18 Aug 2015 17:59 IST

Be irresistible to funders

While the need for capital may be a never ending one, it’s important to answer some crucial questions first

Some of the most challenging aspects of a start-up/scale-up are

> Raising capital

> Ensuring optimal use of funds

> Managing costs

> Ensuring sustained cash for growth

I have, in previous articles, talked about the importance of managing costs. I will highlight the issues of raising capital in this one. Unfortunately, the need for capital never ends. There are a number of crucial questions you must first have clarity on.

How much capital is necessary?

Although it is tempting to start a business with no or little money in the bank, remember that if something sounds too good to be true, it probably is. Having little or no capital is a primary reason why businesses fail.

Bootstrapping a business when you're not drawing a salary and depleting whatever savings you have is one of the most difficult things to do. I know this from personal experience.

There are times that even with all the enthusiasm to start and grow a business and turn a successful entrepreneur; the lack of money makes one think of giving it all up and taking up a secure job.

After all, one needs the basic essentials of life. If a start-up requires even minimal outlays for offices, infrastructure, equipment, or employees, the amount of capital needed before opening your doors for business is likely to be significant.

It is better to plan for such outlays before launching out.

Being Realistic

Entrepreneurs are often die-hard optimists, a necessary trait to get their ventures off the ground. But instead of a unique product, record sales, and slow competitors they usually envision, the real world is quite different. I have found, from personal experience that a good thumb rule is to double estimated expenses and half estimated revenues and add an initial 12-month period for the start up to start getting revenues.

A business should be able to survive this period and needs to provide for cash to take care of this period of uncertainty. No new business succeeds without a detailed and thorough business plan, something that I have elaborated in one of my earlier articles. This plan needs to recognise where you are today, where you want to be tomorrow, what problems might arise, and how you are going to resolve them.

Need for a guide map

The value of a business plan is that you are forced to think about your potential business critically, challenge your assumptions, and research when you're not sure of your facts. A complete plan reduces all of the components to financial numbers including a projection of revenues and profits and the state of the business 3-5 years down the line.

This may not be accurate but is a good guide map that requires to be revised periodically to make it current, live and useful.

Bankers and potential investors generally evaluate entrepreneurs on their potential and their ability to deliver success on the quality and completeness of their business plan. The most common mistake that entrepreneurs make when seeking capital is asking for too little to have a chance at success. While it is important to have adequate capital, over – capitalisation also comes with a cost.

The trick is to strike the right balance.

At Scope, we decided in 1999 to go for a mix of angel investing with some debt. While we thought that the amount raised would be adequate to see us through until we stabilised, some vicissitudes of the market ensured that we quickly ran out of the same. Trying to raise money when you are in dire straits is always all that more difficult and more expensive with far lesser options. We had to go back to boot strapping all over again till we closed our first big deal and were able to raise our first round of venture funding.

How does one raise ‘New Capital’?

The most common source of start-up capital is the business owner him/herself in the form of credit card advances, home equity loans, and loans from family members. There are also some options that state and local governments extend to certain types of business and this must be explored. When these sources are exhausted or unavailable for some reason, entrepreneurs usually seek capital from private sources such as commercial and investment banks, angel investors, wealthy individuals, and venture capital funds. Their proposed investment is usually styled in the form of debt, equity, or a combination.

The most common form of capital used by start-ups is debt. Most form of debt is secured by the assets of the company including the possible personal guarantee of the owners. The company repays the principal with interest from cash flow and is especially recommended for financing if the revenues are assured. For services businesses, that has tied up its customers this is possibly a very good bet.

In 2002, when Scope landed up with the orders from clients in the UK and US, this is what we sought to do. However, the problem here is that very often the business has very little fixed assets as in our case and /or the promoters do not have the assets to give as collateral. Despite having strong credentials and being recommended by a director at the bank, bureaucratic delays and infinite requests for information wore our patience thin and we decided to go for VC funding.

Remember, VC funding is far more expensive for a good running business with assured revenues. While we don’t regret the decision to avail of VC funding, debt would have been the more appropriate source of financing at that point.

Would have given far greater option later on when we needed to raise money for growth. Or with the strategic player we would have diluted half of what we did with the VC’s . However, debt is also a more risky option as if the business fails; the lenders foreclose and liquidate the assets for repayment, possibly seeking any deficiency from the owners.

Asset lenders are concerned with the market value of the assets, not the business enterprise, lending only a proportion of the asset's value to the company in order to ensure repayment. Lenders are not normally in the business of taking risks. While the interest rate on borrowed money may be high, using debt allows you to maintain 100 per cent ownership.

The other less risky option is equity. Angel investors, private equity firms and Venture funds provide capital in return for equity. Strictly speaking venture funds are only now coming of age now because even 5 years ago it wasn’t that common. But now with some of the large deals such as Flipkart, Snapdeal, Zomato etc venture capital in India is coming of age.

When utilising equity, investors become owners of the business with the entrepreneur; the amount of ownership held by each is dependent upon a negotiation, which in turn is based upon the funds invested and the agreed-upon value of the business.

Crowd-funding your way through

Business valuation is an art, not a science; the conclusion is always subjective depending upon the perspective of the valuator.

A new funding mechanism known as “crowd-funding” is also now available for small amounts. This is still unregulated in India but can be a good means to raise the initial capital. This can be done through crowd-funding sites. This allows small companies to raise small money from individuals over the Internet through a simplified registration procedure and limited financial information. This is as yet not very popular in India.

Delaying capital infusions from non-affiliated third parties as long as possible (until you can prove the business concept and show revenues) is always the best approach. Investors typically require that entrepreneurs have “skin in the game” before being willing to invest their own money, and prefer you've made progress toward implementing your business plan as well.

From my experience, it is better to have some traction on revenues and clients with a clear business plan in place before approaching VC’s.

Better still is to be so good at what you are doing, that VC’s make a beeline for you, after all they need to make good investments. That’s the business they are in.

To read more from the Mind Your Business section, click here .

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