With growing demand for entrepreneurship in India, we see a lot of startup companies coming up in recent years. The number of startups in Bangalore itself, which is considered as the Silicon Valley of India, has crossed 800. With these kinds of numbers, it is important to see how these startups finance their ventures, and who their stakeholders are.
This paper covers the different funding options that startups have at different stages, along with a brief description of each of them and what the startups look for while selecting them. It includes examples of some startup companies and the various factors that prompted them to go for that funding option. The paper concludes with a discussion of the pros and cons of each option, and certain pitfalls that need to be avoided.
Before we talk about the technicalities of financing a startup, we need to know what a startup is. A Startup is a company which has a minimal history of operation. In other words, any venture which has been recently started by a person or a group can be termed as a startup. For example, companies like Google and Naukri.Com were startups.
Startup companies usually come in different forms, but the term is often associated with high growth and technology-oriented companies. Investors are generally attracted to these companies, since they are distinguished by their risk/reward profile and scalability. That is, they have lower recovery costs and higher return on investment. However, there is also a higher risk in the initial stages. Many startups become successful because they are more scalable than an established business, as they can grow rapidly with limited investment of capital and resources.
Startups have several unique options for funding at different stages of their operation. Some of the most popular among them are Angel Investors and Venture Capitals. These two options help startup companies begin operations, exchanging cash for an equity stake. Many startups are also funded directly by the founders themselves, so as to avoid any overheads. Some startups also opt for crowd funding, wherein a collective cooperation of people is required to pool in the finances.
Financing a Startup:
One of the major challenges faced by an entrepreneur is financing his venture, since it is imperative that the financial needs of a business change as the business faces different challenges. The entrepreneur should be able to recognize where the organization is in its life cycle, and specify which financing option has to be used. Also, he has to decide whether a certain option has to be sustained during further stages, or another option has to be considered, based on the requirements of the organization.
The diagram shown below illustrates the different stages in the Financing Life Cycle of a startup company.
A. Seed Capital
The small amount of money required to prove that the concept of the startup is viable and feasible, is known as seed capital. It is generally not used to start the business on a wide scale, but to investigate its different possibilities. Seed capital is more like a securities offering, wherein the parties who have some connection to the startup, invest the necessary funds to start the business. This is done to ensure that enough funds are generated in order for the startup to sustain itself for a period of development, until it reaches a state where it is able to continue funding itself, or has created enough in value so that it is worthy of future funding. The people investing in such ventures are known as Angel Investors. Seed capital options can also be generated from crowd funding.
An angel investor is usually a rich individual, who provides capital for a business start-up. This is usually done in return for convertible debt or ownership equity. A number of angel investors have been organizing themselves into angel groups or networks to share research and pool their investment capital. In short, Angel capital is used to fill the gap in start-up funding between friends and family (the acronym FFF in the figure).
An important term for the period of time between a company’s receipt of seed capital and its establishment of a secure cash flow is the Death Valley curve, as shown in the figure. During the Death Valley curve, the startup is unlikely to receive any more financing. The curve refers to the high probability that the company might fail during the Death Valley curve.
Taking this fact into consideration, it can be said that Angel investors have to bear extremely high risks, as their investments are usually subject to dilution from future investment opportunities. Hence, they require a very high return on investment. Since most of the investments made by such angels are completely lost when early stage companies fail, professional angel investors seek investments which have the potential to return approximately 10 or more times their original investment within five years or so. If these results are not met, they have a defined exit strategy, such as planning for an initial public offering, or a merger/ acquisition. Current practices suggest that angel investors might be setting their sights even higher, looking for startups that will have the potential to provide at least a 20x-30x return over a 5 to 7-year holding period. Although this option of funding and the investor’s expectations of higher rates of return on his investment can make angel financing an expensive source of funds, cheaper sources of capital, like bank loans, are usually not available for most startups, which may be too young to qualify for traditional loans.
B. Venture Capital
Once a startup manages to emerge out of the Valley of Death and break-even, there are two stages of financing.
1. Early stage financing:
In addition to the seed capital, a certain amount of funds are required to get the business organized and operational. This start-up capital is also termed as first-stage financing. Also needed is the initial working capital, to support the first commercial sale of the start-up’s products.
2. Expansion/ Later stage financing:
This is the second stage of financing, and it is concerned with expanding the business beyond the breakeven point and positive cash flow levels. This supports trade debtors, stocks, supplies, and expenses. At this point, however, the venture might not have achieved a positive cash flow.
For both these purposes, Venture Capital is preferred.
Venture capital is provided as a funding option to early-stage start-ups, usually after the venture has been funded by angel investors. In return for their investment, venture capitalists expect a return through an eventual realization event like an IPO or trade sale of the company.
In other words, an investment firm will provide capital to a growing start-up. This growing start-up will then use this money to carry out its activities, like advertise, build infrastructure, develop products etc. The investment firm is known as a venture capital firm, and the capital provided is called venture capital. The venture capital firm makes its investment in return to owning a stake in the venture it invests in. The firms that a venture capital firm will invest in generally have a sound business model in place. It is very normal for venture capitalists to identify and fund companies in high technology industries, like IT firms.
Venture capital firms generally consist of people with a deep industry experience, or small teams of people with business training. An important skill that a VC should have is the ability to identify innovative technologies that have the potential to generate high returns at the early stages. VCs also take a role in managing start-ups at an early stage, thus adding skills as well as capital as an investment. The high return on their investments is justified by the fact that they also run a high risk of losing their investment in the startup. In return, the venture capitalists get a significant control over the company decisions, along with a significant portion of the company’s ownership.
Most VC investments are done in a pool format, wherein many investors combine their investments into a single large fund, which invests in many different startup companies. By investing in a pool, the investors are making sure that their risk is getting spread out across different investments, as opposed to taking the chance of investing all their money in one single firm. A venture capital fund refers to the pooled investment that mainly invests the finances of third-party investors in ventures that are too risky for the standard capital markets or bank loans. Start-ups wanting to raise venture capital require a rare combination of qualities, like innovative technology, potential for rapid growth, and a well-developed business model.
Factors to be considered by an entrepreneur before taking venture capital funds:
- Equity Share – The investor owns a certain amount of shares in the company once he provides the startup with the venture capital
- Involvement of High Risk – The Venture Capitalist is willing to take a risk by investing in the company, without any collateral or guarantees. So if the company loses, they also lose out.
- Partnership Constraints – As mentioned before, Venture Capitalists will expect to have a say in the operation of the company.
- A possible Win-Win Situation – When a VC invests in a growing startup, it can help the company grow faster and get better returns. With the right VC, the company can expect help regarding strategy, acquiring customers, recruiting the team, etc. The VC also benefits because of the better returns it gets. Thus, it can result in a possible win-win situation for both.
Because VCs own a certain share of a company, in order to return money to the investors, they have to exit the investment made, by selling their shares to someone else usually at a much higher price than what they had invested.
Generally, there are two ways in which a VC can exit an investment. The first scenario is when the whole company is sold. The second scenario is when the company goes public with an initial public offering (IPO), and sells its shares through a stock exchange. Once this is done, the venture capitalists and their investors are able to sell their shares to the public, and exit the investment.
The average time frame for a VC investment is usually within 5 – 7 years, up to the time the company is reaching stable grounds and can start growing bigger.
C. Initial Public Offering (IPO)
An initial public offering (IPO), often called as an offering, is when a company issues common stock or shares to the public for the first time. This is often done by a start-up that has started making profits through funds received from Venture Capitals, and now wants to expand more.
When a startup lists its shares, it usually looks to issue additional new shares at the same time. The money paid by investors for these new shares goes to the company, in contrast to a later trade of the shares on the exchange, wherein the money passes between investors. Thus, an IPO allows a startup to tap a wide pool of investors, and to provide it with large volumes of capital for expansion and future growth. The company does not have to repay the capital, but the new shareholders have a right to the future profits distributed by the company, and also the right to a monetary distribution in case of dissolution of the company. The existing shareholders might see their share-holdings diluted with respect to the company’s shares when such new shares are issued, but they hope that the capital investment will improve their shareholdings and make them more valuable in absolute terms.
To add on to that, once a company is listed, it can issue further shares to its investors, thereby again providing itself with more capital for expansion, without incurring any debt. This great ability of a company to raise large amounts of capital from investors in the general market, rather than from individual investors, is a key goal of many companies seeking to list.
IPOs also involve a few investment banks, known as underwriters. The organization offering its shares (issuer) signs a contract with a lead underwriter to sell its shares to the investors. The underwriter then approaches the investors, with offers to sell the shares. An IPO can sometimes be a risky investment with respect to a start-up. For individual investors, it is tough to predict what the shares will do on its initial trading day and in the subsequent days, since there is often little historical data about a start-up, with which one can analyze and come to a decision. This transitory growth period adds to the uncertainty regarding their future value.
IPOs, however, have many benefits too:
- They bolster and strengthen the Equity base of the startup. With more people willing to invest in the venture, it is bound to grow faster and attract even more investors.
- Enable the startup to get cheaper access to capital, without having to repay it in direct terms. However, the venture has to provide bonuses to the shareholders, based on the profit it makes.
- They provide a boost to the prestige of the start-up. Once listed, the value of the start-up in the market increases many-fold, and the venture tends to gain from this kind of mass exposure.
- They enable the start-up to attract better management and employees, as bigger growth will require more skilled and experienced resources.
- They create multiple funding opportunities like equity, cheaper bank loans, etc.
NAUKRI.COM – A Case Study
Naukri.com is one of India’s largest job site, founded by Sanjeev Bikhchandani in March 1997. The site was established by Info Edge (India) Ltd, started and owned by Bikhchandani. Info Edge is a listed company on the BSE and NSE since November 2006.
The evolution of Naukri.com has an interesting story behind it. In 1990, the department of telecom came out with advertisements launching a video text service, and wanted content providers to work on it. Bikhchandani got some workers to reword job advertisements from different newspapers, so as to create a job database. However, the project never really took off.
In 1996, Bikhchandani got to visit an IT Asia exhibition at Pragati Maidan in New Delhi. There, he saw a stall with a “www” sign written on it, and was curious to know what it meant for. On further analysis, he got to know that this was what people called the internet, and got a hands-on exposure about what the internet can do. This gave him his unique idea.
The forgotten database project suddenly looked very useful to Bikhchandani, so his workers again began scanning through 29 different newspapers to build it up – The recession of the mid-1990s made sure that he had enough staffers for this work, who, otherwise, had nothing to do. He gave his brother a 5% stake in Naukri for offering an Angel Investment of $25 a month from the US, to a web-hosting firm.
Anil Lall, a programmer, was given 8-9 % stake for learning web-programming and creating the website. Another friend of Bikhchandani, V N Saroja, was given 9% for running the company.
This model clicked, and while Venture Capitalists began calling, Bikhchandani turned them down for a long time. It was only in 2000, when JobsAhead was launched and advertised in a cricket tournament in Sharjah with a budget greater than Naukri’s turnover, did Bikhchandani give ICICI Ventures 15% stake in Naukri for Rs 7.3 crore (Rs. 73 million). In 2005, Naukri’s turnover from fresh ads reached a whopping Rs 45 crore (Rs 450 million), with a huge profit of Rs 8.4 crore (Rs 84 million).
In November 2006, Info Edge (India) became the first Indian Internet company to go public on the Indian stock exchange. It now owned 99acres.com and Jeevansathi.com, in addition to Naukri.com. The initial offer consisted of 53.23 lakh equity shares, of which 5.32 lakh shares (10%) were reserved for the employees. The shares were initially listed at a price of Rs. 320. By November 21st, within two weeks of issuing its IPO, the shares were listed at a premium of 50% over the issue price (i.e. at Rs 480), then hit a high of Rs 624 in the noon deals, and finally closed at Rs 593 – an overall gain of 85% (Rs 273).
The value of the shares, as of today, is Rs. 743.00.
Summary & Conclusion
In today’s times, a start-up company in India has different options to finance and sustain itself through the initial periods. Some of the main funding options, like seed funds, angel investors, venture capitals, and IPOs were discussed here.
Angel Investors come into the picture when a start-up has not yet started making profits. These are people, who are generally rich and have faith in the organization, in return for ownership equity or convertible debt.
Venture Capitalists provide funds to a company in its growth stage, provided it has a strong organizational and technological model in place. Venture Capitalists expect high returns on their investments in order to counter the high risks involved, and expect an eventual realization of their investments when the company issues an IPO, or goes in for a merger/acquisition.
IPOs are offered by a company when it is relatively stable and making good profits, and wants to expand further through public investments. Although there is no collateral or guarantee provided to the public investors, the company is expected to give them a share of the profits, or a capital distribution in case of dissolution of the company.
Thus, an entrepreneur has to analyze various situations before selecting a financing option, or deciding WHEN to move from one option to another; the correct decision taken at the correct time can result in great benefits, not only for the start-up venture and the entrepreneur, but also for all the stakeholders involved.
 “Stay Hungry, Stay Foolish” – Rashmi Bansal
-Nikhil P Prabhu (Batch 2010-12)