For many founders, one of the most important stages in the life-cycle of a startup is to produce and validate a commercially viable product or service – a much advanced stage than just an idea. The next and probably the toughest stage is - how to arrange initial capital to support the development of the company further. Lack of early stage financing is why 94% of startups fail in India. If you have a great startup idea or even if you have progressed further, in this blog, we will walk you through the diverse types of funding available for the startups.
Moneybags is an Indian startup founded by Aditya Bansal, an engineer who is looking to build a credit scoring model. Through his startup, he envisions, he will be able to provide loans to those who are not found eligible by banks and other formal lending institutions. Moneybags will determine creditworthiness based on Aadhar based authentication and credit history of customer along with a few other predictive variables.
Aditya quit his job and is now looking to fund his idea. It is imperative that he chooses the right form of funding based on the type of his business and his future goals. Let’s consider the types of funding available to him:
Personal finance or bootstrapping is not funding in the strictest sense, but a means to survive before receiving Seed Funding – often considered as the first round of funding in the start-up world. Aditya can utilize his personal savings to build a working model or prototype (commonly known as a MVP- Minimum Viable Product) of his solution. He can utilize earnings from this to streamline his business plan and develop the full-fledged features of his product. For Aditya, this can be a basis to prepare for more formal funding sources.
Crowdfunding is another way of funding which is raising a storm online. If Aditya believes his business idea is rock solid and is ready to campaign online for funds, competing with other businesses and grabbing the attention of consumers who could give him money, he can garner funds through this route. Successful crowdfunding campaigns have been very few in recent history and most businesses remain unfunded despite campaigning aggressively. It has different models – incentive based or equity based.
Companies like Kickstarter and Indiegogo provide a platform to creative startups to raise money from the crowd in lieu of incentives or recognitions. For many companies, such campaigns also play out to be a great early sales route and/ or Public Relations (PR) stories. Smart watch company Pebble is one such example where it started a campaign to raise $100,000 and ended up raising $10 million in the first campaign and $20 million in second campaign. It was the third highest funded project on Kickstarter.
Companies like CrowdCube in the UK provide platform to raise money from crowd in exchange for equity (shares) of the companies. There are many companies including CrowdCube itself which have raised money through this model; the biggest success story being BrewDog which raised £10,000,000 via a bond issue. Equity based crowdfunding is not permitted in India yet, but government is looking into this matter actively.
In common parlance, equity represents ownership or stake in a venture. Aditya can receive funding in exchange for issuing shares of his stock. The only difference is that Aditya would own common stock while his investors may receive a different class of stock with or without some preferred rights, these stocks/ shares are commonly known as preferred stock. Preferred stockholders have preferential rights in terms of protection of their investment, higher returns and control. ¬¬¬¬¬¬In the event of liquidation of a company, preferred shareholders may be paid before the latter based upon the preferences associated to their class of shares. Equity funding may consist of several rounds:
Since his business is still in the concept stage, Aditya could raise a small amount of capital required to cover his expenses till he starts earning revenue. This is called the Seed funding stage where funds are raised from 3Fs or Angel Investors. 3Fs are Friends, Family or Fools – as they will invest in Aditya and may not necessarily understand his idea, product or business – but would like to support him. Next seed round comes from Angel investors who are successful entrepreneurs, high net-worth individuals or HNIs who are willing to invest in many companies to build a decent portfolio for future returns. They are motivated by joining initial rounds of the companies so they can get a better value for the money they invest.
This is the first stage of financing where stock is offered to investors and usually intended to aid a company build its business from product development to building a team. Investors could be Angel investors or Venture Capitalists(VCs). VCs are professional investors or investment companies that offer investment and become part of the Board of Directors. Subsequent rounds after this are designated incrementally with the letters B, C etc. and so on. Series A, B, C etc. differ from each other in terms of the life-stage of the business and the purpose for which funds are being raised. Later stage funding involves more sophisticated investors like VCs. A, B or C also differ in the value of the investment but interestingly, in every region, these numbers differ as well – so what is considered as an A round in India may be the equivalent of a seed round in the UK.
Aditya is wondering if he could just borrow some cash i.e. take a loan. A loan is, to put it simply, a transfer of funds with the obligation to repay in equated instalments and periodic intervals. Typically, there is a rate of interest and some collateral associated with the loan. In the startup world, debt funding from banks or lending institutions is not very common due to obvious uncertainty and lack of collateral. In countries like the United Kingdom, the government offers loans that are given to the startups on the guarantees of the founders – In India such schemes are either non-existent or not popular.
Convertible debt is a widely-used instrument in early stage rounds which Aditya may find useful. It simply means that the debt can be exchanged for equity upon the lenders’ decision or the borrower’s offer. The lender may receive a discount on the price of the future round. The primary reason, why many investors go for convertible debt is because at an early stage, it is difficult to determine the value of a company based on just an idea, product or prototype. Deferring the valuation for a later round when it has grown further and more investors are involved, is more likely to result in a fair valuation. Founders can take this route to save time, money and a lot of heartburn of arriving at a valuation number with investors at an early stage. So by the way of convertible note – investors and founders agree that a decent and realistic equity will be allocated to the investor (often on a discount) when a big equity round will take place in future.
Consider this example:
Moneybags receives seed funding from an Angel investor (Angel) worth Rs. 4,00,000 for 20% discount on future round with 2 years’ timeline and 20,00,000 valuation cap – this means any conversion on 20% discount should not have a valuation more than Rs. 20,00,000. Now in Series A, he raises Rs. 10,00,000 at post money valuation of Rs.20,00,000 – where the new investor will get 50% of the company for his 10,00,000 investment at 20,00,000 valuation – Angel investors investment will be converted to the equity of 20% discount i.e. 16,00,000. So, the Angel will get 25% of the company for his investment of the company for his 4,00,000 investment at 16,00,000 (20% discounted from 20,00,000) post money valuation.
Convertible debentures are a type of debt which are mostly unsecured by collateral or physical assets. In the event of liquidation, they are paid before anyone as a creditor (based on their priority ranking), before common stockholders and are a hybrid of equity and debt. Investors are usually willing to accept a lower rate of interest in exchange for the liberty to convert to equity.
Debt funding is exceedingly becoming the instrument of choice for investors since it is cheaper than equity, especially in India. Indian investors are often found to be inclined towards debt funding where they see short term return via interest payments than waiting for long for a higher return, albeit risky, through equity financing. With a lower risk appetite, Indian markets therefore, act very different from their global counterparts.
Now that Aditya is aware of the many ways he can fund his business, he starts identifying the developmental milestones for his company. Based on the nature of his business and the requisite milestones, Aditya is now able to calculate the amount of money he would need and the most suitable funding type. Armed with this knowledge and his Business Plan, he sets out to solicit funding for Moneybags.
Atal Malviya is the Chief Executive Officer of Spark10.com – India’s first European Accelerator. Atal is a successful entrepreneur and an angel investor based out of London. He has founded and exited VC funded technology startups and invested in handful of technology startups in Europe and India. He writes and speaks about Tech Startups, Startups investment, Accelerators and Incubators, Tech innovations and Big data analytics.
She is Content Manager at Spark10.com. Swati has joined Spark10 Blore last month from Goldman Sachs.
PS: This article is for information purposes only and meant for tech startup founders or aspiring entrepreneurs. Examples used are fictitious. Please take professional advice when you make your funding decisions and Spark10 will not be responsible for any decision that you take or conclusion you draw from, based on this article.