Apart from your passion, money is going to be the fuel that will keep your start-up’s engine running. If you have reached a stage that a VC begins talking to you regarding funding, you will need to address some important issues. Specifically, this post is a discussion on three of these issues:

• The amount of money that you should raise
• What is the valuation of your business
• What terms will you raise this money on

[Today's post will address the first part. We will discuss the rest tomorrow.]

If you have been through the fund raising process, this post isn’t for you. I urge you to contribute to the discussion in the comments so that readers can benefit from your experience. If you are raising institutional money for the first time, I’d urge you to get some adult supervision. Find someone who can help you through the process and explain the complexities of valuations and terms sheets. While VCs want to be your partners, this will not stop them from driving a good bargain on the deal. So, be aware of what you are inexperienced in and don’t rush in to do a deal which could with hindsight look like a bad deal for yourself and for your start-up.

[For those of you new to this series, please read the introductory post here.]

In India there is limited history of VC investing across business cycles and funding environments. It makes it even more challenging to get a handle on the above three issues. What follows is an attempt to highlight at least some nuances of the funding process and terms. Lets get from 0 to 60 immediately…..

How Much Money Should I Raise?

This is a tough question. In the pantheon of tough questions, this one is not as tough as “which came first, the chicken or the egg?” but is far tougher than “is there life on Mars?” Often, you will never know the right answer to whether you raised enough money the first time around or not until a few months or years into the business. So what can you use as a guide. Lots has been written in the Western world on how much funding is appropriate. So, should it be any different in the Indian context?

To my mind the big difference between the West and India is that VC funding as a source of capital is a relatively new phenomenon in India. There aren’t enough VC or entrepreneurial track records that one could look at to study where start-ups went right or wrong. Also, because many entrepreneurs and some VCs are first timers, there is also a lack of clarity on how much capital is required by a start-up because of the relative inexperience, a lack of understanding of how much capital certain types of businesses need, and a lack of a track record of capital allocation across certain types of industries and services that are totally new to India.

My own experience has been more as a bystander looking at other start-ups being funded. More recently, I have had first hand experience of this with www.iTrust.in, and we decided to err on the side of caution by raising a little more money than we immediately needed. I’ll tell you more about that in a bit, but first let me make the following points that you must analyze when thinking of how much money to raise.

- What stage is your business in? Are you still in idea conceptualization stage, are you looking to build your team, are you ready to load your business with higher costs, do you have customers already

- What do you need capital for? What activities will you be engaged in, how many people will you be hiring, what is their fully loaded cost (salary, computer, office space, refreshments, transport etc.). Do you need capital to prove the concept, in which case a small round might do; or, are you past that stage, in which case you might need a bigger round to execute on your scaling up plans

- Whats the bare minimum you can do with? If you take a lot more capital than you genuinely have the need for, you might be less disciplined about using your cash because you feel you have enough of a buffer. Also, if you do end up taking too much capital, it will come at a cost, and that will most likely be the cost of giving up a lot of ownership in the company at a very early stage. You might suffer further dilution if you need another round of capital at a later date

- What are the capital requirements of your business? Are you an airline or an aircraft engine manufacturer (reference)– will your business suck a lot of cash or after the initial doze you will not need a lot of cash. You need to have some feel for this, otherwise you will end up hurting yourself in later rounds when you need more capital

- What kind of a margin of safety do you need to build? Things can and will go wrong – a customer you were hoping to lock might back out, you might have to raise salaries to attract even your early team members (yes, this is a common occurrence in India today), your landlord raises your rental…..you need a buffer that gives you some breathing room so that you don’t run out of capital even if unexpected expenditures throw you off

- What is the capacity in the VC community for your kind of a start-up? Not all VCs in India will have the appetite to invest in your chosen industry or stage of business. If you want to start a highly capital intensive business like a power plant, unlikely that a VC will touch you, you’re more suited for a project financier, even though you can rest assured that in the long-run the power sector in India has a great future. On the other hand if you have a novel alternative energy technology that you are in the final stages of testing, VCs might be all over you, even though the economic viability of your technology might be unproven. VCs might still be willing to take the risk on your technology because it might not require too much of capital to get to an answer

In an ideal world, the amount of capital that you want to raise at this early stage is the amount you need to be able to tangibly demonstrate the following:

- Your concept or service works

- You can show that you have a good mousetrap for customer acquisition

- Milestones that will be considered relevant and indicative of the medium to long-term potential of your business idea. This doesn’t necessarily mean that you show that you are revenue positive. At this early stage you want to show milestones around a certain number of customers or certain traffic figure for your website or number of registered users or units shipped and so on.

Raise enough capital with a margin of safety that will get you to the next stage where someone is willing to put seriously big dollars into your business. If you choose to raise too little, you run the risk that this money might run out before you can show any meaningful progress or traction. You might end up being doomed because investor interest in your company might dry up if you haven’t been able to demonstrate the potential of your business despite having raised a round of capital.

Remember that the more capital you raise at an early stage, the more dilution that you will suffer, i.e., the investor will demand that you dilute your share ownership by giving a large part of your shares to the investor. If you need more capital after this initial round, you might get diluted even further, leaving you with what could turn out to be very little upside as your start-up grows into something big. This is another reason why you might want to make do with a smaller round (with a margin of safety built in) that can take you to hitting relevant milestones that will excite someone to invest more money in a future round.

Our own personal experience at iTrust has been one of erring on the side of caution. Out of choice we ended up raising more capital than we had immediate need for. But the decision was not as straightforward as that. We started off thinking that we could do with a small amount. As we dug deeper into understanding the capital requirements of our business, we realized that our initial thinking was wrong. We could not get to any meaningful milestones with a small round.

Additionally, we were worried about running out of capital at a time when the markets and investor psychology might be in one of its pessimistic cycles. This environment would make raising another round of capital very tough. As it turns out, the past three months since the start of the 2008 have demonstrated that maybe our fears were justified.

I am sharing all this because an adverse change in the funding environment will be a practical reality every few years. While you are thinking about your margin of safety, think about what would happen if the funding environment were to completely change. Would you have reached enough milestones; would you have ample liquidity to see you through this crisis where there might be a delay in raising your next round?

As we have discussed in the previous posts, fund raising is emotionally draining and time consuming. So, also think about potentially avoiding any distractions from building the business that you could overcome with a slightly bigger round in the early stages.

Finally, a few practical tips for the Indian market. We Indian consumers are tough nuts to crack. You might want to give yourself enough breathing room to try different strategies and tactics at the early stage of the evolution of your idea, whether its concept arbitrage or a totally new idea. If you raise a small amount and your experiments turn out to be wrong, you might not have had enough fuel left in the tank to keep your engine going.

Also, given India’s current economic environment, wage inflation and rental rates will be higher than what you are budgeting for. Contrary to what one reads in the US press about the deflationary costs of starting a business in the US, the costs of starting a business in India are going up. So raise enough that can allow you to keep paying salaries to your staff and rent to your landlord. Don’t be overconfident that your revenues will offset a lot of your costs and so you can make do with a smaller round.

What’s your take? Do share your comments/questions.

Tomorrow: What is the valuation of my business?

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Tags: Entrepreneurship in India, Startup Financing