Everything you need to know about structuring investments for your startup
One of the biggest challenges for a start-up entrepreneur is arranging the funds necessary to launch and grow businesses. The major challenge is the availability of bank finance in absence of security. Limited availability of instruments for funding startups continues to pose a threat to the survival of startups.
Evolution of a startup
Any business – to evolve – has to pass through varied phases, specifically pre-seed or seed stage, start-up stage, growth stage, or finally expansion stage. At the pre-seed and seed stage of growth, the business is just being established. More focus is placed on research and planning, identifying a product or a service, or work on a prototype model to assess the viability of the proposal. Cost of development is usually met by own savings, backing from friends and family, etc. At this stage, it’s a very high-risk venture and generally, investors are not willing to invest in the business.
However, there is a number of alternative funding mechanisms emerging that could help fill the gap, such as micro-financing, peer to peer lending, and crowdfunding. Crowdfunding means attracting small amounts of funding or donations directly from multiple investors using social media and internet channels and is typically a form of debt finance.
At the startup stage, the business starts demonstrating viability and sustainability with minimal goals of meeting day-to-day expenses and building awareness about the business in the market. Yet for many investors, it may not be a lucrative option for investment on account of lack of visibility and unproven management team and business models. At this stage, major funding can be relied upon in the form of bootstrapping, financial assistance from friends and family, and angel investors to some extent. An angel investor is a person who provides capital for the business of startups, usually in exchange for convertible debt or ownership equity.
In May 2018, Trak.in observed that startups like Open Tap, Disprz, PaisaDukan, and Earth Food cumulatively received more than $4 million in seed/angel funding.
The next level of any startup – where the entrepreneur has been able to showcase a market for their product or service – is the growth stage. At this stage, the company starts earning revenue but it is unlikely to be sufficiently profitable to fund its own expansion. With a proven track record and management team, access to finance becomes easy in the form of venture capitalist investors and banks providing loans. The government has also initiated credit guarantee schemes which undertake the risk of lending to SMEs so that banks can be reimbursed in the event of default.
Various ‘hybrid funds’ in the form of convertibles which may or may not be linked to performance can be used for funding and leveraging risk. Hybrid funds are funds which invest in a mix of equity and debt to achieve the perfect blend of maximum diversification and decent returns in a balanced portfolio.
‘All growth is essentially an expansion of awareness’
At the expansion stage, the company commences generating profits which can be utilised for making investments in the expansion of operations. Startups may go for public funding by way of an IPO and listing on exchanges, or additional rounds of equity funding follow on VC funding, private equity, rights issue, or investments in debt through private placement or quasi-debt instruments such as mezzanine financing. Recently Bizongo, Nykaa, and mfine received more than $50 million by way of private equity, as reported by Trak.in.
There are numerous considerations involved in the planning process to issue instruments for funding. One must consider nuances of each of the instruments issued, both from the viewpoint of incumbent management as well as prospective investors. While the Government of India has made – and is continuously making – efforts to streamline the process for promoting startups, there is a need for legalised and formalised framework for the issuance of a wide array of fund raising instruments.
By Ashok Shah and Amrita Bhatnagar
This article was originally published in Yourstory. Read the article here.