided to startups and early-stage companies that have high growth potential. However, it is typically more suitable after a startup has demonstrated market validation.
While it has a set of pros that have made it a tried-and-tested strategy over the years, owners stand to dilute some part of their equity. Plus, with it becoming harder for startups to gain funding via the traditional routes, perhaps it’s time for India’s modern businesses to turn to a modern funding solution.
At BridgeUp, India’s premier recurring revenue platform, we understand startups’ challenges in securing funding. If you have a high degree of predictability in your revenue, BridgeUp can help you! Fill out our contact form or call us at +91-9819660287 to get expert advice and support.