StartupTalky

Tag: Investing In startups

  • Why Do Investors Invest in Loss-Making Startups?

    The number of startups grew by 8971% from FY 2016-17 to 2021-22 with 65,861 startups in 2022, mentioned Commerce and Industry Minister Piyush Goyal. But are all these profitable? Nearly 95% of these startups are loss-making and significantly burning a lot of cash. Yet, there is something surprising about them. Many of these loss-making startups were able to raise funds and become an IPO.

    Earlier SEBI didn’t allow loss-making companies to go public and raise funds to save investors. It traces back to companies that were making losses, raised funds, and ran away leaving investors dismal. However, this drove these companies to go public in other countries.

    The government did not want these startups with future potential to move out of the nation. So, they enabled unprofitable companies to raise funds limiting them to only 10% of share capital. However, why would investors invest in loss-making startups? They are neither generating any tangible or intangible assets nor do they have guaranteed future profits. What do investors bet on?

    In July 2021, Zomato became an IPO whilst it had losses of ₹63.2 crores. There are many other companies like Paytm and Flipkart that were able to raise money even though they had losses in crores.

    In fact, the well-known eCommerce platform Amazon was in losses for the longest time and sustained solely on investments and raised capital. It was only until the last two decades that it became profitable and is now one of the top 10 biggest companies in the world. The bigger concern is why so many startups fail before or after raising the investments? Let us look into that first.

    Why So Many Startups Fail and Incur Losses?
    How Do Investors Valuate Loss-Making Startups?
    What Attracts Investors to Invest in Loss-Making Startups?

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    Why So Many Startups Fail and Incur Losses?

    A startup tends to burn initially for any reason; but what keeps it flunking year after year? It could be any of the following reasons:

    Talent Acquisition Cost

    A startup needs people to build the product and run the business. Generally, it is difficult to attract and retain them due to competitive salary standards in the industry. As a result, businesses often burn their pockets while acquiring employees.

    Marketing Cost

    Startups invest a lot in marketing to build a customer base. Again this leads to negative cash flow and thus leads to losses. Zomato itself spends nearly 9 crores on advertising.

    Acquiring Technical Competent Tools

    Startups invest a lot to automate and streamline processes with tech stacks. Again it adds up to the recurring costs for the business. Oftentimes, businesses do not assess the usability of these products and end up wasting more money as well.

    Not Targeting Customer Needs

    Many startups are coming every day with the hope to make millions of dollars and exiting. Unfortunately, they do not cater to any specific need and end up creating a product with null demand. As a result, they have a hard time getting users.

    An issue in Business Model

    Many young entrepreneurs jump in to start a startup without assessing the environment and building the right business model. It leads to many issues and friction amongst the teams.

    There could be many other reasons for a startup to be in losses for a longer duration. Initially, every startup makes losses, which is normal, especially for SaaS or tech startups. But if they continue to incur losses repetitively then they need to look for the reason. But the question arises that when these startups are already in losses; how do investors evaluate the worthiness or their valuation?

    How Do Investors Valuate Loss-Making Startups?

    Investors need to assess the company’s valuation before investing. Generally, a company is evaluated based on profits generated. However, when the company is not making profits investors generally look for other key metrics while investing.

    Customer Base

    The first metric is “customer base”. Investors look into the current customer base and estimate the growth thereon. The user must be dependent on the product to generate consistent profits or monetize them. If the user is not mentally invested, it is hard for a business to become profitable.

    So, investors generally invest in the growth potential of the startup and not the profits per se. They look into customer retention rates and other criterions such as CAC and LTV of the business. This gives them clarity regarding business growth potential in the true sense.

    Marketing spend return

    The next important indicator is marketing spend return. Is the company able to generate back the marketing cost? Generally, business investors study the startup market, environment, future growth prospects, and other indicators to understand the true valuation of the company.

    Business management and Moat

    Lastly, investors look into business management and moat. Is business management efficient, suitable, and sustainable? Does the business have a moat to leverage? There are 100s of startups targeting similar problems with identical products.

    Investors generally put their money on the ones that distinguish themselves. But what exactly drives investors to invest in unprofitable startups? Why do they spend millions on a startup that is in losses for years? Why do investors at times end up buying loss-making units? There could be several reasons. Let us dive right into them.

    What Attracts Investors to Invest in Loss-Making Startups?

    Startups today raise funding even with losses by selling their organization’s goal. They aim to scale the business instead of restricting themselves to minimal profits. Investors bet on the company’s vision and future growth possibilities when they are at their loss-making stage.

    Amazon is one of the biggest trendsetters to bring this revolution. Also, the fact that 70% of investors today are below the age of 30 justifies the risk appetite. Now quickly look into the scenarios and reasons why these investors invest in loss-generating businesses.

    Future Growth Promise

    Many investors don’t find other options such as mutual funds and savings accounts lucrative and move to other options with higher return opportunities. Generally, these startups offer the potential for the future even though they are in losses. Hence, they attract young or big investors to invest with the promise of future growth.

    Recovering Money

    Many big investors invest in loss-making startups because they can recover their money even if any one of the loss-making startups blows up. It is more like gambling intended to back the net investment gains.

    Vision and Mission

    Other sets of investors wish to invest in the business’s vision and mission instead of looking for profitability. In fact, many investors are driven to invest in tech startups to promote ‘Digital India’. Also, many startups, especially tech startups, are hopeful for success based on innovation. So, If they resonate with the business idea and see opportunities, they do not shy away from putting their money into the startup.

    Brand Value

    Often investors look for brands that are making losses but still raising money. They bet their money on the brand value instead of other metrics. One of the biggest examples of the same could be Paytm, Zomato. These loss-making companies raised funds only due to brand image.

    Exiting with Profit

    In some cases, instead of investing, investors directly purchase a startup even with the losses. Why? They speculate on opportunities such as mergers and acquisitions with a big player to exit with immense profits. Alternatively, oftentimes they purchase these units to create a profitable alliance.

    India’s best fintech entrepreneurs & a stock market expert, Mr. Vivek Bajaj once quoted that

    “Valuation is not a reflection of the earning, it is the reflection of future potential earning”.

    Investors run by this rule and focus on growth and scalability instead of immediate profits.

    FAQs

    Why do VCs invest in loss-making startups?

    VCs invest in loss-making startups in the hope of a profitable future, even though the startup is in loss but it might turn profitable in future.

    Should you invest in loss-making companies?

    Investing in loss-making companies is like gambling either you’ll lose all your money or will exit with huge profits.

  • What Do Investors Look For Before Investing in Startups?

    The article is contributed by Mrs. Deepti Sharma, Managing Director, Thinker Place.

    Investors are always on the lookout for ideas that are unique and can be of use in whatever sector they are being pitched in. Every idea, irrespective of what the idea contains, can be a great idea depending on the pitching method and the solutions/interactiveness that the idea has with its target audience. Ultimately, it all boils down to the product that you have and the potential – whether prominent or hidden, it contains.

    From personal experience, investors always want a thorough breakdown of potential products they are going to invest in. The standard breakdown questions by investors include the following:

    1. What is your idea/product? – A question to check what made you come up with the product and to know the root of development and the thinking process behind developing something.
    2. How does it help? – Products are made for consumers. Investors look for your target audience and the functionality of your product through this question. Products/ideas that provide immediate solutions or benefits to the target audience are ranked higher for investors.
    3. What does it do? – A trick question by investors to know the end-to-end process of a product. This is a critical question where investors check the development state of a product and make decisions on the amount to be invested.
    4. Materials used in the product – Investors today are always on the lookout for sustainability. The materials used in a product give investors a judgment on the cost of making a raw product and can help them determine the selling price. As an entrepreneur, this is also a key moment to display hidden trinkets and other special features that your product may hold.
    5. The “Units Sold” question – After the idea and the products have been pitched, investors ask about the market trend and public reaction to the product. This is a statistical question that is answered purely in numbers, raw data, and through a variety of content.
    6. Additional cost questions – The “make or break” question while pitching. Cost questions by investors look at individual raw material costs, production costs, the team’s cost, and most importantly – sales and marketing costs.

    PRODUCT IS KEY. There is no other way around it. Taking an idea and perfecting it to near-perfection is what all entrepreneurs and business owners strive for. On an added note, investors fall head-over-heels for PR activities and recognition that a product or entrepreneur has received. In short, the more recognition or “brand awareness” that you or your product has, the better.

    As an entrepreneur, you are not only pitching for the idea and the product that you’ve worked so hard on, it is also a pitch for trust. Investors look at your convincing power, your confidence, your real-world knowledge, your market knowledge, and above all, how far you will go for your product.

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    Statistically, most investors have already decided whether or not to invest in your startup business based on the first 5-10 minute interaction you’ve had with them.

    A quick guide to getting into the good books of investors:

    • Do your research – Knowing who you are pitching to, their background, their job profile and work history, what and who they’ve invested in previously, and any other details can help you in your pitch.
    • Dress to impress – There is no excuse for not looking professional. Think of it as a very important job interview. Though the new-found trend is to dress as one sees fit when attending business and pitch meetings, dressing in formal attire is a classic move that can never fail. Professional attire emits seriousness and intent and makes a lasting impression on investors.
    • Be confident – Pitch meetings can be nerve-wracking. Being anxious and nervous is a natural feeling for most anybody. Displaying what you’re feeling inside can leave a bad impression on your investors. From the moment you meet your investors, your confidence should be on full display. The way that you walk and the firmness of your handshake or head nod can assist you in showing confidence and seriousness.
    • Being organised – Before you start your pitch presentation, or before sharing your business module with investors, make sure to have all your documentation, gadgets, flashcards, products, and other necessary documents and items organised. One way investors know that you are not-so-serious about having them as investors is by being flimsy with documents and slow with setting up your presentation. For investors, time is of the essence, being organised always goes a long way in assisting your pitch presentation.
    • Portray yourself as the subject matter expert – The pitch for investment is all for you and your product, so it is only natural that you know thoroughly all about the origins of the product, where your product stands in the market, and the complete inside work of your business. Investors look for the devotion and near-obsession that entrepreneurs have when it comes to their products. This point answers the very important “Why should we invest in you?” question quite clearly.
    • Quick and logical thinking – Most of the time, based on data and other statistics that are provided to them, investors hunt to find defects or loopholes in your pitch. As such, they come up with scenarios or situations for the entrepreneur to answer. An entrepreneur should have quick and logical thinking based on real-world statistics about their product and should be able to answer all questions smoothly. Roleplaying different situations, and foreseeing or predicting the future of your product and the company is a sure way to answer most questions belonging to this category.
    • Negotiation skills – Lastly, but most importantly, entrepreneurs need to have a clear picture about what’s the purpose behind the investor pitch meeting. The skill to bargain and negotiate or “not settle” for something that’s outside the expected quotation is vital for success.

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    Conclusion

    To conclude, getting an investment is like a game of chess. Playing the right move at the right time to pique the interest of your investors and to keep them always occupied with you and your product is the key to a perfect pitch. What really matters is convincing investors to trust you and your product and to see the vision that you have. With the right attitude and confidence, getting investors on board is easy.