The word ‘startup’ is currently used to describe technology companies or technology-enabled companies that have the potential to get funding from angel investors or VCs. However, using that definition for a startup narrows the possibilities that the entrepreneur can pursue as a business because the kind of companies that VCs can invest in is a very small subset of the many kinds of businesses that entrepreneurs can pursue.
While many ventures can be good businesses for the entrepreneurs, they need not necessarily be a good investment for VCs. And to understand why that is so, it is important to understand the business model of angel investors and VCs.
The VC Business Model
Possibility Of An ‘Exit’ Is Critical
Investors make money when they sell shares they hold in your company. NOT when they buy the shares by investing in your company. So, unless there is a reasonable chance that they will be able to sell the shares to someone else – next round of investors, strategic buyers or, in very rare cases, IPO, there is no reason for the investor to invest, even if the venture becomes a reasonably successful business.
There Must Be A Reasonable Chance To Get More Than 10x Returns
Because many of the ventures they invest in will fail, unless the few successful ones return 10 – 20 times the amount invested, the investor won’t make money on the overall portfolio.
Market Leadership Is Important:
To get 10-20 times return on the amount invested, the venture must achieve a commanding position in a potentially large market … else the next round of investors won’t have any reason to buy the earlier round investor’s equity at a significant premium. So, even if a venture is a reasonably profitable company, but not in a reasonably dominant position, the investor will not be able to sell shares (certainly unlikely at a good premium) even if the business is a reasonably satisfying one for the entrepreneur.
Scale Is Important
Else the numbers just won’t work for the investors to get a decent return on their investment.
And therefore, the only kind of businesses that angel investors and VCs can invest in are businesses that can scale up massively and who can have a dominant position in a very large market and in which they can sell their stake to someone else for 10 – 20 times the amount they had bought the stake at.
Not all businesses will qualify on these criteria, even if the venture is a reasonably happy outcome for the entrepreneur. So, when entrepreneurs start with VC funding as a focus for their business, it narrows their choices to a small sub set of possibilities rather than a large number of possibilities that an entrepreneur can pursue if VC funding was not a criterion.
A restaurant or a handmade shoe making company or a boutique or a furniture store or a jewellry brand or an ad agency or a manufacturing unit, or indeed any legitimate business that the founder is happy doing and satisfied with the financial outcomes is a good business. But these, and many other businesses, may not qualify for venture capital. And that is okay.
In my view, any legitimate business that creates employment and generates wealth (to whatever extent that is satisfactory to the founder) is an entrepreneurial venture i.e. a startup.
My advice to entrepreneurs is to think of the business they will enjoy doing, assess if the financial returns that the business can give will satisfy them, and then access the right funding option for that business. If your venture is not fundable by VCs, and many good businesses will not be, think of how else you can fund your aspirations. Some pointers:
- Many businesses can get to profitability with very, very limited initial capital.
- Focus on getting to profitability the quickest, focus on profitability rather than ‘scaling up’. If you sustain, you will get a chance to participate in the market as it evolves.
- It takes a decade to become an overnight success. Don’t be in a hurry. Build a strong business patiently. If external capital is not available for growth, scale up as best as you can with internal accruals.
- Be frugal in your expenses. Spend on what’s necessary.
- Creative marketing ideas necessarily must cost a lot.
- Venture debt and collateral-free loans for working capital are now available… not as easily as one would want it to be, but things are getting brighter on this front.
- Crowd funding is an option in certain categories
- Some ventures may be able to attract initial investments from strategic investors i.e. companies that may benefit from what the venture does. E.g. a pharma company may find value in investing in a startup that is creating a network of doctors.
About The Author
[Prajakt is the founder of Applyifi and the founding partner of The Growth Labs. Before starting Applyifi, Prajakt was the head of operations at IAN, and the Asia-Director for TiE (2004 – 2007). Previously Prajakt had co-founded Orange Cross, a healthcare services company, and was part of the founding team member of Idealake Technologies. Also, he is author of the book, ‘Starting Up & Fund Raising’.]