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A Roadmap for an Entrepreneur, Stage 3: Staying Afloat and Chasing Success

In the third stage of creating a company, you need to raise serious money for your plan. This article explores the trials and tribulations of gaining funding for an entrepreneurial venture.
This article by Dr. Sridhar Jagannathan and Ravi Venkatesam originally appeared in Business Line (http://www.thehindubusinessline.com/).
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Raising Serious Money

At this stage, you have reached certain critical milestones in your venture. It could be the end of a product development cycle, a critical number of customers, the need for expansion of sales channels, and so on. You now need to raise serious money for your plan. This struggle for money most exemplifies the trials and tribulations of an entrepreneurial venture. In contrast to the glamorous portrayals in the public media of 25 year-olds walking away with suitcases of cash from VCs, the more common scenario is endless number of telephone calls, being told to compress a one-hour presentation into 15 minutes because the VC partner is running late for a golf game, and then waiting, usually in vain, for a term sheet notifying you of a VC's interest in funding. The Industry Standard (June 12, 2000) notes that while 1 in 5 ideas become business plans, only 1 in 174 received VC funding.

Raising venture capital money involves many ingredients:

  • An understanding of the target set of VC firms in your business space. Most VC companies are specialized and governed by guidelines of their funds.

  • A strong recommendation of your company to a VC partner by a credible source (successful prior entrepreneur, noted academic, respected industry leader, and so on).

  • A credible business plan and crisp presentation.

  • Round of financing, amount sought, and company valuation.

  • Sufficient merit in the three legs of management, market, and capability.

  • Demonstrable value (as in prototypes, simulations, and key agreements).

  • Pure dumb luck.

Not all money is "equal," because you need to consider the "quality" of the money. Considerations of quality may be related to the leverage of the VC company in the industry, size of their investment pool, the potential for follow-on investments, and the ability to secure beneficial partnerships. Raising money is a full-time preoccupation and needs to be conducted like a battle, with highly specific objectives, management readiness, recovering and learning from defeats, and rapid adaptability for new targets.

Once there is interest in funding your company, you would naturally want a "fair" valuation for your company. Here the objective is to get the amount you want for the minimal equity of company that you are giving away, namely at the highest possible valuation. If you have multiple suitors, you may be in a position to bargain. The valuation of a company in its early stages is a black art. One time-tested way to value your company would be by using the discounted cash flow method.

Your company will go through four phases: the initial investment phase, the operations breakeven phase, the rapid earnings growth phase, and the stable earnings phase.

  • Project net earnings in your stable growth period, say, EN for N years from now.

  • Obtain a reasonable PE (price equity ratio) for your industry segment. You could look up this data for companies in your industry that are already publicly traded on various stock exchanges.

  • Use a reasonable IRR (internal rate of return) value:

  • 50 to 70 percent for early stage

  • 30 to 50 percent for companies with a second round of funding

  • 15 to 30 percent for pre-IPO companies

  • Now calculate your valuation as follows:

  • ValuationNow = (EN x PE Ratio) / (1 + i )N

The most contentious piece here is the EN value, which is a function of revenues and the net margin several years into the future. VCs, once interested, may also want a particular slice of the pie—say, 30 percent. In general, especially in early funding rounds, raise sufficient money to keep the company afloat between funding rounds, which may be 12 to 18 months apart, including a six-month fund-raising cycle. While parting with equity may feel painful, the bottom line is that cash in the bank is usually better than stock certificates....

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