Funding has been the most pressing issue for SME and start-ups in India despite Government schemes, banking sector’s initiatives, and NBFC’s schemes. Challenges to pledge collaterals and fulfil innumerable number of requirements have always been hurdles of many SMEs in getting the loan.

While getting loan is difficult, SMEs miss onto other option which is equity funding, commonly known as VC (Venture Capital) funding. Lack of knowledge and structure of funding are the main reasons why they miss on to this opportunity. Let’s see how VC funding works in start-ups and SMEs. Department of Industrial Policy and Promotion (DIPP) also stressed on the need of VC financing to SMEs and start-ups. In fact, DIPP is exploring the idea of incentivising domestic and foreign VC firms.

The cornerstone of VC funding

Venture capital is financial capital provided to start-ups and SMEs. Traditionally VC funding has been very active in funding software, biotech, and e-commerce businesses. Recently, however, venture capital is also looking forward to other sectors such as power, real estate, finance, and manufacturing.

VC firms take high risk in funding new ventures. As per one estimate, only 20% start-ups provide returns while 80% barely survive. In such a high stake scenario, it is but imperative for VCs to be very strict about the projects they select for funding. This, sometimes, is taken as arrogance of venture capitalists and is a source of much conflict between VCs and start-ups/SMEs. VC funding works on the law of averages. The expectation is that the successful businesses, even though small in nature, will not only compensate for the losses in unsuccessful businesses but also provide returns.

To make this process smoother, SMEs and start-ups have to understand the expectations of VCs before they approach them for funds. VCs look for two things, namely the stake in the company, and the exit option. Let’s explore these requirements in details.

Stakes in the company

Since this is equity funding and there is no interest paid on funds, VCs look for stakes in the company. Many SMEs and start-ups are not sure about the percentage of stakes they need to give to VC. There are two important concepts that SMEs and Start-ups need to understand.

Pre-Money valuation – Pre money valuation is the existing value of the company before VC funding. Calculating this value requires that assumptions are realistic and achievable. It is extremely important for SMEs and start-ups to work on the numbers & assumptions in details than giving high level statements such as “the market is worth $20b and even if we capture 1% of it, we are talking about $20m revenue”. This simply doesn’t cut ice with VCs.

Post-Money valuation – Post money valuation is the value of the company after VC funding. Once this valuation is done, stakes are given to VCs accordingly.

Let’s take a look at an example –

Assume that a company Startup India has been able to achieve a profit of Rs 20 lakhs per annum. The pre-money valuation can be done by using multiples or discounted cash flow analysis. Suppose the company uses multiples and comes up with EV/earnings multiple of 10. The value of the company will be 10 times the earnings. This values the company at 2 crore. This is pre money valuation.

Startup India is now looking for VC funding of Rs 50 lakhs for expanding into new area. Once the company gets 50 lakhs, the valuation goes to 2.5 crore. This is post money valuation.

Out of 2.5 crore, VC owns 50 lakhs or 20% of the company. Hence it will be expected from Startup India to give 20% stake to the VC.

Exit option

VCs look for exit option within a specified time. SMEs and Start-ups should work on a clear exit plan for the investors. The exit option can be by going IPO, offering for sale to other strategic investors, or going for mergers & acquisition route. While the exit option is executed in future, it will help SMEs and Start-ups to consider pros and cons of each exit option and its impact on the business and their plan for the company.

Most of the VCs look for exit option in a timeframe of 5 to 7 years.

Important point to consider before going for VC funding

First, be clear about the amount of funds needed. Bootstrap your financial needs. VC funding is not free money. You have to give stake. In the beginning, you may not estimate the value of your stake but when your business grows, the same stake will look much bigger than you anticipated.

Second, understand that VC funding come in two forms, namely dumb and smart money. Smart money is money with guidance and possibly network while the dumb money is just the fund. Both types of funding have their pros and cons. Smart money may give good leads and networks but it may also look like interference while dumb money may give freedom to pursue your own idea but it may also not understand the complexity of business.

Finally, understand that every VC has its own way to judge the suitability for your business with their funding guidelines. Many VCs may fund a start-up at idea stage while some may fund only those companies where revenues have started flowing. Look for the nature of the businesses that the specific VC funds. For example, some VCs may mention clearly what they will fund. An example could be “We invest only in businesses which are service oriented and that have started generating profit”.

Hence you should not be disappointed by few VCs rejecting your proposal for funding.