Can Indian Startups Raise Funds Without Giving away Equity?
Updated: Sep 11, 2019
Having worked closely with Indian startups before, I can personally vouch for the fact that our country has no dearth of innovative minds buoyed by robust entrepreneurial spirit.
Yet, why is that the fire in so many of these passionate entrepreneurs' bellies prove to be insufficient to fuel a fast paced growth within the startup ecosystem?
The answer seems to lie in funding, or the lack thereof.
Nurturing a brand new startup is no walk in the park for any entrepreneur, and the quest for funding only seems to lodge more obstacles in the paths of these ambitious and driven innovators, preventing then from fulfilling their ambition of establishing a profitable, steadily growing business with rock solid foundations.
Angel Investors are hard to come by, and Venture Capitalist funding often proves to be infeasible for absolutely nascent startups. When it comes to strategically investing their money, venture capitalists frequently steer clear of startups that have barely even started crawling.
Many online listicles will tell you about some 25-50 companies that managed to raise VC funding without even having a tangible product to pitch.
But let's face it, not all of our ideas are as earth shatteringly brilliant or even particularly pioneering, which means that venture capitalists will have to worry about their competitive potential before taking them on.
While this does not necessarily portend an eventual failure of the idea, it does mean that the investors tighten up their purse strings because they do not want to engage in a space that already has established players, regardless of how much better the pitched product may potentially be. To rake in substantial funding, a startup then must show 'em the money, which is hardly viable for a business that is just starting out.
Meanwhile, debt availability for brand new startups also tends to be scanty at best, because even banks and other credit institutions are unwilling to part with their money for something that has little to offer in the way of past trends for making reliable future projections.
Moreover, in the current financial climate of India, where credit seems to have dried out with banks exercising a high degree of conservatism and non bank financial institutions staggering under a severe liquidity crunch, early startups have hardly any hope of securing some debt capital to finance their operations.
In any case, even if a startup were to find a suitable lender, it would be widely infeasible for the business to take on debt so early on in its growth cycle, as instalment payments would potentially bleed them dry even if the wheels of profitability did start turning in their favour.
For venture capital funding as well, the concern is similar.
Even if a VC firm were to look past the potential size/speed mismatch, and decide to invest in a startup, it would, more often than not, entail a severe equity dilution for entrepreneurs and founders themselves.
To invest in an early stage startup, most VC players would prefer to keep some skin in the game, and negotiate aggressively for the same. This would often mean giving away way too much equity to VC investors even before the business is up and running, leaving the founders with little wiggle room to raise more money in the future, as that would only worsen their own equity dilution.
In the light of all these practical constraints, a better mode of funding for these nascent startups might be to take recourse to the revenue based funding model, that frequently assures investors of fairly steady returns without the founder having to give away equity at such an early stage of his or her business.
How Does Revenue Based Financing Work?
This model of funding essentially entails an agreement between the startup and the company that the former will pay the latter a predetermined percentage of its total revenue or sales over a given period, till the investor makes back an agreed multiple of the supplied funding amount.
This model ensures monthly payments to the investor, who gets to tangibly see what kind of money he is making off the investment, and the founder manages to retain the lion's share of the equity.
The investor enjoys a great deal of payoff in the strong revenue months, only to be balanced out by the months when the company earns low to moderate amounts of revenue.
While this model of funding has always existed, it has gained predominance in the global stage lately, especially in the case of funding tech-focused startups.
If you have watched at least a few episodes of Shark Tank, you would know that this is a favourite model of funding used by "Mr. Wonderful" Kevin O'Leary, a shrewd venture capitalist who understands how this model of financing benefits both him and his entrepreneurs.
Even if you look at the latest trends from the latest YC Demo Day, you would know that this model is fast taking over the tech space, as far as fundraising is concerned.
While this may sound like a dream model of funding for most new startups struggling to amass funds to grow their businesses, it does come with a few disadvantages as well.
For starters, it does cut down on the operating cash available for the business in a month, as a section of it goes to pay the investors.
For that reason, a number of founders often resist the model altogether.
Moreover, this model only seems to work when the business in question is growing steadily and generating enough revenue to sustain the regular payouts, meaning that even if a pre-revenue company were to secure some revenue based financing, it would have to start raking in the moolah at a lightning speed, to satisfy the investors.
Besides, even when the revenue is flowing in regularly, investors feel uncertain about how effectively they can compute and enforce royalty payments, especially considering the governance framework for royalty returns tend to be sketchy at best
Even though this model is yet to be implemented in India with noticeable frequency, offshoots of this idea seem to be doing extremely well in other countries.
The United States, for example, has Clearbanc, a firm that helps startups raise growth capital solely based upon its performance indicators (revenue, ads, third party data). It does not dilute the founders' equity share and neither does it treat it as a loan.
A percentage of the revenue along with a flat fee takes care of the repayment in a convenient manner.
Clearly, with new startups mushrooming all around India, our potential unicorns could heavily benefit from a similar model without having to shoulder the burden of debt or give away massive chunks of equity at such an early stage.
Of course, startups may choose to finance through methods such as invoice factoring, which keeps the cash flow intact even when its transaction with a customer has not been fulfilled; or by simply depending on grants and industry-specific credit options.
However, these again entail more complicated measures than simple revenue based financing would ordinarily require.
Naturally, as I see it, the time is ripe for the Indian investment arena to embrace this model, to make it a win-win situation for both the parties involved in a funding transaction.