Despite the pandemic, the startup ecosystem is not exactly thin on funding.
According to The Economic Times report (1), Indian startups have raised more than 7.8 billion USD in the initial four months of 2021. It is about 70% of the overall funding of 12.1 billion USD secured in 2020, and over 50% of 14.2 billion USD secured in 2019, as per data of PitchBook, a US-based research fund (2).
With so much capital availability, it is no wonder we are witnessing more and more new startups coming from entrepreneurs with unconventional backgrounds.
Dunzo, for example, is a startup making waves in delivery services across major cities of India. It is a hyper-local on-demand delivery service startup tied up with several clothing stores, restaurants, and general stores. It offers all commodities on one platform, be it grocery items, health and wellness, pet supplies, bike rides, laundry delivery, pick and drop services, and a range of other services at a minimum charge.
The startup has secured over 128.4 million USD over 15 funding rounds. It’s latest funding round was on 19 January 20201, a Series E. Lightbox and Evolvence India fund are Dunzo’s most recent investors (3).
Dunzo is an excellent example of a startup succeeding in securing capital (4). However, several first-time entrepreneurs don’t know the proper avenues to bring their products to market and properly budgeting for all the things required to launch a business.
That’s what makes choosing the right investor crucial for a startup’s success.
Any entrepreneur needs to get it right because saying “yes” to the wrong investors could create a stir.
Ensure Your Best Interests
Founders don’t need to receive investment funding offers with an automatic “yes”! While entrepreneurs often see funding as an excellent opportunity that frees them from one of their biggest pain points, finances. However, it can also lead them to different challenges of their own making.
If the only reason you are bringing an investor is for a quick scale, it could be the most towering disappointment you will have in the life of your startup. Why? The moment you give up the ownership of your company, it is nearly impossible to get it back. That’s why it is necessary to make certain that a startup matches with the right VC (5).
Consider how much control the venture capitalist asks to have over your startup’s business decisions before agreeing to any financial help. If he is not willing to clearly define terms, it is a major red flag.
You will also need to consider what kind of resources he or she brings to the table:
- Does the VC have a network of different providers and companies to work with you on marketing, branding, and public relations?
- Has the investor worked with other businesses in your industry?
- Is the VC a good fit with your company?
In short, this person should allow you to connect with other experts in his network or provide the advice you need. If not, you need to be careful and question whether it is a good fit or not.
Moreover, it would be better if you assure that the investor’s goals align with yours. You don’t need to get sucked with the idea of easy success and fast growth.
Your choice of investor should be as strategic as every other decision you have made during your entrepreneurial journey.
Finding the Right VC
Finding the right investor who matches your goal is not. However, here are some strategies that can safeguard you against getting involved with a VC that doesn’t have your best interest in mind:
Wait for the Right One
Holding out for the right investor sounds obvious. However, new entrepreneurs may feel the urge to jump at the first offer. Choosing the right investor is a lot like dating. Don’t jump at every offer, or you may end up in a bad marriage (6).
You need to play the field while looking for your ideal match, especially when there are plenty of investors looking to get in on the front row of the next big thing.
Keep your weapons close, and know that several investors will come knocking on your door if your product or business idea is viable.
Relationships have a lot of weight. Often, people don’t work with a business for the end product but also for the process of doing business and experience. If you fail to develop mutual trust, respect, and communication, it will not be fun for anyone.
When you work with the right VC, there is mutual support and understanding (7). It will make everyone involved work a little harder to get the job done. Hence, it is necessary to meet potential partners and ensure there is the right chemistry. It is not only about the timing or money.
You want investors who genuinely desire to see your business, and you succeed the way you envisioned.
Never be afraid to ask pointed questions regarding how they intend to see the relationship working.
While we enter into deals with the best intentions, it is usually recommended to plan for the worst and expect the best.
Taking on any VC can be tricky, and it is all about negotiations. Figure out the areas you are flexible about and those you are not.
Once you have those defined before moving into a deal, it will offer a North Star for what is most important and nonnegotiable to you and what matters are open to discussion. It will also allow you to set ground rules that make parameters clear and are onset. And once you have built up a trusting relationship, you can relax the constraints.
The need to make decisions upfront is a lesson that Organic Avenue’s founder, Denise Mari (8), learned the hard way. Her initial investors were focused on growth over anything else and were highly involved in her business decisions.
Soon, Mari was bought out and watched her company be forced to bankruptcy. She again enlisted investors to reclaim control. This time, she was specific and direct about her wants. Even though the two deals fell apart because of Mari’s demands, the right partners came along eventually.
Take Things Slow
While we are not saying to drag things out but avoid jumping into a partnership, don’t assume that it will work out or because you are afraid to lose this “golden chance.”
Take your time to do extensive research and consider the relation and its effects on your business. Understand that contracts are lifelong, and hence, thoroughly read every one of them. Never assume anything to its boilerplate. Believe that investors will wait for you to vet their offer if your idea is worth it.
If the investor is rushing you into choosing without mutual due diligence (9), consider it a bad sign.
Don’t Overlook all the Work
When new founders enter the marketplace, they think they have gotten a brilliant idea now; all they need is capital, marketing, PR, branding, network, etc. However, they soon realize the hard reality of running a business.
When someone comes in to offer help, you may be inclined to say “yes.” However, the trick is to ensure that you are getting the right help. Because if you end up saying “yes” to the wrong investor, the final deal may feel like a solution, but you may also open the door to somebody that may be hard to get rid of.
When to Walk Away?
Knowing the early signs for an entrepreneur to walk away from a potential investor is a lot tougher than it sounds. Several investors are at their most accommodating and charming when founders are raising money. After all, they are also in sales.
So the bigger question here is where do investors-founders misalignment come from, and how can you spot it early?
It comes from two factors:
- Different outcome goals: some investors are looking for billions plus exits, whereas you could be okay selling your business at 20 million USD. In this case, the investor will push you in ways you may not want. All investors want big, but some are more binary about it.
- Different risk/spend profiles: Some investors will see a 1 million USD loss as big, while others will see a 10 million USD loss as a bummer but a rounding error. It can vary not only by the fund but, more importantly, by individuals.
It is good if you are aligned on both of these points. You may want to find another VC if you are not.
If you are aligned on these points, it is highly likely for things to be okay as long as other factors we discussed above to evaluate potential investors say thumbs-up.
Harm Wrong Investors can Bring to Your Startup
As we discussed, investors are often at odds with the goals of new founders, and in some cases, it can lead to destruction.
Zachary Crockett from Guides (10) talked about a guy he named Ben who built his startup into an exciting enterprise after seven years of hard work. He raised a hefty investment from a top investor, and a few years later, Ben found himself on the final stages of an exit, with an 88 million USD buyout offer in his hand.
The deal looked like a win to Ben, who was 31 at that time, ready to walk away as a rich man. And the investor with over a double of his investment.
However, the VC who had veto power axed the deal at the last moment and asked Ben to hold out for something bigger.
However, that something never comes. In the following few years, the company lost its moment. Ben’s co-founders jumped the ship, and eventually, it got folded altogether and was sold for chump change.
Ben’s narrative is one of several cautionary tales of VC funding gone astray.
Why Can VC be Toxic to Startups?
Startups today are fixated on raising funds, and it is certainly there for the taking.
The market sees companies that raise a ton of funds as successful by default. It is a dream of every founder to close a big round, get the customary TechCrunch write-up, and secure the support of a top-tier investment team.
In theory, investors should offer the following:
- Cash for faster growth
- Validation to attract customers, talent, and press
- Guidance, advice, resources, and connections
However, it can be a toxin that can potentially destroy startups.
Here is why.
They Take Big Bets and Ask for a Big Payoff
Investors often are not satisfied with 10 million, 25 million, or 50 million USD exits or IPOs. They work with a “go big or go home” mentality (11) and typically want to see over 100 million USD worth of an outcome.
Some VCs are pretty selective, and it is not uncommon for them to invest in only two to three companies a year. They look for companies with huge growth potential that cater to multi-billion dollar markets. A startup that sells for about 50 million USD and nets them, say 25%, has a very low impact on its portfolio.
Let’s say some VCs would rather run startups into the ground trying to make them unicorns than entertain an offer under 100 million USD.
Often, founders who raise VC end up in a place where they have to reject a great offer because it doesn’t satisfy an investor’s pompous return expectations.
They Push for Hyper-Growth at all Costs
Micah Rosenbloom, a Managing Partner at Founder Collective (12), says, “VCs are funding rapidly growing companies and not inventions or inventors. They often look to make you a 100 million USD company before you are ready to be a 10 million USD company.”
The “go big or go home” attitude is often incredibly damaging and can be a “masked death spiral” for startups.
Investors want to see 10x to 30x returns within a fund’s lifetime, about six to eight years. Such a timeframe often forces startups to solve complex problems before they are even structurally prepared to do so on a large scale.
However, the most significant issue with this obsession is the “marginal dollar issue.” There is such a rush towards revenue and growth that people stop looking at the cost of that revenue. Companies will do things such as doubling sales forces when sales are not even close to return their expense. And soon, you will be spending one USD on getting back 50 cents.
VCs Severely Dilute Founder’s Stake in the Company
When raising capital, a founder gives up a hefty percentage of his company to investors.
During seed funding, a company typically gives up about 15% of its shares. An option pool, offering shares to early employees takes up an additional 15%.
However, the dilutions start to happen once VCs get involved. For the average Series A funding round, investors look for a 25% to 50% stake. For series B, they look for about 33%. And after a few rounds, a founder is lucky if he is left with 20% of what he had started.
While, in theory, these sacrifices should give entrepreneurs a big payoff in the end, but that is not entirely true.
For instance, Arianna Huffington, founder of The Huffington Post (13), sold the company for over 315 million USD. However, multiple VC funding rounds left her with only a fraction percentage of the company. And reportedly, she walked away with only 21 million USD (14).
Another example is Michael Arrington, founder of TechCrunch (15). He sold the company for about 40 million USD, one-tenth of Huffington’s exit. However, since he did not raise any external funding, he received around 25 to 30 million USD.
Overrated Advice and Expertise
There is a false understanding that VCs have investment down to a science.
According to Harvard research, more than 75% of all VC-backed startups fail outright (16), and 95% do not deliver projected investment returns. Another research for Chalmers University outright called them overrated (17).
Raising ore Cash Doesn’t Mean Success
At some point, valuation, driven by inflated VC investment, turns into the barometer for success in the startup world.
However, in reality, there is no strong correlation between the amount of cash a company secures and a successful outcome (18).
One doesn’t need hundreds of millions of capital to become a unicorn.
Entrepreneurs are often tempted to secure two to three years of runway simply because they can, and it can be a liability.
We are Not Saying VC is Inherently Bad
However, at present, there are often misalignments between what startups need and what VCs want.
Bootstrapping is an ideal alternative for young founders as it enables them to set their pace and formulate their value concept (19).
However, if they need outside capital, the rule of thumb is only secure enough to sustain operations for 18 months, more or less 25% (20).
And don’t waste it on kombucha, ping pong tables, or branded hats.
When an investor offers to seed your startup but is not in line with how you want the business to grow, this person can be one of the biggest regrets you will make. Hence, take your time, decide wisely, and don’t be afraid to say “no” and walk away.