Pros and cons of the many options available for entrepreneurs raising seed capital in India
We get the opportunity to talk to 100’s of entrepreneurs in India every year who are just getting their business off the ground and are looking to raise seed capital. One of first question we ask is “why are you interested in raising seed capital from a fund like us?” Often this leads to an interesting conversation where the entrepreneur describes some of the different fundraising options they are considering and we talk through the pros/cons of each option. We thought it might be helpful if we wrote up some highlights of those seed funding options discussions.
The #1 option for seed funding is to generate revenue. Not only does this not require you to go through the complexity of taking outside money, but it demonstrates that there is real demand from customers. The challenge is that often revenue is insufficient by itself to cover the startup costs of a business as the entrepreneur experiments with various strategies and needs to pay other staff.
Crowdfunding is the latest trend in generating revenue for product companies. Entrepreneurs pre-sell products (or as for funding for projects) via Kickstarter, IndiGoGo and similar sites and get the money in advance to help them complete projects and/or pay for manufacturing. This however is not likely to help a BoP startup as they are mostly service based, and BoP customers are not in a position to order products online or pre-pay.
Nearly all entrepreneurs put in their own cash in addition to tremendous amounts of unpaid labor in the early days of a startup. If you have the means to put in cash, it also demonstrates additional commitment to investors from whom you might raise money later. Sometimes entrepreneurs fund via loans to their company. This is a fine option, although most venture investors will require that all debt be converted into equity as part of the investment process.
There seems to be another contest or grant prize program announced every week in India. Many of these are structured as either business plan or pitch competitions. If you can get one of these prizes, you’ve got some non-dilutive capital. And you will get some “bragging rights” and possibly some short-term media coverage. We know companies that have spent lots of time applying/pitching to competitions and have received many tens of lakhs of funding. The disadvantage of these programs are: (a) they often take a lot of time with multiple rounds of competing to win; (b) prizes are typically small; (c) winning generally doesn’t translate to any fundraising advantage with other investors (other than giving you the opportunity to generate more traction before going for investments); and (d) there may be conditions on how the money can be spent and/or reported on.
Friends & Family
Especially for first-time entrepreneurs, the one of the best funding sources is people who know you and believe in your capabilities – your friends and family. You need to be very honest with them about the risks of “losing it all” if your business fails so that their expectations are set clearly upfront. Another risk is that because these “investors” are often not sophisticated, they might have unrealistic expectations on how much ownership stake they should have. You need to be careful about selling too large of a stake in the company too early for just a small amount of capital. The opposite is also a problem – if you give them a tiny stake for their money (meaning you set the valuation very high), you will have problems when professional investors are not willing to pay the same high valuation. See Avoiding the Valuation Trap.
A final issue is that friends and family may think of their investment more like a loan and have expectations to be repaid (with interest) in 1-3 years. If you do bring on professional investors later, they will almost never allow their capital to be used to repay your earlier investors, so this could put you in a difficult situation.
Historically, most India HNIs (high net-worth individuals) usually only invested in their own businesses or in people they already know well, but this is starting to change. There are a growing number of HNIs in India who are investing in high potential startups at an early-stage based on the idea, traction and the team’s qualifications. Most angels invest in business sectors they are familiar with based on their business experience.
In India, most angels are short-term investors wanting to see an exit in 1-2 years with a 2-3x cash on cash return. That means they are looking for 100-150 lakhs returned, soon, on a 50 lakh investment. If your business can start generating sufficient free cash flows within this timeframe, then this might be a good option for you. If you need to raise more venture capital though, this might be an issue as institutional venture investors will be very reluctant for their capital to be used to buy out earlier investors. Additionally, most angel investors are not going to provide much help as you seek to raise more capital because they typically don’t invest in follow-on rounds and they often don’t have great connections with the venture firms.
Another option is to try and raise capital from angel groups such as Mumbai Angels or Indian Angel Network. These are associations where a bunch – sometimes 10 to 20 – of angel investors agree to each invest small amounts (often 5-10L each) as a group for an early-stage startup financing round.
One advantage of angel groups is that they can often assemble a larger investment round than a single angel can provide. Most angel groups also promise value-added support from the participating angels, but in our experience some angels are very hands-on and helpful, but most are not. Angel groups are setup to be active investors with a target to make a certain number of investments per quarter, unlike individual angels who have no commitment like this. That said, because of this, angel groups receive a LOT of business plans, so you may have a harder time getting your pitch to stand out.
One of the big disadvantages of angel groups is that you’ll have a LOT of tiny investors and each angel may have a different opinion/interests. They will tell you that they mitigate this by having a lead investor, but that person still has to deal with all of the syndicate members. Also, as noted above, angels often expect exits in 2-3 years at 2-3 times invested capital, which will make raising future venture capital more complicated. Finally, in theory having an angel group as an investor is a positive signal to downstream investors. And it certainly can be much better than having an unsophisticated friend or family member as an investor. But because most angels will not invest in bridge or follow-on rounds, there may be complications when you need to raise more capital.
Historically, it is very challenging to get bank loans for startup businesses until you can show multiple years of reliable profits. You might be take a personal loan using your home or other assets as security. But do you really want to do this when 9 of 10 startups fail? There are some new government sponsored initiatives to encourage banks to lend to more risky startups with programs for collateral free loans such as the CGTMSE Scheme.
International Philanthropic Impact Investors
If you have a startup that is addressing an important social issue, you might be able to pitch some international philanthropic impact investors for seed funding. Most of them are private foundations based in the USA (e.g. Sorenson Impact Foundation, Lemelson Foundation, Rockefeller Foundation, Omidyar Network, Michael & Susan Dell Foundation, Acumen Fund). The advantage of these larger foundations and their affiliated funds is that they have deep pockets and often have lower return (and longer timeframe return) expectations. The challenge for seed funding is that most of them are only setup to invest 6 crores (USD $1m) or more. Also, many of them don’t have investing teams in India, so in addition to the normal bureaucracy of a larger institution, they need to fly people to see you which extends the due diligence process. Finally, many of them require you to be fully aligned with their mission which may be hard to maintain over time, and require regular complex monitoring reports to confirm your compliance.
Seed Funds/Micro VCs
Seed funds are starting to pop up in India over the last 2-3 years. Most of the seed funds are focused on the Internet/mobile sector, similar to their counterparts in Silicon Valley. A new model that is gaining the most traction (in our humble opinion) is the “Micro VC”, pioneered in the USA over the past few years. Micro VCs, often also called seed funds, make a high-volume of seed investments at a very early stage of a startup … generally long before the traditional “Series A” venture funds invest. The most active tech seed fund in India is Blume Ventures. The most active impact seed fund in India is Unitus Ventures.
The advantages of bringing on a professional seed fund as an investor include:
- Seed investing is the sweet spot for seed funds, so lots of interests are aligned. They have capital ready-to-invest and can often decide quickly and move even faster to close and deal and get you the capital you need.
- Well-regarded seed funds are a very positive signal for downstream investors (vs. friends/family or inexperienced angels). This should make it somewhat easier to raise follow-on capital.
- Often the best seed funds have principals with significant startup and scale-up operating experience, similar to series A and later-stage venture firms. This enables them to add more value to your business at an early stage than say principals who are mainly from investing, finance, consulting, or legal backgrounds.
The disadvantages include:
- Most seed funds don’t have large enough funds to lead large follow-on investment rounds. So, in the future, you will need to bring on a larger venture fund as the lead investor. Good seed funds are setup to help you with this process.
- Since most seed funds invest in a lot of companies, the ratio of seed fund principals-to-companies is higher than for traditional venture funds. So, you might not get as much attention from the seed fund as from a conventional Series A investor who only does one or two deals per year per investing principal.
- Seed funds, unlike angel investors or foundations, have accountability to deliver returns to other investors. As a result, they may have higher return targets than angels or foundations.
Series A / Early-Stage Venture Funds
Many of the name-brand venture funds are the most well-known early-stage investors in India. The advantages of having a conventional venture fund as an investor are:
- They typically have deep pockets and therefore can provide growth capital in the future, leading Series A financing rounds and participating in Series B and beyond.
- Principals have more time to do “heavy lifting” to help a company to get on the path to success. This can involve everything from helping to recruit new executives to driving strategic planning to helping with strategic partnering.
- Access to other resources – either within the fund itself or via their extensive networks.
The downside of conventional venture funds is that seed funding (despite what they might tell you) is NOT their sweet spot and therefore they are really buying an option to invest more later, which has consequences for the company. See our earlier post on taking seed money from VCs.
There is no right answer for from whom/where you should raise seed capital. In fact, many entrepreneurs choose to raise seed funding from multiple sources. If you are seeking to build a scaled business that will require significant venture capital over time, then there’s probably a seed fund investor in your future!