Startup funding is definitely a popular topic which is discussed in the world of startups today. A lot of entrepreneurs have asked me about Startup Funding. There seems to be a lot of myths surround the subject of startup funding. So I decided to create a three part video series along with the article to help aspiring entrepreneurs through the funding cycle. The first section and the video talks about the prerequisites of funding, followed by the sources of funding and the process of funding.

Section 1: Pre-requisites of funding

Gone are the days where you can get funded based on an idea. In order to secure funding you must establish the feasibility of your idea through proper planning and implementation. You must have a prototype or a minimum viable product. You should also establish the proof of concept of your business before you qualify for funding.

Here are some ground rules you must understand before you start looking for funding.

• Firstly, Not all businesses are fundable – A business must satisfy a certain set of criteria before it qualifies for funding. A business is only fundable from an investors point of view if it has the potential to scale up and give exponential returns.
  
  

• Secondly, you must remember that funding is not an indicator of success. – Irrespective of the impression that you might get from the news and media. Funding is just a stepping stone. Many businesses around us has grown without any funding. So funding might be a need in some cases, but its not an absolute necessity.
  
  

• Which brings me to the third point. Your business should be self-sustainable. The primary source of your funds should be your paying customers i.e. your business should generate enough revenues and profits to fund the growth and expansion. Only in the case that this is not possible or there is a specific need for additional funds then only you should look for funding.
  
  

Let’s talk about some of the reasons why you should look for funding.

• One of the most prominent reasons for funding is to scale up your operations, for expansion and achieve economies of scale. For example: You have already started a business and successfully implemented your idea and its running well. Now you may want to scale up your operations or expand your presence. This is the point you should definitely consider funding.
  
  

• The next reason is to establish a competitive advantage over your competition and quickly acquire a substantial market share. Let’s take an example – In case of an internet or app business, the user traction and market penetration is a must. Getting users organically might take a lot of time and your competitors may take advantage of the situation. So, to get a large number of users inorganically, you would need funding. You must have seen a lot of startups giving out promotions, discounts and incentives at the early phase of their business. This is primarily to gain market share and a dominant market position.
  
  

• The third reason is to fund your short term operational expenses or working capital. For example – A small manufacturing firm suddenly receives a large order. To fund the sudden spike in production, funds will be required for additional inventory and wages. Once the order is fulfilled and paid for, the funds can be paid back.
  
  

• In very few specific cases, depending on the nature of the business, the business model might demand a large gestation period or extensive research and development. For these businesses it is imperative to get funding from the start without which the business cannot be setup. For example – Any custom manufactured IoT device would require software development as well as hardware customization. Both of which are expensive and time consuming. It is going to cost a lot of money just to get the initial batch of products to test the market and would definitely require external funding. This kind of funding is only applicable if the product is unique and innovative.
  
  

Apart from these reasons and leaving a very few special case exceptions, you would struggle to justify your funding need. Do not get funding because it is cool or it’s fashionable. Ensure that you create a strong foundation of the business before looking for funding. Seeking funds for wrong reasons is clearly a recipe for disaster.

Section 2: Sources of funding

Let’s start with the different forms of funding.

• Firstly, we have equity investments. This is definitely the most popular and most talked about avenue for startup funding. These investments are done in lieu of shares or equity in your startup. The shares given out can either be common stocks or preferred stocks.
  
  

• Then we have the debt investment which would have a repayment timeline and incur interest rate. Debt investment are primarily in form of long term loans (personal or commercial) and short term loans in form of invoice debts and working capital loans.
  
  

• The third form is royalty based investment. This a very interesting mode of funding. In lieu of funding you pay the investors a structured royalty which is a portion of the sales. The royalty may be of a limited timeline, variable rate or perpetuity based on the investment agreement.
  
  

• Convertible bonds and convertible equity are also another form of funding. Under this mode the stakeholders would have an option to interchange between  debt and equity investment based on a pre agreed terms and timelines.
  
  

In reality, investments can either be purely in one of these forms or may be structured as a combination of multiple forms. It is important to understand the funding structure stated in your term sheet and the advantages and disadvantages it may have for your business. For example, in case of royalties and debt investment you will have a regular cash outflow which might be a hindrance to the future growth. In case of equity, you must be prepared to give out a substantial portion of the equity over several phases of funding to the extent that you might not have the controlling share in your own company.

Now let’s see what are the sources of funding.

• I always recommend that you start with bootstrapping. Bootstrapping is when you put own money or borrow from friends and family to setup your business. Bootstrapping inculcates the entrepreneurial discipline and financial responsibility to run a lean business.
  
  
• Crowd funding is also an option where you can raise funds through crowd funding platforms like Kickstarter but unfortunately Indian regulation only allows crowdfunding for some non-profit businesses.
  
  
• Participating and winning Startup competitions can also help you to accumulate some funds along with gaining some credentials and as well as  getting some media mentions.
  
  

These were the options for initial setup.

• Then we have startup platforms like incubators and accelerators. These usually play a role in very early stage of your business primarily pre-revenue. Accelerators and incubators support the startups with a small amount of funding, mentorship, networking opportunities, resources and workspaces.
  
  

• You should also research the government programs like subsidies, funding and grants that are available for your business sector and ensure you understand the parameters to qualify for these.
  
  

• The third source of funding is from equity investors. Under this category you have the angel investors who would invest their own money and Venture Capital or VC firms, who manages funds aimed towards specific startup sectors and stages. For matured businesses there is Private Equity or PE firms.
  
  

• The fourth source of funding is debt investors which is usually banks and commercial institutions. The crudest form of debt funding is through credit cards. I have interacted with a lot of founders who actually funded their initial business expenses through credit cards. I would not suggest this unless it’s a dire necessity. Because credit cards tend to have extremely high interest rates along with the personal liability to pay back. The second form of debt funding is personal loans. You can get a personal loan without a business plan. Personal loans would also have a personal liability to pay back and interest rates are comparatively higher than commercial loans. Which brings me to the next form of debt i.e. commercial loans. This is the most popular form of debt investment for businesses. Unfortunately commercial loans from banks and lending institutions is very difficult for a startup and usually requires collateral.
  
  

Now let’s have a deeper look in to the different stages of equity based funding.

• The inception stage is primarily focused on building the prototype or the minimum viable product and validating the business concept. It is almost impossible to raise funds at this stage unless you have a proven entrepreneurial record of creating a large business. So, I would suggest that you bootstrap during the inception stage.
  
  

• Once you have established the feasibility of the business concept and created considerable traction for your business, it is now suitable for the seed stage. At this stage the investors would be expecting at a return of 15 to 20 times their investment over a period of 5 to 7 years. The seed stage is focused on building the core team, product optimization, exploring avenues for monetization.
  
  

• Once you have created the footprint in the market the business qualifies for Early stage investment. An early stage investor usually looks at a return of 10 to 15 times. Early stage funding is primarily focused towards business expansion and increasing customer traction.
  
  

• Once the business has established a solid market position, and is at a point of influx, the investment stages that follow are growth and expansion stages. The core focus of these phase are business expansion and scaling up. For these phases, investors usually expect 5 to 10x return.
  
  
• The bridge or exit stage is usually of very large transactions and for companies with substantial valuation. These phases are focused on inorganic growth, mergers, buy outs, acquisitions and exit preparation for the business. During this phase investors usually look for a 3 to 5 x return on the capital invested.
  
  

As you can see the expected return for the investment gets lower as the business grows. This is primarily because the risk is reduced as the business matures. As the business grows bigger it becomes more stable and sustainable. So earlier you raise funding more equity you would need to shell out.

Let’s have a look at the investment ranges for different categories of investors. This chart will give you an indication of the quantum of funds invested by each category of equity investors. Please note these numbers are just an approximation and may vary case to case.