10 QUESTIONS ENTREPRENEURS NEED TO ASK THEMSELVES BEFORE SEEKING VENTURE CAPITAL AND ASSESSING THE DEGREE OF RISK

In the first part of this article, we have seen what is venture capital funding and how it works. It is time now to take up how to get venture capital funding, or whether to go for it at all. What does it take for an entrepreneur to get funded, and what are the circumstances in which he may be better off growing his startup organically?

Here are the 10 basic questions an entrepreneur needs to ask himself before going off in a quest for venture capital funding.

1. Do you have a viable, rapid-growth, highly-scalable idea?

Every entrepreneur believes his startup is a winner, and that his business idea is brilliant. But that’s hardly enough. Other people have to see evidence of it to back the idea. Especially VCs. Your pedigree, academic credentials, and even the idea might get you a meeting with potential investors, but not further.

Sumit Jain, co-founder of CommonFloor, one of India’s leading real estate portals, learned it the hard way when he started his entrepreneurial journey. He and his co-founders were engineers from the prestigious Indian Institute of Technology (IIT), Roorkee.  He recalls.

“We thought getting venture capital funding will be easy. If we won’t find funding, who will? We pitched to so many VCs but nobody was willing to bet on us then. Finally, we decided to bootstrap and make our business work. In a year’s time, investors were coming to us.”

So, if you are comfortable running a small or niche business which you can make profitable, venture capital funding may not be your cup of tea. Bootstrapping with your own savings, or raising money from family and friends, would be a better option. On the other hand, if you have the ambition to launch a high-growth company – and deal with the stress that comes with it – then at some point you will need to go for venture capital financing. The right time for it is when your startup is poised to take off on an accelerated growth path into the big leagues.

2. Does your business suit the venture capital model?

As we have seen in Part 1 of the article, VCs need big winners. You can run a small, profitable business comfortably, but that doesn’t interest a VC. You should go to a VC only if you have ambitions to scale up your business with big infusions of capital. You should also be prepared to get onto a fast growth track, because your venture capital investors will want to sell their stake and reinvest in new startups.

3. What is the size of the market that your startup is targeting?

Some businesses are just too niche to be fundable. A US$20 million market size may be good enough to run a business, but remember that institutional investors are looking for a rapid scaling up – and for that, a market size in hundreds of millions of dollars is more like it, because if a startup manages to capture even a small share of that market, it will be large enough to give a venture capital fund the quantum of returns it needs for its investors.

4. Deep down, what is your reason for starting up?

Some people start up because they want to be their own boss. Others do it because they like the status of being an entrepreneur. A third kind of startup founder is driven by a passion to disrupt the status quo. Probably in most startup founders you will find shades of all three, but it’s the third characteristic that appeals the most to a VC. They are the ones who will not be satisfied with making a good living from their business; they want to change the world. Some introspection at the very outset can point to the road ahead that is most suitable for you. 

5. Are you ready to share control of your startup?

A VC-funded startup will go through several rounds of funding, and the founders will have to part with large chunks of stock in the process. Venture capital funds invest large sums of money, and in order to generate returns on those, they need to own significant percentages of their winning startups. For a founder, this means getting used to the idea that he can’t call all the shots in the quest to make the company grow large. Of course, that doesn’t mean the founder won’t become rich – even a small stake in a high-growth startup can be worth millions.

6. Which venture capital fund is right for you?

A multitude of factors come into play here, but the most important of them relate to the value that a venture capital fund can add to your startup, beyond the capital. The guidance of an experienced venture capitalist can prevent mistakes and turn errors into valuable lessons. They are well-connected with potential customers, investors, and acquirers, which is invaluable to a fledgling startup. Ideally, they should have experience in your field, but at the same time not have another startup in their portfolio that would be your rival. And finally, it’s always best to catch a fund in its initial investment phase, so that there will be more opportunities for follow-up funding.

7. Do you have the boldness and perseverance to cross the dark valley?

“When an entrepreneur succeeds, there is so much glamor and halo attached to them. What is forgotten or undervalued is the walk through the dark valley entrepreneurs go through.” Vani Kola, managing director of Kalaari Capital, shared that with me some time ago, and those words have stayed with me because we see it in so many successful startups we profile at Tech in Asia. Having been an entrepreneur herself, it is that elusive quality of perseverance that Kola the venture capitalist looks for in startup founders.   She says.  

“On the days when things don’t go great, this quality will see the entrepreneur through.” 

8. Do you have the team and leadership to grow your startup into a viable business?

However good your idea may be, or however strong your tech credentials are as a founder, if you don’t have a strong team or you can’t persuade a venture capital fund manager that you have the leadership traits and connections to build a great team, then he will be inclined to walk away from it. Getting from seed stage to the next levels before ultimately reaching the big exit point that investors are looking for requires organization and collaboration. That’s why a VC will try to figure out if an entrepreneur has the makings to be a good team leader.

9. How should you approach a venture capital fund?

You have identified a pain-point in the world, you have an idea to resolve that pain-point, and you have worked out a business proposition for it. You know how the business will grow, where the revenue will come from, who your customers will be. You have markets and their sizes in mind, as well as competitors and obstacles. Now, how do you take all that to a VC?

One way is to be selective, studying the past behavior of venture capital funds to see which ones may go for your startup. The problem is that the past is not always a reliable guide to how a venture capital fund will invest going forward, because it is in a constant state of flux.

The other way is to use a scatter-shot – that is, to fire off proposals to a multitude of venture capital funds in the hope that you strike upon one looking for a startup like yours.

There is a third way too, and that is to first find an incubator, accelerator, or a tech evangelist to back your idea. Screening startups and deals is a complex and time-consuming process. So it helps to have your idea vetted by somebody the VC respects. Pre-screened business opportunities save time for VCs, and have a better chance of being funded. The caveat is to look for a genuine backer with VC connections.

10. And finally, can you get a VC excited about your startup?

Venture capital investing is an inexact science – even more so than investing in stocks. Even after various checkboxes have been ticked and business models analyzed, the GP will take the final call from the gut. That is something to keep in mind.

With so many startups clamoring for venture capital funding, it’s the ones that get VCs to respond emotionally, and not just analytically, that are more likely to make the cut. It may come down to how well a GP connects with the founder or team, or whether he can relate to the problems the startup is trying to solve. Parag Dhol, managing director of Inventus (India) Advisors, is candid about it:

“One of the key reasons we choose an entrepreneur is if he has the passion. If he bores you, there is no point funding it.”

Karthik Reddy, managing partner of Blume Ventures, seconds it. “The investors who eventually end up cutting the cheque are those who become equally passionate about solving those problems. They see that spark in the entrepreneur. They see that market opportunity, just as the entrepreneur sees it. And at the seed stage, it is probably an extreme version of that shared passion and faith.”

The startup journey can be as exciting as it is fraught with risk. Paying attention to what goes on there can prevent sleepless nights and take you soaring into your dreamland.

COMMENTARY:    You have probably heard plenty of times that being an entrepreneur is a risky business, and investors talk all the time about reducing the risk. Yet everyone seems to have their own view of key risk drivers for startups.  Like bankers who rely on credit scores, financial ratios to assess the degree of risk associated with granting a loan, and the experence of the founders and management team, the first priority is to avoid startups without successful business models, look for an experienced management team with a proven trackrecord in the industry, solving a real need in the marketplace, a very compelling value proposition, a scalable business model, knowing and targeting the right target customers, and competing in the right market, not just a large one.  

Here is a priority list of key risk drivers that both entrepreneurs and venture capitalists should evaluate and minimize in starting a business: 

1. Team experience and depth risk. Here I’m talking about both the experience and track record of the founders in starting a business, as well as their experience and knowledge of the business domain. Like most professionals, when I get a business plan, I flip first to the founders section to see if it is a balanced team who has been there and done that.
2. Market and opportunity risk. There is always less risk with a well-defined problem in a large and growing market. All the people in China is a large and growing market, but all the people with cancer is much more well-defined. It’s hard to make money in a shrinking market, or with a solution that is “nice to have” versus painfully needed.
3. Competitive risk. Think seriously about the number and clout of your competitors. Having none is a red flag (may mean no market), but having more than a couple of large ones may mean this is a crowded space. Even in an open space, you need intellectual property, like patents, to keep potential competitors from overrunning you.
4. Financial risk. Very few businesses can be started without money. You as the founder will be expected to put your own “skin in the game.” The business plan should be realistic about how much cash will be required to break-even, and how big the return will be for investors in the first five-year timeframe.
5. Market entry strategy risk. The selection of an inappropriate pricing, marketing, or distribution strategy is a large potential risk. For example, many new social websites proclaim that they will offer a free service, and live on ad revenues (not likely in the first year without a huge marketing investment).
6. Political and economic risk. Sometimes founders are just in the wrong place at the wrong time. Recessions are a tough time to sell luxury goods. Under-developed countries may have a strong need for your product, but are often unstable and dangerous. Four specifics include tax rates, tariffs, expropriation of assets, and repatriation of profits.
7. Technology risk. New technologies, especially those characterized as “paradigm shifts” or “disruptive” may have long and costly acceptance cycles, or may run into unpredictable performance or manufacturing problems. Medical technologies have costly legal testing requirements, approval processes, and insurance validation.
8. Businesses with high attrition rate risk. Certain business sectors have historical high failure rates and are routinely avoided by investors and many founders. These include food service, retail, consulting, work at home, and telemarketing. On the Internet, I would add new social networking sites, and new matchmaking sites.
9. Operational risk. Some businesses require huge support or administrative infrastructures. For example, vehicle fuel improvements require service stations and maintenance shops nationwide, before they are viable. Even small operations can have breakdowns of specialized equipment and complex support processes.
10. Environmental risk. A nuclear reactor built on an earthquake fault line is a huge risk. Evaluate your business and location for sensitivity to floods, hurricanes, and catastrophic pollution problems, like an oil spill in the Gulf of Mexico.

The biggest risk of all is starting a company, any company, for the wrong reasons.    If your startup is clean on both of these lists, you will most likely build a successful business, get the funding you need, and have fun at the same time. What more could a budding entrepreneur want?

Courtesy of an article dated September 22, 2014 appearing in TechInAsia and an article dated April 10, 2013 appearing in Startup Professionals Blog