Startups often resort to getting their funding from venture capitalists (VC) and angel investors, the idea being to accelerate growth and get expertise from the best in the field. The pandemic era, unsurprisingly, aided the startup boom in India. This year, a whopping $3.5 billion was raised across 130 deals, which is almost six times the figures from January 2021.
So investors are happy backing the startup ecosystem, and startups are happy raising capital from the big names. It’s almost too easy to paint a rosy picture of the relationship between VCs and founders. The truth, however, is that the decision to take VCs on board has its own set of risks and all that glitters (quite literally!) is not gold.
My outright intention with this article is not to deter anyone from raising funds but to highlight the other (less covered and understood) side of VC funding, something that may be helpful for entrepreneurs who are planning to choose the road that is now not-so-less taken.
And, I believe VC funding is here to stay, current slowdown/pullback will only help align expectations, valuations, towards their sustainable equilibrium.
Bootstrapping vs Fundraising: The Dilemma
Startup founders are almost always feel short on time; they have many things to juggle at once. Fundraising takes up a considerable chunk. Reaching out to investors is a tedious process. If you’re lucky to crack the VCs and get funding (which a very few do), it’ll need more time with pitching, due diligence, paperwork etc. It’s almost a full time job for one of the cofounders atleast.
Most startups have to wait for over a year before they can even convince a VC to back them. Imagine if all that time was invested in building and growing the business—it would probably do enough to excite investors on its own. It remains a hard call for founders to run after VC funds or devote time to operations. The former can either leave you without time and money or make you an overnight superstar. Unfortunately, you do not get to choose which one.
The other choice is to bootstrap and scale business slowly, primarily with client revenues. THIS model also works well, and has been the most sorted traditional proven business model. It helps prove product market fit much sooner. And firms like Zoho and Zerodha have been prime big scale success examples of bootstrapping.
Dilution of Vision and Expertise
VCs typically invest in a startup because they resonate with the vision of the founders. However, it is hard to ignore the more ‘transactional’ purpose behind their investment—to make money. The only way that they can get the returns they seek is when the startup grows exponentially, something that requires the founders to make tough decisions. As a result, VCs tend to exert pressure on the team and suggest expansion plans that may or may not align with the original vision. After all, if they have shown faith to pump millions of dollars into your business, founders are liable to take their point of view into consideration.
In other cases, the vision is diluted within the startup itself. To raise more rounds of investment, they themselves adopt different high-growth strategies that lead them into directions not originally planned. Founders tend to diversify their offerings and spread themselves thinly across channels because they feel that they can do almost anything with their VC money. When you are still building your footprint in the industry, you do a disservice to yourself by venturing into areas of no expertise. It is always better for startups to be the master of one than the jack of all trades.
While the initial growth spurt may seem very satisfactory, it is hard to sustain a startup when the money-making mindset replaces the passion-driven problem solving one.
Lack of Focus on Sustainability
Growth is great, but unsustainable growth isn’t.
Many startups that have raised millions of dollars are not profit-making entities. There is no dearth of competition in any segment nowadays and VC-backed startups tend to spend large sums of money on marketing, awareness campaigns, cashback offers and more. Even as far as hiring is concerned, paychecks are written without much thought. This puts the startup in a worrying position. Will they be able to chart out a plan to offset these costs with enough profits? Mostly the answer is negative.
The new startups on the block that wish to compete with the big players should be praised for their effort and vision. But this is an expensive endeavor, and sustainability remains an after-thought. Once they raise a round of funding, they always look at the next one and then the one after that. This over-reliance on VCs and the crazy valuation game pushes a startup to its limit where it’s looking to achieve its targets no matter what.
For example, Shyp was a startup focused on the on-demand shipping domain. Since its start in 2013, it raised more than $60 million. However, as said by its founder, Kevin Gibbon, its demise was due to his failure to focus on sustainability. Once a startup is trapped in a business model that burns heavy money, it is difficult to come out of it.
Conflicts with Investors
When venture capitalists help you with funding, they usually get a say in how you run your company.
This can pave the way for conflicts between founders and investors, especially in tougher times and markets. The issue is that startups that grow to this level are in the public eye 24×7 and cannot run away from its consequences. To add to that, when people choose to air their dirty laundry in public, it affects every stakeholder, right from the customer to the top management.
The most recent case is that of BharatPe in India. Ashneer Grover raised about $600 million in equity funding from top funds, including Sequoia Capital India, Coatue Management, Insight Partners, Dragoneer Investment Group, Steadfast Capital and Tiger Global, within four years of the start of his venture. However, after a series of events that created ripples in the startup ecosystem, he was asked to step down. This was followed by more talk about the growing toxic culture at BharatPe and the very public conflicts between the founding team and investor group.
VC Promises Are Not Set in stone
With VC funding comes the setting up of a formalized internal structure. While this does bring a degree of transparency, it does limit the flexibility with which you can work in your organization. Even if you have founded the business, your controlling power diminishes. Due to this, when issues arise, you might find that the investors don’t meet and deliver on the promises that they had initially made. Remember that VC investors are likely to promise the world and oversell themselves, but when it comes to action, the chances of crumbling under pressure always exist.
The bottom-line is that market forces are not in anyone’s control, and it is hard to predict what the future holds. Take the pandemic, for instance. No one could have predicted it and no one could have changed it. But it had a major impact on certain industries, some that saw huge sales and others that were forced to shut down. At this time, VCs can not do much, regardless of their connections and their promise. To add to it, if you were burning cash all this time, you would find it almost impossible to get through such a tough period. Therefore, startups must rely on their own abilities and efforts while preparing for unforeseen circumstances. No matter the relations you share with your investor group, they cannot always save you when you are drowning.
Here’s a prime example. About 6-7 years back, just when Ola and Uber emerged as strong competitors in the taxi space, another competitor company was called TaxiForSure (TFS). As the latter started raising funds, TFS also pitched to VCs to pump in money. However, market dynamics changed with news highlighting the rape of a woman by an Uber driver. Investors became reluctant to back TFS leading to its eventual death. It takes one piece of bad news, that too with regards to a competitor startup, for VCs to hit the brakes.
Makes the Market Uncompetitive
VCs can give you a lot of money, but you need to go all-out to skyrocket your business. This is when you are likely to resort to tactics such as heavy discounting, freebies, and undercutting market prices. Even if this means a loss for you, it will not bother you much, as the funds will keep coming in and sustaining you. Think about big names like Zomato, Swiggy, Zepto, and Cred—all are burning money faster than they can ever rake in through profits.
In the long run, though, such a model is unhealthy. The tactics mentioned above can be anti-competitive and come at the expense of the industry’s growth. It is not only your business that suffers due to an unsustainable business model, but you also wipe off healthy competition by driving other businesses into losses. If you are raising millions of dollars, you should be all the more careful about how you project your company. What you promise and deliver to your customers must be of a certain standard because there might come a time when the funding stops, and you are forced to backtrack from your current delivery quality. This will hamper how your customers perceive you, leading to a dwindling of brand loyalty. And then there will be more buzz. Will the market share drop? How drastically? Will customers trust the brand again? How will the startup recover? Will anyone invest in them again? Questions galore, as they should be.
Monopolistic practices, in general, are generally kept in check through specialized government bodies in different countries. VC funding and the funded startups, operate with applicable local regulations. Despite this, stricter regulation is needed to try and mitigate the ill effects of VC funding, like buying market share by offering unsustainable discounts etc.
Funding is Not a Sign of Success
Contrary to popular belief, getting capital from VCs does not mean that the business model is great and will become the next big thing. All it represents is that some people believe in the vision and think that it can go places. But there is never any guarantee. In fact, the likelihood of success is far less than the likelihood of failure in the case of all startups across the board.
VC money cannot camouflage a strong business model. There are numerous examples of startups such as Zerodha who achieved success purely because they identified a niche and built a product that solved real pain points. As a result, they never felt the need to go to investors to scale their business. Funding can definitely fast-track your efforts, but the litmus test lies in the hands of your customers. If you don’t deliver quality to them, you will fizzle out sooner or later.
Similarly, getting the approval of VCs cannot be a substitute for investing time into running a business. A popular analogy in our startup community is that you cannot put nine mothers together to create a baby in a month. And you cannot even put nine mothers together, and create 9 babies in 9 months. That’s because they will argue among them. Essentially, as founders, you need to focus on solving limited problems for wider markets in depth, and let it take its own time. Do not thinly spread yourself into doing too much too early and end up doing them all badly.
Although cliched, there is indeed no shortcut to success for a startup. VCs can guide and accelerate you but can never chart out an unfailing plan. Many / majority VC funded companies also do not go on to becoming profitable. Remember that capital is a means to an end, but not the end in itself.
Again, VCs bring value to eco-system and many of them add lot of values to startup, but some of its challenges are covered above.
Also, adding on a current context of funding at this point in time.
2022 – The VC Pullback is Happening
Now that we have spoken all about the ‘dark’ side of VC funding let me highlight another new phenomenon that you may hear much more of in the coming months. As I had suggested at the start of my article, huge sums of money went into startups, even during the pandemic. But guess what, after that sudden surge where every other startup was shooting for the stars is now coming back to Earth. The hot industries are now becoming cold. The re-investments that were at record levels are now dipping. Let me explain why.
During Covid, prices of almost every commodity rose due to excess liquidity in the system, led by the US, which themselves printed close to $10 Trillion. This empowered the commoner to invest in the stock markets, cryptos, real estate, etc. However, due to this excess liquidity, inflation started to rise. Now, to take corrective measures, liquidity is slowly being taken back through methods like quantitative easing and an increase in interest rates, which impacts the cost of capital.
Stock markets are forward-looking and tend to be the best proxy for where the world is headed. A few months back, platforms like Zoom dropped back to original market share levels after a major boom during Covid. Many other stocks are reflecting similar trends. Now, VCs generally work by having a group of General and Limited Partners who invest in the fund from where money is taken to back startups. Because of the liquidity crunch and delay in milestone-driven results on the part of startups, funding, especially at the Series A stage, is drying up fast.
So Startups will have to move towards a less / no burn model, and become unit economic positive fast. The valuations of startups will also go down (upto 3/4x) in short term for those who still need funds, lot of VC funded companies will consolidate, and the startups that can figure product market customer fit fast will survive. All this is progress and much needed re-alignment market correction.
It is, thus, clear that funding in the near future will be an even tougher journey for startups. My advice is simple—focus on building a solid foundation. Build Value, Valuations will follow. Have a product that solves pain points, incorporate feedback and most importantly, focus on bootstrapping for as long as you can. Go in with the mindset of running a profitable business that can fund itself and ride out the tough times. Finally, if you are lucky to raise capital, don’t lose sight of sustainability. The ebb and flow of today’s economy will only result in the survival of the fittest.