Seeking Capital for your Startup? Look for the right source!
Entrepreneurship is all about working in the midst of constraints — constraints of resources, people and time. As a founder one is always walking a tight rope of maximising growth and value with minimal time and money, while attracting the best people to join your rocket-ship. This seems like a catch-22 situation, but perfecting this trick is what differentiates a rockstar founder from the rest.
Capital, after a good team, is the next big leverage that the startup can put to work to create significant value for itself.
An early stage startup needs capital for various purposes — to hire the initial team, to build product, to setup sales, marketing, distribution and operations functions, to procure raw materials and the list goes on.
One might wonder, where does the money come for spending on all the things we just listed. While many founders tend to gravitate towards equity-based capital as the default and the only choice available, it’s important for founders to remain cognisant of other possible sources of capital at various stages and smartly allocate the right blend to achieve maximum impact in terms of scale, growth and revenue. Let’s discuss the various possible sources of capital in this article: Revenue, Equity, Debt and Grants.
Customer Revenue: The Holy Grail
Someone rightly said that customer’s capital is the best source of capital. Why you may ask — it comes without any dilution or liability and in a way validates the startup’s existence as it is earned in exchange for the value you create for your customer.
Sustaining through revenue is the ultimate endgame everyone is working towards — that is the money you make from customers is large enough to take care of all your expenses, fuel your expansion plans as well as generate returns for your shareholders
Thumb Rule: Always aim to gravitate towards value-based revenue model. This will make you push the envelope further and enhance possibilities of customer revenue.
Sources: All kinds of revenue models under the sun — sales of goods, service fee, licenses, commission, brokerage, subscriptions, referrals etc.
Equity: When it rains, it pours-kinda capital
Startups at an early stage do not have this luxury of sustaining through customer revenue (also commonly called internal cash accruals). Infact many startups, as we know them, are even negative contribution margin in their quest to acquire customers faster. In this context, an equity investor becomes both — the funder of first and last resort!
Equity capital can primarily used to hire the core team, build the product, capital expenditure and in some cases also spend on marketing and initial customer acquisition to demonstrate initial traction. Many a times, startups don’t have the luxury of other forms of capital and hence, are forced to spend equity capital to fund all kinds of expenses.
Founders must also realize that equity is the most expensive form of capital as founders are giving their valuable shareholding to an equity investor every-time they raise funds.
Abusing this source is counterproductive for everyone in the long run as founders gradually lose skin-in-the-game and along with it, the incentive to grow the venture.
Thumb Rule: Use equity capital for the highest leverage items — spends that give them maximum ROI for the longest period of time. Hence product, leadership team, fixed assets etc. are direct candidates, while other costs should ideally be avoided over a period of time.
Sources: Angels, Incubators, Accelerators, Seed Funds, VCs, PEs
Debt: The elusive capital — everyone wants it, but only a few get it
Raising debt capital for an early stage startup is like chasing a mirage in the desert. Only a few lucky ones end up finding this metaphorical oasis. By nature of the instrument, most startups don’t qualify for debt — lenders typically require a certain period of track-record as well as a particular threshold of balance sheet strength. Also, unlike equity, debt comes with a legal compulsion to payback the principal along with the accrued interest in the stipulated time, failing which, the startup is pushed into default and liquidation.
Thus, debt while desired, is a double edged sword — one should sport it only if one can wield it!
Hence, while it is a challenging source for an early stage startup, given the uncertainty of revenue, it can turn out to be a cost-effective source for certain turnover based business models with constant flow of money. Further startups should look for possibilities of soft-loans, credit enhancements, credit guarantee schemes (like CGTMSE or Mudra) and interest subvention possibilities to make this source attractive for early stages as well.
Also, some amount of debt also helps drive discipline in startups in terms of monitoring cashflows and making regular repayments as the cost of default is quite high. This invariably leads to incorporation of processes and systems to manage the startup’s finances better and setting them up for scale.
Thumb Rule: Raise debt only for items that have a predictable cashflow to repay it back along with interest.
Sources: Banks, NBFCs, Venture Debt Funds, Channel Partners, Government Bodies and Programs (SIDBI, MUDRA etc.)
Grants: Don’t plan for it. And if you get it, don’t squander it
Grants are a great way to fuel your initial journey. Grants as the word indicates is an equity-free, one-way transfer of money, and in most cases — with no-strings-attached. Basically it’s free money, a windfall you never expected.
While one can’t predict grants in a business plan, once you get it, you can definitely use it to take you to the next logical orbital.
I have commonly seen how grants have helped startups:
- Many founders were able to beat the opportunity-cost conundrum to kick-off their venture
- Early stage ventures have built new product-lines and validate them through pilots and early adopters
- Growth stage ventures have built teams for strategic projects that you couldn’t fund otherwise, or invest in team and partners to acquire new markets etc.
Whenever you get such grants, treat it as an investment into one of such several mini projects in your wish-list. Hence it is important that you create a business plan for each opportunity and select the most attractive one that directly or indirectly maximises your northstar metric.
Thumb Rule: Forget the thumb, just grab it with both hands! :)
Most grant programs are selection based on applications. So keep those standard answers about your startup ready and get interns to continuously apply to these programs. The tip here is to attempt every delivery, persevere and stay long enough. And you are sure to get your share of low full-tosses to capitalise.
Sources: Govt. schemes (BIRAC, DST, MEITY, State Govt Programs, Patent Reimbursements), CSR and Corporate Grants as part of accelerator and social impact programs, Awards and Competitions etc.
Note — I’ll shortly share a list of non-dilutive funding opportunities that you need to keep a track of. Stay tuned for that.
To sum up, appreciating the various sources of capital is extremely important for an early stage startup founder. While one might not have the luxury to choose at the stage one is in, it’ll help founders to keep an eye out for leveraging future opportunities, internally prepare your organization to qualify for certain categories of capital and also have a mental picture of where to use different sources of capital as you scale your venture.
PS: While diversifying your capital base with a blend of source is desirable, for growth seeking, tech-based ventures, raising equity capital is unavoidable. If you are at that stage, do reach out to us so that we can get you Investment-Ready by organizing your captables and transactions. We also help founders manage ESOPs, digital shares or ESOP liquidity programs.
[UPDATE]: Here’s what I have written about Grants for Startups and different sources of non-dilutive capital that startups can leverage.
Will cover more asset classes in the future.
Do hit me up: srikanth@qapitacorp.com
