Lesson 8- Raising Capital

Introduction

The end of the Internet bubble means that there is a dearth of good deals. In fact some

venture capital funds have been returning money to investors because of this. The combination of

plenty of money and lack of good buys has opened a market that has been available only to a

selected few in the past.

At the end of the unit, the students shall be able to:

1. Discuss what start-ups is.

2. Discuss the different sources in raising capital: debt and venture capital, incubators,

accelerators, grants.

3. Describe and familiarize ways in identifying competitions.

Start Ups

Start-ups almost always raise capital in stages. Hopefully for the technopreneur the value

of the business increase at each stage. But this may not always happen. Market conditions may be

difficult (like now) or there may be internal problems in the company. The reason for different

rounds of investment is that the significant risk involved in a start-up decreases as the business

manages to prove its technological concept, develops a product or service, markets the product

and generates income through selling it. As time passes, the business is able to project its cash

flows more accurately; investors will sink money into the ventures more confidently.

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 Financing in rounds mean that investors usually put in only a small amount of money

initially, increasing the amount gradually. Usually the technopreneur is happy with this

arrangement even though there is the danger he may not find funding at a critical stage. This is

because the larger the initial amount the investors put in, the more equity he would have to give

away. He prefers only to raise what he needs because as the business becomes progressively less

risky, he can get a better valuation.

The following illustrates the typical rounds that a business raises money

1. Start-up seed stage: The concept and management are in place. There are some

projections (more like guesstimates) of viability and commercialisation. This is typically

priced at around $100,000 to $5 million.

2. Development stage: The product or service has been developed and there is some product

confirmation on viability and commercialisation. Typically priced at around $2 million to

$5 million.

3. Sale stage: Products and services confirmed with sales and customers. Revenue

Generating. Valuation is based on capital required and for what purpose. Can be pre-money

or post-money valuation. Typically priced at around $5 million to $10 million.

4. Expansion stage: Company has achieved great results in a small market. Expansion is

being made into new markets or products. Valuation is based on profitability. Higher

valuation is due to profits. Typically priced at around $25 million to $100 million.

5. Liquidity stage: Good company, great solutions, located in the right markets. Pre-IPO

stage or exit stage funding round. Valuation substantially higher and based on cash flow,

future potential and so on. Typically priced at twice the price of previous round.

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 6. Cashing out stage: If the company is listed, it is valued based on market sentiment, peer

group comparison and company's potential. If it is acquired then the valuation is based on

start “a willing buyer-willing seller“ model. Typically a good exit should be priced at 50

to 75 times of the seed stage valuation. And after various levels of equity dilution, a

typically early stage investor looks to make a gain of 20 times the amount he put in.

RAISING CAPITAL: DIFFERENT SOURCES

Financing Alternatives: Debt versus Venture Capital

Key Takeaways

 Venture debt is a cumulative term used to describe loans specifically created to provide

support to startups backed by investors. Venture debt is generally used for startup

companies that deal with products and services in the field of technology, life science,

and other inventive economies.

 Venture capital is a type of financing where investors provide capital to companies (in

their early stages of development) that show great potential for growth in the long

term. Venture capital is generally provided by experienced investors who have been in

the business of backing up startups for a long time (generally >10 years).

 While venture debt and venture capital serve the same goal of providing capital to

startups, they can differ in a few ways. The factors where they differ include equity,

value, repayment, valuation, and ownership.

 When weighing the advantages and disadvantages, venture capital seems to be best suited

to a company that has been doing business for a few years and has created a solid

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 structure (or org design). The startup must also be in an industry that is currently in high

demand. When these factors are present, the founder would typically already have the

necessary knowledge to deal with venture capitalists.

 Venture debt is best suited to companies that are in the early stages of establishing their

products and/or services. Under these circumstances, you are generally not making any

impressive leaps with your revenue and require quick money to cover expenditures such

as making key hires and investing in marketing.

What is Venture Debt?

Venture debt is a cumulative term used to describe loans specifically created to provide

support to startups backed by investors. Venture debt is generally used for startup companies that

deal with products and services in the field of technology, life science, and other inventive

economies. It’s targeted at small startups with venture capital backing rather than startups that have

borrowed capital from friends and family.

Most of the credit that is available to startups is based on their ability to generate cash flow.

Another category of lenders is the one that provides advances against a startup’s liquid assets.

These lenders rely on collateral as a source of repaying the borrowed money instead of cash flow.

Both of these approaches are not recommended for startups that are in the early stages of

generating revenue. In the case of venture debt, repayment depends on the startup’s ability to raise

more capital which will fund growth and also repay the debt.

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What is Venture Capital?

Venture capital is a type of financing where investors provide capital to companies (in their

early stages of development) that show great potential for growth in the long term. Venture

capital is generally provided by experienced investors who have been in the business of backing

up startups for a long time (10+ years). While their investments generally take a monetary form,

they are also known to provide valuable technical and managerial advice to founders.

During a venture capital deal, ownership to chunks of the company is sold to the investors

with limited partnerships generally established by the venture capital firm. Venture capitalists take

a major risk by investing in new startups but the payoff if the company goes public / is acquired

more than makes up for the initial investment. They generally get paid by selling their stakes in

the company at a point of earning maximum profit.

Venture capitalists work at venture capital firms (or “VC firms”) and are known to invest

in small businesses at later stages of their existence. However, in the early days of a startup, angel

investors play a very important role in providing funding. Angel investors could often include

High Net-Worth Individuals (HNWI). These are individuals who have retired from their days of

business and now look to provide early investment to entrepreneurs. Startups that have received

angel investments for some time have a better portfolio -- which benefits them when they apply

for funding from venture capitalists further down the road.

A technopreneur needs to study each VC firm's investments criteria and approach only

those firms that offer the best value in terms of growth and expertise that the start-up may need.

Some venture capitalist firms are also run by technopreneurs, who after one or two rounds of

success and capital, have headed out to help other technopreneurs build, craft their niches and

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create greater success stories, with their experience in a start-up environment. Their added input

can be invaluable, so start-ups should first turn to these ex-technopreneurs.

With the market downturn since the dot.com crash, most VC firms are hibernating like

bears in winter. At the present time, there is very little VC activity at the seed stage. VCs should

ideally be approached once a company has completed product development, has a few customers

and revenue is coming in, that is, at the second or third round.

Difference between Venture Debt and Venture Capital

While venture debt and venture capital serve the same goal of providing capital to

startups, they both can differ in a few ways.

The following are some of the factors in which venture debt differs from venture capital.

1. Equity

Investors provide founders with capital to build their startups in the initial stages. Venture

capitalists tend to ask for a good chunk of equity in the company in exchange for the capital. In

the case of venture debt, on the other hand, the issuers tend to avoid taking any stake in the

company.

2. Value

In the case of venture debt, the cost of debt remains constant and is limited to interest rates

which are agreed upon by both the company and the issuing party. Venture capitalists tend to rely

upon equity, the value of which tends to fluctuate over time and sometimes does so drastically

depending on the company’s stock performance.

3. Repayment

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 Venture debt is similar to a bank loan -- repayment includes the principal amount plus the

interest that the lender would have imposed on the borrower (i.e., the startup) in the beginning. In

the case of venture capital, borrowed money is not paid back like it is in traditional loans. Rather,

the investors buy a significant stake in the company which they can sell as the overall value of the

startup increases over time. The exit strategy for venture capitalists generally comes into play when

a company plans on going public, when there's a merger, or when it is acquired by a larger

organization.

While venture debt returns have less risk when compared to those of venture capitalists, the

average payout for venture debt is less than that for venture capital.

4. Valuation

Business valuation is a process where the total economic value of a business is calculated. This

is used to identify the fair value of a business. In the case of venture debt, a startup does not need

to be evaluated, a circumstance that reduces the complexity of due diligence. However, in the case

of venture capital, a startup will be thoroughly scrutinized with a rigorous due diligence process.

5. Ownership

In the case of venture debt, there is no requirement to provide a seat to the lenders on the

startup's board. The lender lets you retain 100% ownership of the company and does not weigh-in

on the way you run the business. By its very nature, venture capital generally requires a seat on

the board. This is primarily because venture capitalists, in addition to money, provide technical

and managerial advice to the startup. However, this tends to cost the founders a certain loss of

control in the business.

When to Use Venture Debt?

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 While venture debt can be a great asset to a budding business, there are a few instances

where it is advantageous. This is especially true in cases when venture capital might not be right

for a startup.

The following are some of the scenarios when you can use venture debt:

a. Insurance. You can come across various obstacles while running a new business. Many times,

to overcome these hurdles, you will need some kind of monetary cushion. Venture debt can

come very handy in such situations to avoid any lasting damage to the business and help it

keep moving forward at a smooth pace. If the startup takes longer than anticipated to reach its

next developmental stage, then venture debt could come in handy as insurance.

b. Fund larger expenses. While running your startup, you may come across scenarios where you

need more money. These expenses will generally have something to do with the expansion,

scaling, or acquisition of valuable assets. If you require extra capital during these moments,

then opting for venture debt is a fairly safe option available to you. It the cheaper alternative

of options available to you.

c. Covering under-performance. You cannot always expect your profit graph to be pointing

upward. There will come points, especially in the early days of running a business, when you

will be underperforming. During a downturn in the market, you may fear a decline in your next

tally of capital. Venture debt comes in handy in this situation as it will help finance your

business during this time so that you don’t take any significant losses until the market

stabilizes.

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d. Milestone boost. When running a business, you will likely set certain milestones which, when

achieved, will be an indicator of transitioning into the next phase of the venture. However,

while you may be making a steady profit, you may still fall short of hitting your next milestone.

In such situations, venture debt acts as a kind of a stimulus to provide the remaining capital.

e. Avoid Bridge Rounds. Bridge rounds are small fundraisers that raise enough capital for

startups to help them survive till the next major infusion of funding. They are generally

implemented throughout the life of a company. However, raising a bridge round from your

investor can be an expensive endeavor and potentially create a poor image. Venture debt can

help fill these portions so that you can make it to the next milestone without requiring a bridge

round.

When to Use Venture Capital?

Venture capital is a smart and established way for businesses to raise capital to get things

going. The following are some circumstances where venture capital can come in handy:

a. Early-stage. As mentioned above, venture capital is a great way for startups to obtain the

money to acquire the assets that are required in the early stages of establishing a business.

Early-stage financing can take multiple forms based on why you require the capital.

Seed financing is when startups request a minimum amount that will help the founder

become eligible for a startup loan.

Start-up financing, the next step in early-stage capital, is where financial support is

provided to a company in its early days to finish the development of products and/or services.

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 The next form of early-stage financing is when financial support is provided to a startup

for pushing it into full-scale production.

b. Scaling project. After a startup has been running for some time and has found a comfortable

pace at which it can develop and deliver its products and/or services, the next big step would

be to expand the business. An expansion could entail anything like moving from a small office

to a larger office, adding more to your infrastructure, growing the team significantly, or

expanding to international markets.

Expansion financing can take various forms based on the amount being raised and its use.

One of these types is called second-stage financing which is provided to companies looking to

begin the process of expansion. The amount of capital needed in this type of financing is rather

large and used to cover all facets of initial expansion efforts. Another form of expansion

financing is bridge financing. This type of financial support comes with short-term interest and

is used as monetary assistance for companies that use an Initial Public Offering as their

standard business strategy.

c. Acquisition. After a certain point in running your business, opportunities to expand into newer

avenues will arise. One of the ways to go ahead with this expansion is by buying entire

companies or certain parts of them. The acquisition and merger of two companies, regardless

of their size, will almost always be an expensive venture.

In such situations, venture capital funding can give you the right push to make acquisitions

go smoothly.

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 Which is better: Venture Capital or Venture Debt?

To understand which one of these options is better for you, founders must understand the

advantages and disadvantages of each of them.

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Advantages of Venture Capital

 Since VC funding is not a loan, there is no need to pay the money back and it is free of any

form of interest. The risk completely lies with the venture capitalist.

 Venture capitalists are a great font of experience and knowledge related to running a

successful business. Other than knowledge, they can also provide crucial guidance and

support in the form of valuable networks and quality hires.

Disadvantages of Venture Capital

 Venture capital is provided to businesses in return for equity in the company. This allows

venture capitalists to have their voices heard during important board decisions. There is

potential for some clash in beliefs between founders and VCs as the latter assert their

ownership. Since founders give up some percentage of the total stock, there is an added

threat of losing ownership of the company.

 Since most of your projects will be confidential before the official release, members will

be asked to sign an NDA (Non-Disclosure Agreement). However, some VCs tend to avoid

signing any documentation in this regard.

In weighing the advantages and disadvantages, venture capital seems to be best suited for

a company that has been doing business for a few years and has created a solid structure (or org

design). The startup must also be in an industry that is currently in great demand. When these

factors are present, the founder would typically already have the necessary knowledge to deal

with venture capitalists.

Next, let’s look at some of the advantages and disadvantages of venture debt:

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Advantages of Venture Debt

 Venture debt helps startups extend the time after which they run out of money

(their runway) and help provide the necessary boost to reach certain milestones. This

increases your value to investors without you losing significant control of your business.

 Venture debt works great as a safety blanket for businesses that are trying to cover a drop

in profits.

Disadvantages of Venture Debt

 You will have to pay the money back over time along with the interest. Sometimes, to

qualify for venture debt, you are required to keep some assets as collateral.

 In case you are not able to reach the goals that have been laid out in the loan contract, your

image starts to falter and lenders tend to lose faith in you.

Considering the aforementioned advantages and disadvantages, we can safely say that

venture debt is best suited to companies that are in the early stages of establishing their product

and/or services. Under such circumstances, you are generally not making any impressive leaps

with your revenue and require quick money to cover expenditures (such as making key hires and

investing in marketing).

Other Sources for Raising Capital

Incubation Centres

Incubation centres tend to be like laboratory centres that hatch ideas under one roof. They

share resources as their main contribution instead of capital and offer start-ups a

procreative environment.

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 Incubation centres often understand business dynamics and needs which technological

companies face. They provide free office space, consultancy services, Internet access, data contre

facilities and networking opportunities within the same centre and elsewhere. They allow founders

to concentrate on their early stage core competencies of research and development without

worrying about raising money.

As the start-ups mature, they provide mentorship and networking opportunities so that

newly researched and developed products could be cross-sold to other incubates and matured

further before they hit the markets. Another key benefit is that solutions are tested in a cohesive

environment.

Once the need for capital and expansion arises, they work on structuring business plans

and financials. They also provide assistance to plug gaps prior to pitching to venture capital firms

for growth capital.

Incubation firms are a great idea for technopreneurs who lack the business know-how and

commercial viability of their products. It is a great place to hone business skills before stepping

out on their own. The downside is that incubation firms will take a 10 percent to 30 percent share

of the equity, depending on the roles they play and the assistance they offer in the projects.

However, the technopreneur should not be too bothered by giving away equity because each party

has to justify it share.

In recent years, many intubation firms have gotten into big trouble. They were driven by

greed and not performance. Many real estate companies, landlords and Old Economy companies

with excess resources were pushing their services to technopreneurs, trying to build a portfolio of

companies so that they could be pushed to the public. Such firms offered very little value to take

technopreneurs. Technopreneurs should check to see if incubators provide R&D facilities such as

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software development tool kits, application development, training guidance and technical support.

They then need to provide incubates with help on the commercial viability of their products,

feasibility studies, implementation plans and finally with support in sales and marketing.

Incubators also need to understand there is need for additional resources such as hardware

and software licenses which are a requirement for the development of scalable solutions.

Incubators nurture young firms, helping them to survive and grow during the start-up period when

they are the most vulnerable. But an incubation company, just like the venture capital firm, is

driven by its own set of goals. It is therefore important that the incubation firm is chosen carefully

as the wrong choice can kill any or all potential that a start-up may have. Technopreneurs, once

they have decided to work with one, should ensure an agreement is drafted, setting out both parties'

roles and responsibilities, so as to lessen any possibility of future disputes.

Those who have the management and technical expertise but are too early in the cycle to

approach a venture capital company and do not want to use incubation, could look for an angel.

Angels

The word "angels' brings to mind a fairy in a white dress who comes to ones rescue in dire

times. Well, this is exactly what an angel does for a start-up company. Angels are usually high net-

worth individuals or individuals with a budget for investments. They are often stock market

investors or observers who, understanding the stock market and the valuation theory behind

companies listed there, preer to get closer to the value chain by investing directly in start-ups.

Angels come in different sizes and roles. An angel may be a university professor, an investment

strategist, a business person or even a retired civil government servant. The shared characteristics

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among angels is the understanding of how the stock market functions, the valuation game,

technology innovation and its evolution, and the business need for capital.

His appetite for risk grows as he gets more successful. It is estimated that for most start-

ups, the angel is the key driving force behind them. He is responsible for the largest source of start-

up capital in new businesses. It is extimated that one-seventh of the 300,000 early growth firms in

the US receive funding from angel investors. This translates into over US$20 billion of investments

over apporximately 50,000 deals each year.

Angels are not interested in controlling the start-ups business and they will typically invest

in companies within their immediate geographical location. They simply want to be mentors to the

start-up and ensure that their capital is well taken care off. They look for sincerity and honesty in

the founders. Those who simply don't have the time to mentor founders themselves can pay

someone else part of their profits to do the job would simply hand over the management of their

capital to another professional, usually a venture capital firm

The benefits of going to an angel over a venture capital firm or incubator is that angels are

usually more informal. They do not tie down founders with mandates, milestones and performance

clauses. The angel will simply discuss the opportunity and his potential reward for his contribution,

which may be his expertise or money or both. An angel is less likely than a VC or incubator to

have a hidden agenda, for example, trying to get cheap proprietary information for their portfolio

companies.

The angel does not need to have a complete business plan and seldom questions a founder

on value creation or competitive advantage. He may work with a founder in the early stages to do

all that is required to build a sustainable business strategy.

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The first search for an angel should usually begin at home; friends, parents, teachers, associates

and others can be a part of the angel chain. Anyone who understands the business of the start-up

and what it is trying to do can be a potential angel. The deal can be closed once the angel trusts

and relies on the founder's goodwill. A deal with an angel can be concluded in less than a month.

Government Assistance/ Grants

If all efforts to get funding fail, start-ups can get capital and assistance from governments

via enterprise grants, innovation grants, or venture capital assistance. When everyone else has

stopped investing due to the economic downturn the only party that can promote the wheels of

commerce are the governments themselves, because start-ups could potentially boost employment,

create opportunities in the economy and enhance a lacklustre stock market.

For governments, the motivation is simple: they need to boost use of technology and they

need solutions which can make businesses react efficiently to economic cycles and changing

business environments. They also want to see companies lower costs, penetrate new markets and

become more efficient.

Government assistance can be used for subsidising research and development costs and the

building up of the start-up's core business model. In the US, the Small Business Administration

has funded companies like Apple, IBM and Hewlett Packard. Established since 1953, the SBA has

offered financial technical and management assistance to almost a million companies yearly and

is one of the world's largest financial backers of small businesses. The results speak for themselves.

The added benefit is that government grants need not be repaid. The drawback is grants are in

range of $10,000 to $500,000 only. They are suitable for R&D, not for cash flow. Therefore if a

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start-up is looking for more than R&D money, they should consider approaching government

backed venture capital companies.

Fortunately, government bodies operate VC funds. They too operate in the same manner

as commercial VCs. Unlike the latter VCs, the key agenda for government venture funds is to see

how the project will benefit the economy and the country as a whole. Having the government as a

shareholder can open business doors and can provide credibility for the new company.

Raising money for your startup: Identifying your competitors

Because in almost all cases it isn’t true and investors will take that phrase as a sign that you

haven’t carried out in-depth market research.

Once the alarm bells have started ringing, it’s likely they won’t be interested in your

business. This is why it's vital you conduct a competitor analysis when looking to raise capital.

What you most likely mean is that you don’t have any “direct” competitors, but there are

two other types of competition your business may be facing: “indirect” and “replacement”. As way

of a brief explanation: A direct competitor is a business that essentially offers the same product or

service as you do, an indirect competitor is a business which offers a similar product or service but

may be in a different sector of the same market, and a replacement competitor is a substitute for

the product or service offered by your business which doesn’t need to be in the same sector and

won’t be immediately obvious. To find out more and see some real-world examples, check out our

post, “So you think your startup business doesn’t have any competition”. Identifying your

competition is one of the most important things you can do for your business, especially when it

comes to approaching investors and raising money.

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 You need to know (and then relay to potential investors) what else is out there, what they're

doing, and how your business is better, faster, or cheaper than them.

Determining Your Competition

Because it’s not always immediately clear who your competitors are, some entrepreneurs

struggle to determine exactly what they’re up against.

Analyzing the activity and criteria of your customers, as well as what else is available in

the area surrounding your store, can give you a fantastic insight into why people choose you instead

of your competitors, or vice-versa.

He wraps up the post with a handy suggestion for how to present your competitor analysis

in your business plan:

How to Identify Your Competitive Strengths for Your Business Plan

a. Entrepreneur Media staff. This is an excerpt from the book, “Write Your Business

Plan”, which focuses on identifying what sets your business apart from others and gives it its

competitive edge. Investors want to know that you understand the challenges your business

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 faces and in which ways you’re better than those around you. They can’t get this information

from a list of names and they’re not going to do your research for you. Once you’ve identified

the competition, you need to find where your competitive edge lies? For example, is it in cost,

features, service offered, quality, distribution, or something else entirely?

b. Getting the scoop: How to research and identify your competitors. Studying industry

associations, search engines, and startup databases may give greater understanding of what

already exists, what startups are in the works, and what he’s facing.

Tips on How to Research Your Competition

In order to keep them at bay, you need to monitor them regularly to ensure that you know

what progress they are making. The results are invaluable to any entrepreneur and technopreneurs

looking to identify their startup's competition, whether or not you're raising money.

References

https://www.abstractops.com/financing-alternatives-venture-debt-vs-venture-capital

https://www.growthcapitalventures.co.uk/insights/blog/raising-money-for-your-startup-step-6-
identifying-your-competitors

https://www.cbinsights.com/research/venture-debt-venture-capital-vc-comparison/#:~:text=Some
%20of%20the%20differences%20between,they%20have%20received%20backing%20previousl
y.

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