Rethinking Capital: First Principles for Entrepreneurs (ContraMinds Timeless Wisdom)

Q1 Understanding Capital

So I think the first question that I wanted to really start off this conversation, Shyam, is, you know, in your opinion, if I were an entrepreneur and if I actually were doing a start-up, how should I understand the word capital that is the most important fuel for business or an enterprise?

[Shyam] (2:11 – 3:36)

Typically, entrepreneurs come with ideas. So entrepreneurs know that they want to do something, they are very clear that they want to do this. But for them to do what they want to do and to prove the idea, what we call as a proof of concept, they need capital first.

So capital is something that bridges an idea to a proof of concept. That’s the first bridge, okay. So capital for an entrepreneur at the starting point is money that will help him prove that his idea is good, it is scalable, and it can be taken to a next level. So beyond that, at the starting point, an entrepreneur need not unduly worry about capital. That’s the first point. Because if you are right, then there are going to be believers in your idea.

If you are wrong, you will probably move to the next idea. And we also have many entrepreneurs who have tried ideas which did not do well and then they went on to do more ideas which went on to become hugely successful. So capital is merely the bridge between an idea and the proof of concept stage.

Great.

Q2 Equity Capital – How Perspectives Have Changed

[Swami] (3:37 – 4:25)

So literally, you know, when you look at this whole startup ecosystem, that’s actually, you know, got a lot of hype nowadays. Normally it is said that, you know, equity capital is the most expensive and, you know, you don’t give away so much of equity capital at the start. But that does not seem to be the general philosophy nowadays, right?

So they just go out and say, okay, let me raise as much capital at, you know, whether it’s an early stage or whether you are at a seed stage. So how is the thinking on equity capital changed over maybe your generation to this, you know, Gen Z or millennial generation?

[Shyam] (4:27 – 6:38)

Firstly, in the earlier avatars, equity capital once diluted could not be reset. That is the first point. Today, entrepreneurs bring value to companies, which is something which will evolve. It’s not set at the dilution stage. It can always be changed subsequently as well. 

But the dilution of equity as a concept has always been a problem area, whether it was in a different era or in the present era, it is always difficult.

Earlier, we used to see people overdo the dilution. If I look at companies which started 9-10 years back, I see that the dilution is excessive. You will have a financial investor straight away owning some 30% today even after multiple dilutions, which is, in my view, not reasonable, especially if you are just given one time money, right?

But today, it’s the other extreme. You are seeing very low dilution, as a result of which a lot of money has already gone into a business and the outcome is not significant. So, in the earlier era where there has been higher dilution of the founders, we are seeing cases where the outcomes are better.

And in a latter era or in more recent times where there is lesser dilution for more capital going in, the outcomes are really not so great. So, the difference really is that earlier it was an excess on one extreme and today it’s probably an excess on the other extreme. Ideally, there should be a middle ground or somewhere closer to the middle ground which will make this whole process of diluting capital of a founder, giving them growth capital and then seeing outcomes more meaningful and productive.

So, there is still a lot of ground to be covered there.

[Shyam] (8:03 – 8:42)

Also, one more thing is that dilution must be more critically aligned to outcomes. I think that would be a better way to manage this. Because if somebody has shown the outcome or he has exceeded what he has sought to create, then that dilution should be fair to the person who has performed.

And if somebody has given more capital than he ought to have and if the performance is lagging, then he needs to be penalized or the capital should be adequately priced, appropriately priced. So, this balance has to happen.

Q3 Early Stage Capital

[Swami] (8:45 – 9:25)

Okay. So, clearly, there are multiple ways in which today you can raise capital, right? So, today you have warrants, you have convertible debt, you have equity financing.

So, if I am a company at a very, very early stage, how should I look at my capital requirements and what are the best forms of early stage capital, you know, fundraise? What would you think is fair for early stage startup enterprise?

[Shyam] (9:27 – 10:04)

I think that would entirely depend on the gestation of the idea, the structure of the business, what is the financial structure of the business. Assume that you are in a business where you don’t have too much requirement of working capital. For example, your customers give you an advance, you deliver a product or a service over a period of time, then you could well be funded by the working capital itself, right?

So, you have to understand the structure of the business. You also have to explore whether the business you are going to do can be done differently from conventional ways.

[Swami] (10:06 – 10:09)

Okay. So, give me some example.

[Shyam] (10:12 – 12:42)

See, there are businesses where you deliver a service and then you collect the money at the end of delivery of the service. Let’s say you are giving a one year service to somebody. Today you have digital payments.

Can you change the terms of contract where they always just give you one month payment in advance? Okay. As you deliver, they pay, almost.

Okay. So, if the structure of the business can be changed, let us say you incentivize the person. It’s like newspapers collect three years subscription in advance.

It’s capital, right? Similarly, digital media can also do it. It’s capital, right?

So, for every business, there will be an alternate way which we have not explored which can become a source of capital. So, if we can change the way we do business, that itself can also change the way we structure our capital. So, effectively, we should look at ways of doing business first.

Is this the most optimal way to do business? Can we do it better? And once we arrived at the most optimal way to do the business we want to do, then we estimate how much capital we require.

Then we understand whether we will be needing that capital permanently. That is the next question. Suppose I am going to do a business where in three years, I will scale myself so much that after that, cash flows will be sufficient to run my business and my business will give cash back to me.

Then should I go for excess dilution of equity or should I have some optionally convertible equity with a reasonable horizon where I give the investor cover of debt and then decide whether it should become equity or be returnable. So, all this structuring should be done keeping in mind the nature of the business, my expectations of when the business will become self-sufficient and whether I really require permanent capital. I think once we understand these things, then we decide what is the best financial structure for the company.

[Swami] (12:45 – 12:45)

Brilliant.

[Shyam] (12:47 – 13:53)

Blindly raising money because it’s available may not be a smart thing because somebody who understands your business better than you may actually overpay in the near term to take a higher stake and you will realize this after 3-4 years and there is no comeback after that. In a number of businesses which don’t require capital after they stabilize, in 2-3 years, you see that the damage of dilution is done at the early stage itself. Okay.

So, therefore we should have a very clear understanding of the financial structure of the business. Be sure that you are doing business the right way and in the best or most optimal way. Is there a better way of doing your business?

Is there a new way to do the same old business because that is also something that has created lot of opportunities for many startups and then you figure out what is the capital structure.

Q5 Distributing Equity Amongst Founders

So one of the key questions then which comes up next Shyam is that today is a day where you know almost in this period five people come together to start up a company and they may be friends in college or they may be working somewhere else, they have an idea, they come together and literally this discussion around how do you distribute a founder’s equity is a very touchy topic because do I bring in the strength, do you bring in the strength and this is something that is discussed to death by Y Combinator to lots of great investors. So if I am really looking at distributing equity between startup founders, what do you think are the basic principles around which you distribute it so that you know you are building something whether for instant gratification for various things that you mentioned in the past so how do you really look at distribution of equity amongst founders and what are the best practices and principles that you believe we should follow.

[Shyam] (22:51 – 26:05)

I think when you say five people I am immediately going back to the Mahabharata and reminded of the Pandavas but it is a difficult question because when you start as five people I am giving an example because I have seen one example the natural tendency is to start with everybody being equal because it is a very easy decision to arrive at the starting point but that decision may not stand the test of time because over time you start realizing that a few people are more important to the organization or a few people are not as important as others so then what happens is the motivation levels of those who are more important tends to be less than the others or tends to be less than what it ought to be. 

This is like equally true of family businesses where there are multiple stakeholders and my lesson comes from there because I have operated in that environment as well I think that this is a very very difficult area there are no simple solutions to this because when you start a venture I think that to have a fair conversation about who is going to bring what and who should be given a better position in the venture is not easy but we need to find that answer basically I think that setting it correctly in the beginning is very very critical taking this idealist approach of all five are equal is not going to work I think that you should have a separate pool from which the contributors will be rewarded subsequently and there should be well established metrics of how these rewards are going to happen instead of simply taking “all five are equal” approach same at the same time I think that we should not make it too lopsided either so I think that having an approach to evaluate this fairly and get it accepted by everybody is critical to organizations where there are multiple founders. 

So I think that you should have some mechanism to do this with people who are impartial and objective to help you along the way to carry this decision fairly and to take it forward you should not get stuck after making a decision that is very very critical we should have a mechanism to not only start the process but also to run the process of stake distribution among founders until it reaches a steady-state and to ensure that you reach that steady-state with a feeling of fairness that is very important only then they will stay together otherwise we are going to see things dissipate or move away from each other.

Q11 Cashflow

[Swami] (50:31 – 51:24)

So when you’re really talking about you know angel investing when you’re talking about putting money in companies, the current trend is let me raise money for my business because money is available… versus my business really needs money okay. we seem to be seeing more of the first trend so therefore how does it affect businesses and therefore you know when should I really trigger my fundraise and how should I look at it from a “enough cash in my bank” versus “what cash my business needs”… how do you really balance this and what mistakes are people making today

[Shyam] (51:27 – 55:50)

I think that when people raise money which they don’t need. I have seen one universal trait it tends to get squandered. the second point is that when you raise too much money at that point you think that you are diluting less but you are taking away the right to dilute in future because if you dilute at a valuation which is unreasonable, people will hesitate to again give you capital even when the valuation becomes more reasoned… because they see that you have not handled the capital well. so there is a problem you are setting yourself up for. so it’s very important that when you raise money you raise money which you really need and money on which you are reasonably sure of delivery. yes, you have the option of raising some more money. you can raise a little more than what you require if you want a slightly longer runway, but don’t raise too much money just because money is available. 

because the risk of capital going into unproductive areas and leading to destruction of capital is very high and this has happened time and again. whenever I have seen companies which are in the listed space raise money when capital is easily available whether it was the 94 GDR rush or even the current VC driven raising of huge sums of money by the unicorns, I am seeing that after raising so many millions of dollars within 12 months the company is again coming and trying to raise venture debt because it is not able to raise equity at the same valuation it has raised last time and it is still hungry for capital because that capital has been misallocated. we are seeing that happen in multiple Indian unicorns today. 

Now this is a road to destruction clearly. so how you raise money is not just about that one race it sets the context and trajectory for the future of your entrepreneurial journey itself and the future of your enterprise so it is very important that you are going to think of a scenario when things may become difficult and you should be able to raise money at that point if the need be raise money now or whenever you raise money remember that you should always maintain that optionality to raise another round and you should be reasonable enough to be accepted by investors at that time. if you do unreasonable things then, later, you are not going to get acceptability… in fact people may actually not reach out to you at all so in the sense you will isolate yourself and that is the risk which one should never run in his entrepreneurial life. things may go right wrong but people should be again willing to come and give you their trust and capital. so whenever you raise capital think about this that is there another time… don’t act as if this is the last time it’s never going to be a now or never situation, and if you think it is now or never you are going to set yourself up for a never again situation that you will never be able to do it again so that is something which is a real risk today… I know the last two years I have been very lucky for a lot of people but from here I think that we are again reverting to mean or moving in that direction so one should be very very careful.