Funding can be a double-edged sword for startups

12 Oct, 2015

Funding is crucial for all kinds of companies. I would say that funding is a double-edged sword that can make or break a startup's future. While well-funded companies can create shareholder value and disrupt markets, excess funding or poor use of capital is a recipe for failure.

Timing of fund raising

For an entrepreneur, it's hard to know when fresh funding should be raised. Raising a lot of money in quick succession can lead to arrogance within the ranks. Imprudent financial management would eventually cause failure. Founders should try to spend every penny of external capital as if this were to be their last round of funding. While startups need the right amount of cash to maximise their true potential, founders need to stay humble and ensure existing cash resources are wisely spent. They ought to focus on generating profits as relevant to the business. Do not raise capital only because existing investors want it.

Origin of VC money

Let's take a realistic example. A US pension fund gets its money from pension contributions of US citizens. The pension fund invests in a diversified portfolio of investments, including VC funds. The VC firm's role is to invest in startups and help them grow. Typically, VC investments are 'high risk, high return' sort of investments from a pension fund's standpoint. As a rule of thumb, most VC firms will invest in about 10 startups in a given time frame. Of this, five may fail, three will give average returns (two to five times original investment amount) and maybe one will become a unicorn, generating up to 100 times in returns. VC firms compete with each other to find that one startup that can become a $1-billion entity.

Risk appetite and failure

A VC's role in mentoring, offering advice, creating value and innovation can be overhyped. VCs are not risk takers of their own capital; it's the investors' money (like a US pension fund) that they deploy. In most VC funds, the partners' own money accounts for less than five per cent of the fund's corpus. There is no doubt that a VC fund would root for an investee company to succeed as the partners' variable bonuses and incentives are aligned to the startup's success. However, the fund would be fine financially even if a startup fails. Hence, a VC's risk appetite may not be as high as that of someone who invests his/her own capital. Having said that, there are some exceptionally good VCs out there who are committed to partnering with entrepreneurs and share the common vision of building a company for the long term. Entrepreneurs should try and work with such VCs.

Is there a bubble?

Startup valuations, specifically those of e-commerce ventures in China and India, point towards a big bubble in the making. The bubble is driven by investors. The amount of money raised by some of these startups is unprecedented. Too many 'me-too' ventures (with no real value creation or differentiated / sustainable business models) are getting investor attention. This leads to over-spending on customer discounts and expensive hires while the real underlying business continues to make losses. In order to sustain the momentum, more money has to be raised. Eventually, there comes a point when the entrepreneur's holding in his/her startup ends up becoming so insignificant that investors tend to drive the business strategy. This is dangerous as investors would be driven by short-term valuation gains instead of long-term value creation.

Kunal Nandwani is an entrepreneur-cum-angel investor. He is a founding member of the Chandigarh Angel Network, a newly formed angel network for tech startups. Nandwani is also the founder and CEO of uTrade Solutions, a fin-tech firm that provides multi-asset trading platforms, order and risk management systems. At a personal level, he has made angel investments in EduRev, a crowdsourced platform for educational content, alumni app maker Alumnify and other startups.

As told to correspondent Varun Arora.