Startups can opt to skip the conventional funding cycle, but should they?

The unwritten textbook version goes like this. Bootstrap and create some building block for your business; sell the idea to a college alumni or a moneybag you met at a startup/angel event who is willing or having a passion to diversify his/her investment portfolio; hit a few milestones and go all out to court the venture capitalists (more than once) and hopefully one day ring the opening bell of a large stock exchange or get acquired by a big fish.

But that's easier blogged than done. In the real world, entrepreneurs tend to or are forced to hop skip and jump some of these steps. A few don't get a chance to jump either.

Well, there is the emerging crowd-funding model but there are some regulatory challenges attached to it. Modern capital market world has created another window or rather an intermediate step in the form of SME exchange(s). There are two in particular within India, launched a few months ago as junior markets attached to the national bourses BSE and NSE.

Already around 14 firms have got listed on these exchanges (more than the new companies listed on the main markets last year) and surprisingly not doing too bad either. Although trading in these stocks has been thin, as expected, three out of four companies have seen a positive movement in scrip compared to issue price.

To be fair, these do not comprise full-fledged alternative for an entrepreneur to get seed funding or bringing on board an angel investor or for that matter to scoop a huge sum as some Indian e-com firms have managed based on early traction and execution.

What they do offer, however, is an option to skip those follow-on rounds of VC funding as also to provide an exit route to early investors. This could come in as a saviour for startups as also angel investors amid growing talk of a Series A crunch (read more about it here).

Most of the early birds who have gone public in the SME exchanges are not 'startups' in the conventional sense. They are SMEs in sectors that may not attract a VC investor or the firms may not clear the VC investment filter in the first place.

However, there is a beginning with a Kochi-based startup already appointing a merchant banker to get listed on NSE's SME platform. Its eventual debut and the market response could be a critical indicator of investor's appetite to back such relatively mature startups.

'Mature' startups as there are some riders to qualify for listing in the exchanges. So they need to have a history of at least three years and two of them having positive cash flows (bye bye e-com startups).

Ceteris paribus, entrepreneurs need to juggle with the choice of taking this route and implications for future. Again, in an ideal world such firms would hope to graduate to the main market sooner than later and thereby a full-fledged public listed company.

Here, I digress to draw some quick parallels with how student admissions work at Delhi University, arguably the largest and one of the most prominent in India.

There is a set of handful of 'North Campus' colleges of which the university's very own Ivy League is almost a sub-set (there are some top colleges outside the main campus). Getting admission to a north campus college is considered a big plus almost akin to being a company listed on the main BSE/NSE exchange (though very few make it to the top indices ~ Ivy League).

Those who are admitted to the lesser known colleges, however, have an option to migrate to a more prominent college (even within the north campus) based on performance in the annual exams and available seats. Many do every year and they do go on to make a big career for themselves.

Two lessons: listing on a junior exchange may not mean getting banished for life. However, making it to the smaller listing platform means missing out on high quality investor base (indulging in some generalisations, teachers and academic activity is more sullen in most colleges outside north-campus).

But what is more critical issue for entrepreneurs is whether they want to skip the mentorship which comes, more often than not, with having a VC investor on board.

This is not just in terms of advice from possibly successful-entrepreneur-turned-investors who have the domain knowledge in the particular line of business, but also from network of other portfolio firms and co-investors who can bring in follow-on rounds of funding.

Furthermore, as a listed firm, a different set of investors could be making more myopic decisions on backing you in the future every six months (not every quarter) as against a more timeline and milestone driven approach of a venture capitalist who's typically 'in' once signing on the dotted line for at least 2-3 years. This may appear trivial but could be important from the point of leveraging the listing status and using it to get access to bank loans.

If an entrepreneur is largely interested in the money, making life relatively easier for next working capital loan and are confident enough about goals to scale up to qualify and migrate to the main market, going public is a real option as against knocking on the doors of VCs.

If you are an angel or seed investor backed startup (and need to give an exit option to the early investors) but finding it frustrating to sell your story to a larger VC, then again SME exchanges are an option for the next round of capitalisation.

However, some caveats are in order and here's one. If you are a very small company then making a mark (read: returns for shareholders which need not necessarily be consistent with financial performance) assuming you have managed to graduate on the main exchanges is a toughie. There are thousands of listed firms in India and for most large institutional investors and also retail shareholders the universe of investment grade firms practically does not exit beyond those outside top 500 market cap firms.

Ultimately, the decision to go public this way or not would rest with the entrepreneur and how much time he/she can devote to compliance with regulatory requirements as against his/her product. Whether or not this window of funding option develops for start-ups, it does come in as an alternative and could serve a different segment of market. The new regulations covering Alternative Investment Funds do allow some interesting possibilities- 'VC' firms or category I AIFs participating in PIPE deals related to SME exchange listed firms.

(Vivek Sinha is Executive Editor of VCCircle)

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