Why is it important to think through your fundraise ask before starting the fundraise

Last week, I got an email from a solid entrepreneur building real stuff saying he was in desperate need of funds and was okay to raise even $1 million. The same entrepreneur originally started his fundraise process with a $12-million ask about one quarter back.

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Over the last few months, I have observed a similar situation playing out across multiple startups, where the entrepreneur originally starts fundraise process with ask of $10 to $15 million. After a couple of months, the entrepreneur is okay to raise any amount. And in the end, on many occasions, the funding doesn’t happen at all.

I tried to find out what exactly goes on in such situations and why even good entrepreneurs reach this unfortunate situation. Here is what I have come to understand and my thoughts on how to avoid it.

Quite often, the $10 to $15 million number is inspired by other funding announcements in media. In fact, these days many old yet unannounced rounds are being announced in the media, creating distorted expectations. Second most popular reason is to build enough dry powder reserve before market completely dries up.

Now, an interesting dynamic starts emerging with this ask of $10 to 15 million. In today’s funding landscape, many investors give blind pass to such high-risk deals. Many others, just keep the company hanging around (without saying no), so they have an option to jump in later if funding is actually happening.

This obviously means that no one funded the company. And why would anyone invest in a company that’s struggling to raise funds in the market (remember: investment world is full of herd behavior). This basically creates a seriously negative virtuous cycle and makes it impossible to raise any amount.

So what could be done to avoid getting into this situation?

I think the key is to manage demand well. It’s much better to be in a situation where three funds are willing to put in $4 million, than where no fund is putting $10 million. Then you can easily increase the round size to support high demand. Seeing your demand among other investors will be a great confidence boost for your potential investors and gives you the ability to raise the round size.

Here are few more actionable things to plan better:

  1. Most importantly, have an honest sense of reality of your product’s traction. Set your expectations based on genuine progress in business rather than being influenced by media. Trying to bargain from a higher number is not good for you.
  2. Talk to your existing investors. If they are a good set of folks, they should help you estimate the right range of funding. You can hit the market with this range and then adjust based on reactions.
  3. Talk to a bunch of other entrepreneurs who are raising funds in the market and learn from their experiences.

To succeed, you need to survive longer than everyone else. And to survive you need money. So don’t compromise on your chances of raising money for stupid reasons.

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What are you building – a business, product or hack?

Are you wondering if you are on the right path with your startup? Are you seeing a sudden uprise of competition?

These are the kind of challenges that an entrepreneur faces all the time. It gets even more challenging in an environment where everyone is advising to reduce burn.

I have been wondering if there is a way by which entrepreneurs can predict what to expect in future. Anticipation can help plan better. I do realise that it is impossible to make accurate predictions, but after meeting more than 250 entrepreneurs in the last nine months (as entrepreneur-turned-VC), I see a few patterns emerge.

building a startup

Thinking through this framework would either force you to think deeper about your business and create a defensible strategy or allow yourself to fail fast at a low cost. It starts by asking a basic question –

What are you building?

I find startups building roughly one of three types of products – Business, Product or Hack. Let’s see how to identify which bucket you belong to and what to do about it.

Business

If you are building a business, then at some point of time you need to be able to sustain as a standalone business with revenue and profits. Any successful business has to be able to withstand pressure of economic cycles. In today’s technology world, I see a few key characteristics of a good business.

  • Is your business defensible? This is one thing that is most underrated in entrepreneurial setups. Any guy trying to replicate your business must be forced to spend either 10X more money or 10X more time than what you have spent. This is why network effect is the most beautiful way to build defensible business today. If this is not true, then you would always find yourself fighting with a strong competitor.
  • Are you building a faster horse to compete with a car? Every few years a new paradigm emerges and creates new winners in an otherwise already existing market. People who get stuck with past baggage and don’t move to a new paradigm generally become redundant. For example, businesses that are trying to build SMS solutions in 2009 by arguing that the world is still largely on feature phones are no longer alive.
  • Are you over dependent on another organisation for sales/distribution? Quite often I meet entrepreneurs who win one large partnership (often with an established company) and assume that this partnership will make them big. Only later do they find out that they are either not big enough for this partner or this partner starts treating them as competition. Most new-age lending companies are trying to partner with our four e-commerce platforms. And I can’t imagine a reason why e-commerce giants would allow any lending company to become big on their shoulders.
  • Do you have unique insight into how the market/customer or technology works? While competitors can copy the front-end and visible product, they can’t copy the deep insight that’s driving the product. Best example for this was redBus. Everyone used to think, redBus was an OTA, but internally we always worked to solve the pain of eliminating the unpredictability of a bus traveler. Such businesses get clean runways to execute before competitors become aware.
  • Do you have a concentrated set of suppliers? If you do, then sooner or later you will be fighting for margins with those suppliers. The moment you attain a bit of success, these suppliers will come hunting for you. Good example of this was the music streaming service Dhingana. The service itself was compelling, but labels weren’t happy seeing someone become big.
  • Are you 10X better than replacement? Just because you launched a new product doesn’t mean consumers will move from current behaviour to your product. For example, quite a few laundry service companies cropped up recently. They all cited that they have a huge unorganised market to capture. However, the proposed solution didn’t seem any better than the current alternative of giving laundry to your local dhobi.
  • Is there another large company that has the right to win against you? If that company launches your proposition as a new feature, you will become redundant. This is not a breaker, as long as you can build defensibility.

It’s impossible to get favourable answers to all the above questions for your startup. But by asking these questions, you can probably tweak your strategy to solve for as many variables as possible.

If your startup doesn’t qualify as business then it might be in category of product or hack.

Product

If you find that another large company has a right to win against you, then please think hard on how you could build defensibility. Please don’t assume that a larger company will find it hard to execute. There are many ways to build defensibility. If you can’t figure out defensibility then it is probably best to get acquired by the large company by making yourself as attractive as possible.

In case you are not able to figure out your own distribution and are too dependent on another company for distribution then also, it is probably best to get acquired.

Hack

If you are neither a business nor a product, you are probably a candidate for this bucket. In such cases, instead of trying to claim yourself as a business, showcase your skills to a larger company and get an attractive job.

So many things are ambiguous in the startup world that you may not be able to find the right answers all the time. But in my view asking these questions is better than ignoring them.

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Is this the last Diwali with fireworks in e-commerce?

Over the last few weeks, there has been lot of debate about a bubble
in Indian ecommerce. The last 18 months have seen an unprecedented
amount of funding for Indian startups. Not only has the number of
investments gone up, but the average ticket size also has increased
significantly.

There are about a dozen companies that have raised more than $100
million (Rs 650 crore) this year. The unprecedented amount of funding
pouring into the country’s startup ecosystem has done some great
things for us (for one, being an entrepreneur is no longer taboo in
the marriage market!). At the same time, it also sparked off the trend
of running a business on negative gross margins (a practice that is
primarily driven by way of perennial discounting).

Without getting into the debate to prove or disprove the existence of
a bubble, I was curious to understand what it would take to sustain
these discounting fireworks till Diwali 2016.

According to various industry sources, the total burn rate across the
top 10 ecommerce players appears to be ~$9 million per day. (Note that
this number is not officially reported and is completely based on
secondary sources.)

If we were to assume year-on-year growth of 150%, by next Diwali, the
top 10 companies would need about $22 million per day to sustain
business with the current unit economics. That means companies will
burn about $6 billion to sustain the current trend until next Diwali.

There are hardly any investors out there who can support that pace of
cash burn. But let’s assume for now that there are investors who are
willing to put in an additional $6 billion. Let’s look at what needs
to happen for these ecommerce companies to get the $6 billion in cash
they need. Historically, in India, every dollar of investment in this
sector has created $4 of enterprise value. Hence to raise $6 billion,
we would need to see $24 billion of enterprise value being created in
the top 10 ecommerce companies. The current enterprise value of these
companies stands at about $35 billion, so their market cap needs to
increase by about 70% to about $60 billion.

As of now, everyone is expecting something dramatic that will enable
reducing the burn rate.  Here are a few possible scenarios.

One of these players suddenly cranks up the innovation engine
full-throttle and out-innovates everyone else in their sector. This
may potentially define the winners.

A global company may buy its Indian comparable and create a
monopolistic situation.

Multiple domestic companies may merge together and give the global
player a solid fight.

A few domestic players disappear as they run out of money.

It is hard to predict which scenario will, in fact, play out, but it
does look like gathering enough dry powder to buy “fireworks” next
year will be a tough job.

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What does a VC look for in a startup?

The most intriguing question for early-stage entrepreneurs is most often, “What does a VC look for?” Two of the most common responses from VCs are that they’re looking for something that has a large market, and that they want to partner with great teams. Many entrepreneurs have told me that they have spent countless number of hours trying to understand why these (particularly #1) matter so much. After all, what should matter is profitability, right?

I too wondered about these questions for years, and I was fortunate enough to have interacted with few dozen venture capitalists during my tenures at Google, redBus and FreeCharge. In the world of business, when you need to understand how someone thinks, it’s a good idea to understand that person’s business structure. So in my interactions with VCs, I tried to understand the dynamic of a venture capital (VC) fund and discovered quite a few actionable insights. Based on that, I’d like to share a framework on what a VC thinks considers when exploring a potential investment (particularly in India), especially in the context of the two common responses from VCs, as described above.

At its core, every VC firm also has investors of its own, typically known as LPs (limited partners). LPs ‘lend’ money to a VC firm for a long but specified duration (typically 8-10 years). During this time, the VC firm is expected to invest money in promising startups, which are expected to become valuable businesses. Once the investment matures, the VC firm is expected to sell its stake in those companies and return money back to the LPS.

Naturally, because a limited partner lends money to a VC firm, it expects a healthy return on its investment. So a VC firm has fiduciary responsibility for this money and has to put in all the effort required to return the money to LPs with appropriate returns. Imagine the future of a fund that fails to return money to its LPs; such a fund will lose the trust of its LPs and the LP is unlikely to lend the VC firm any more money.

During these 8-10 years, the VC firm is expected to return at least 3x the investment. This is hardly an easy task. Devaluation of the Indian Rupee against the USD further increases the difficulty; at the very least, the ability to return this money becomes a matter of survival for a VC firm.

How the fund works across investments 

For our discussion, let’s take a fictional VC firm, say “ABC Capital”, which raises $30 across its LPs to invest in startups (typically a couple of dozen startups). Let’s assume ABC Capital invests this money of $30 equally across 30 startups (i.e. $1 per startup) and takes 20% ownership of each company in lieu of this investment.

As time goes by, not everything goes well in all investments. Some startups fail to raise follow-on rounds, others fail to find a product-market fit and yet others will see founders fight and separate – on average, most of these 30 investments will fail.

If we go by the typical industry benchmark numbers for a portfolio, 65% of investments will go bust; i.e. 20 investments out of 30 will result in nothing. Another 20% will just barely return the principal; i.e. 6 investments out of 30 will return the money invested. Another 10% of startups will succeed and generate 10x returns for ABC Capital; i.e. 3 startups will return $10 each. The remaining 5% of startups, i.e. one out of a portfolio of 30 companies, may become a multi-bagger and return 50x; i.e. return $50.

So this is how ABC Capital’s hypothetical portfolio will look like:

yourstory-What-does-a-VC-look-for-graph-1Now comes the interesting part! When ABC Capital invests in these 30 startups, it has no way of knowing which of those 30 companies will result in 50x returns and which ones will not return any money. Had it known this a priori, the folks at ABC Capital would have set up the 50x startup themselves!Overall, our hypothetical portfolio will return 2.9x the money that was invested. As you can see, this barely reaches the acceptable level of return, and hence ABC Capital won’t qualify as a great VC firm.

So when ABC Capital makes an investment, it needs to have complete conviction that each of those 30 investments will result in 10x gain and also hope to be lucky enough that one of those 30 investments will result in gigantic returns. This is the only way to create a healthy return for the overall portfolio.

Now let’s put this in perspective from the startup’s side. A $1 investment in company for 20% ownership will mean that company is valued $4 before a sale or listing or $5 after. To generate 10x for a $1 investment, the startup needs to become a $50 company. Let’s extend this example to more realistic numbers. Let’s assume a $5M round of seed funding. This will necessitate the startup to become at least a $250M company. So every single company being invested in should have genuine potential to become a $250M company.

There is no way for a company to achieve those figures unless it operates in a really large market. If we assume that a successful company will capture 20% of the overall market, then the overall market size has to be at least $1.25B. Now you see why the large market size becomes the most important question when investing in any company. If you don’t invest in large market then you are fundamentally setting yourself up for failure as the investment won’t grow 10x irrespective of everything else going great for the startup.

Now let’s assume you have done great job at pitching and ABC Capital is convinced that your startup is operating in a really large market. Now what else would ABC Capital need to get convinced about for before giving you the cheque?

Reaching that $250M mark will be a time-consuming process spanning across 5-8 years (please remember that recent hyper-valuation rounds where a company reaches a $250M valuation in 6 months is not the norm). Venture capitalists at ABC Capital are not the guys who can manage a startup’s day-to-day operations. That is the entrepreneur’s job! And this journey of 5-8 years is going to be full of ups and downs. In such a scenario, ABC Capital would like to be satisfied on three more key questions about the entrepreneur.

(A) Does this team have skills or ability to figure things out? Generally it’s very difficult to hire great talent into a startup early on. Founders have to possess the skills and capability to operate startup until it becomes a real business. They have to be able to attract talent around them. If founders fail to execute then there are very few people in the world who can rescue the startup.

(B)  Is this team going to survive through the bad times? You don’t want to be left with a company where founders leave when the going gets tough. If a founder loses motivation and moves on, the whole company will become a liability for the investor. Over time, investors will end up owning a majority of the company and hence will have more to lose.

(C)  Is the entrepreneur intellectually honest? This is an obvious attribute to look for whenever you are giving your money to someone. After funding, the cheque signing authority moves to entrepreneur who can use money in many different ways. ABC Capital won’t be happy if the entrepreneur keeps showing hockey-stick growth but actually simply keeps buying business.

This framework provides entrepreneurs a few points to think about too. “Is the market really large?”, or “Do I have what it takes to execute?” Because if the genuine answers to these questions are negative, then there is very little chance that entrepreneur will make it big. It is probably quite easy to fool someone in ABC Capital on these questions but over time, reality does catch up, and at that time entrepreneur is the first one to lose (he or she also has the most to lose). Little wonder then, that VCs always look for great teams to partner with.

Disclaimer:

  1. Read my personal views on various things related to the world of startups at alokg.com.
  2. The math described above for a typical venture capital firm is overly simplified. There are many technicalities which make the real math more complex such as follow-on rounds causing dilution for investors, what happens if an investor doesn’t participate in follow-on rounds, more investors coming aboard in successive rounds etc. This math was only intended to demonstrate the point in a directional way and it is sufficient for that purpose.
  3. I’ve written this as an individual and the article has no connection to any of organizations that I am engaged with or have been in the past.
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My learning while building FreeCharge

People have asked me to share pointers that proved critical in the stupendous growth of FreeCharge. In this writeup, I try to detail the things that I feel played a critical role.

They are not intended to be prescriptive but more of an indication of what worked for us, and the tenets that were key to our company’s culture.

Transparency is a magic pill

We had an internal mailing list and added all managers to it. We ensured that every single MIS report was sent to this group. In fact, we were sending over two dozen reports which would show different unique slices of the business. And quite often these reports had more data than any one individual could digest, but we still shared everything transparently across this group.

With everyone having access to daily transaction numbers, funnel, payment, recharge performance numbers etc, the team had fun contests to predict end-of-day transaction numbers and would celebrate when numbers would be met or kick themselves when they didn’t! One day we were tracking the 1,00,000-transaction mark in the day and suddenly our recharge integration with operators went bust. Everyone was upset about not meeting the mark and the team started analysing what caused the issue and went about fixing it. It came back brilliantly in just two days and crossed 1,00,000 transactions without any hiccups.

So this ensured the teams started owning all problems. Several chat rooms sprung up on Google hangout to keep track of problems on real-time basis and irrespective of the time of day, people kept a watch for issues.

We had practice of sharing our board decks with the team pretty openly. We never sandbagged between our internal targets and promise to shareholders. Everyone had one view of the system and was working towards achieving that one goal.

Build for future

Every few years a new paradigm emerges and creates new winners in an otherwise existing market. People who get stuck with past baggage and don’t move to a new paradigm generally become redundant. Whatever we build today will be used in future. Hence having a perspective on how the future will look like is very important. Companies that used to build calculators responded to the threat of computers by building faster calculators. People who built bicycles countered the attack of cars by building better bicycles. You need to decide if you want to build a better bicycle or car.

Mobile is one such shift that happened in the country over the last two years. Many companies which didn’t focus on mobile are today irrelevant. In Dec 2013, we had only about 5 per cent of our transactions through mobile platform. Our android app was a simple shell app, which wrapped around the mobile site. It was clear to us that we needed a solid mobile product offering. We quickly set up a mobile team and the team put together a brilliant design in just few weeks.

Late December, we launched our first Android product. It appeared that customers were just waiting for a good FreeCharge mobile offering to arrive. We instantly saw a ‘hockey-stick growth’ with inflection point strongly visible on the day of the app launch. Our app ratings started improving and touched 4.3 in no time. Soon, mobile started contributing 30 per cent of our transactions. It became clear that more new customers were coming on mobile than desktop and their cohort/engagement was twice as good.

In retrospect, I strongly believe that if we had not focused on mobile, we would have become irrelevant by now.

Another example of building for future is the latest update of FreeCharge Android design. I attended last year’s Google IO and was blown away by Google’s vision on material design. While Dave Burke was talking about material design, I wrote to Harish (our design head) to think about building material design app for FreeCharge. Within five minutes he replied in the positive and within a couple of months we launched material design on Android before most of the others even started thinking about it.

Build team on trust & culture and not on money

This is becoming even starker with the kind of massive funding being raised these days, which is resulting in significant wage inflation in our industry. However, we always believed in building a team around people, culture and vision and never solely on the basis of money. We spent significant time in several instances to convince folks to join us for culture. Someone joining you instead of taking a 50 per cent hike from someone else is a very strong signal that the person is bought on the direction and is committed. People who move needle always work for passion, independence and learning as primary attraction and not money.

The basic problem of building a team primarily on the basis of money is that of adverse selection. Over time, people who will be left with you will be those who have lot of need/greed for money. Such people are also generally low on risk appetite. They will take any grief from you as long as you compensate them for it. Good people want to work with good people. They want to get challenged in their thinking. They want freedom to do stuff.

Hiring right is necessary

At FreeCharge, we continued to build one of the best teams in the Indian startup ecosystem. For all critical positions, we adopted a practice of asking, “Where would our ideal candidate be working at right now?”. Based on this question, we would narrow down on few potential folks who will be rock stars.

Hiring also has a network effect problem. Once you have a great team, that team will attract more great people. But how do you seed a great team? Focus on getting couple of great guys around you. And those couple should have potential to act as magnet to attract more talent. And the new people will be able to further bring good talent. Pretty soon, word will be out that you have a great team to work for.

A very important challenge in hiring is to get people who are culturally aligned. We also adopted an interested approach for this. For any senior management hiring, the candidate would talk to each of the persons that he/she would work with in any capacity. We used to give enough opportunity to potential candidates to understand our mode of operation and culture. I believe everyone wants to succeed in life and if exposed well into the culture, the candidate itself will make a good choice around culture alignment.

Growth of company is a balancing act

Paul Graham describes a startup as “a company that is designed to grow fast”. In order to continue growing fast, a company would need to invest time in things that create growth today as well in efforts that will enable growth in future. In my view, product innovations give long-term sustainable growth and marketing (excluding brand creation) innovations get short-term tactical growth. For any startup to succeed, it should do both in right balance and at right times. It’s ok to do discounting to generate short-term growth, as long as you are focused on improving product experience in parallel. A startup that just focuses on discounting for growth without a balancing effort towards product will soon find itself riding a tiger that’s impossible to get off from.

One approach to solve this is to form two separate teams in the company with two different mandates – short term and long term. This way you are not compromising one over the other.

But don’t focus on marketing before you get your basic product right because nothing puts off a consumer more than a bold marketing promise with a flop product. At the same time, delaying marketing too much to keep nailing the product will mean a missed opportunity to grow faster.

Flat organisation structure worked for us

At FreeCharge, we had something rather unusual, which may not work in all settings: we had a flat organisation structure. Someone in the team once called it “as flat as a pancake”. Not having too many hierarchies helped alignments happen without any time wasted, and decisions were made instantaneously. There were several downsides of this approach as well. This structure demanded me to spend a lot of time on the floor. Any periods of extended travel would create confusions or friction in our decision-making.

As is natural for a fast growing organisation, we had a fair share of friction and debates internally on several things. But as I look back, the above tenets certainly played a key role in enabling us to grow fast in sustainable manner.

And as a team, we are really proud that we could execute the largest M&A in the country and made FreeCharge a household name with millions of users who were not ‘recharging’ but ‘FreeCharging’.

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