The many questions entrepreneurs have

A few weeks ago, I had the opportunity to conduct a fund-raising workshop for start-ups in partnership with this newspaper. As I stepped into the lecture hall that was filled to capacity on that balmy Saturday afternoon, two things caught my attention. First, the positive vibe that prevailed in the room. There was an unmistakable confidence on the faces of participants that their venture would succeed. Second, is the wide dispersion in the age of the participants. From the early twenties, to surprisingly, participants even in the seventies. This indicated that start-ups have become a strong area of interest across the societal spectrum. The optimism reflected the increasing appetite to take risk.

As the session began, three prominent questions emerged where the participants needed clarity. Upon reflection, across similar programmes that I had conducted previously, the participants had raised similar questions. In this article, I provide my responses to these questions so as to benefit a large cross section of entrepreneurs.

What is a start-up?

First, is the question of what is a start-up? Are they different from traditional MSMEs? Though the setting up of businesses is nothing new, the tag of being called a start-up is. Many entrepreneurs are confounded by this. Differences between start-ups and MSMEs exist – both in terms of practice and philosophy. From a practical perspective, start-ups have a higher degree of innovation quotient as compared to that of MSMEs. Innovation could be across any of the dimensions – product, business models, or technology, but the bottom line is the tag of a start-up sits well on businesses that are innovative.

The nature of assets also differ between start-ups and MSMEs. While the former would be characterised by a higher proportion of intangible assets, the assets of MSMEs are more likely to be tangible in nature. At a philosophical level, start-ups are driven by a passion to increase the size of the pie rather than just the share the pie.

A question that several have is whether only technology companies can be called start-ups. The answer is an emphatic NO. Start-ups may use technology definitely (as a matter of fact, it would be difficult to name a business today that DOES NOT use technology), it does not mean that it has to be in the technology sector. The start-up tag is sector agnostic. An otherwise common question is, should we register as a start-up? The answer is, why not? The cost for registering as a start-up with many government agencies is virtually nil, while registration makes the venture eligible for a host of benefits. The biggest of which is the credibility. And, for a newly formed start-up, this can be one hell of a benefit!

When to get funding?

To start with, it is important to know that it is possible to create businesses without any external funding. Several examples exist of such bootstrapped businesses. However, founders seeking fast growth need capital to finance the growth. The bourgeoisie background of the founders of modern day start-ups mean that they have to get that capital from other investors. The process of fund raising can be frustrating for a first-time entrepreneur. Less than 8 per cent of businesses are successful in getting the first round of funding. Like in most instances, timing is important in venture fund raising.

Broadly, an early-stage venture can be classified in one of the following phases: Ideation, Proof of Concept, Beta Launch, Early Revenues, Repeat Revenues. In the Indian context, the probability of getting funded dramatically improves after the Beta launch phase. My advice to entrepreneurs in their first fund-raising phase is to have the Beta version ready before going for funding. What about the capital needs before that? That I would it leave to the entrepreneurial ingenuity to manage.

How to determine the valuation?

That’s a million dollar question that most entrepreneurs have. While science dominates art in traditional valuation, in venture valuation it could be the reverse. With so many uncertainties, the traditional discounted cash flow models may not be easily defensible because of the numerous assumptions behind the projections. Our research has indicated that during the first few years of a start-up, much of the valuation can be estimated by a handful of factors. Comparable company valuations play as important a role in determining valuation of start-ups, the same way precedence is for the legal profession, comparable is for valuation.

Large differences in valuation expectation between the investors and founders, sometimes referred as zameen-aasmaan ka farakh, often precipitates a stalemate in the deal. Using comparable start-ups that have been recently funded as benchmarks would ensure that a middle ground is quickly reached without major heartburn on either side. If there is still no agreement, then a common strategy is to push the issues under the carpet to deal with in the future. Use of convertible instruments helps to sidestep the contentious issue of valuation for the moment and treat it as a discount to the next round valuation in the future.

Myths & misconceptions

I vividly remember the English lesson in my high school reader three decades ago exhorting the simple moral: Misinterpretation leads to misery.

The start-up scenario in our country has myths and misconceptions in abundance, which are becoming a drag on the start-up ecosystem. Enabling clarity on issues such as the ones highlighted in this article would help in staying on course to achieve our goal of reaching $10 trillion by 2030.

The writer is a Professor at IIT Madras, an Associate at Harvard Kennedy School, Harvard University and co-founder of YNOS.in