Modes of Funding/Capital Infusion for Startups

A successful business requires investment of time, effort and MONEY for its long term growth and prosperity.  Infusion of funds is an essential pre-requirement, especially for Startups if they want to scale up and make their brand popular and visible.

Innovative and promising Startups or businesses always attract enterprising investors who are ready to stake their money and a get a good return out of the same. The difficult part arrives when the decision on the mode of funding has to be evaluated.

There are a lot of factors which determine the mode of funds infusion. Whether the funds are to be given in exchange of Shares or to be treated as Debt or Convertible instrument depends upon the expectation of return and repayment by the investor and relationship with the Company.

This article will give you a brief about different modes of funds infusion and their applicability:

SHARE CAPITAL

One of the most common methods of raising funds is by issue of shares of the Company.

Share capital is a long-term source of finance. In return for their investment, shareholders gain a share of ownership in the company, access to voting rights and right to participate in the management.  Shareholders are not entitled to any interest on their investment. They can be paid dividend on their investment depending on the profits of the company which is subject to the provisions of The Companies Act 2013.

The purpose of investing in Share Capital is to reap the benefit or gain through increase in value of shares. For example – Angel Investors who invest at early stages intend to exit by disposing off their shares in next bigger round of investment at a higher valuation.

Share capital is generally of two types: Preference Share Capital and Equity Share Capital.

The major difference between Preference and Equity Shares is that the former does not enjoy voting rights and have a preferred right to dividend as well as return of capital at the time of liquidation.

 

Most of the investors prefer to invest in Preference Shares to avoid the risk of loss of initial investment in case of liquidation or bankruptcy of the Company. This goes well with the Company also, as Preference Shareholders do not have management and voting rights and hence, there is no interference in the working of the business.

DEBENTURES/BONDS

Bonds and Debentures are debt securities. They have an implicit level of safety simply because they ensure that the principal investment is returned to the lender at the maturity date with interest or upon the sale of the security.

Generally, a legal agreement is executed between the Company and the Investor at the time of issue of debentures specifying in detail, the term and conditions of repayment and interest.

Also, the Debenture-holders are creditors of the Company who get preference in repayment of liability over the shareholders, at the time of liquidation.

Debentures are further classified as Convertible or Non-convertible.

Convertible debentures can be converted into equity after a specific period of time. You can read about these under the section “Convertibles”.

Non-convertible debentures do not have the option of equity conversion but are generally coupled with a higher interest rate.

CONVERTIBLES

The most commonly used instrument for raising Capital by Early Stage Startups is Convertibles.

Preference Shares, Debentures and Loans – all can come with a convertible option. These instruments provide the benefit of deferring the valuation of the Company to a later stage when the conversion to equity actually takes place.

Convertibles are particularly attractive to those investors who want to participate in the rise of hot growth companies while being insulated from a drop in price should the stocks not live up to expectations.

Convertible Preference Shares or Debentures have the advantage of being fixed-income securities that the investor can choose to turn into a certain number of shares of the company’s common stock after a predetermined time span or on a specific date. The fixed-income component offers a steady income stream and some protection of the investors’ capital. However, the option to convert these securities into stock gives the investor the opportunity to gain from a rise in the share price.

The conversion into Equity Stock takes place through a pre-determined conversion price or conversion ratio which represents the number of equity shares, investors may receive for every convertible preferred share or debenture.

UNSECURED LOAN

A loan is when you receive money from any person, bank or financial institution in exchange for future repayment of the principal, plus interest. Loans can be either secured or unsecured.

A secured loan involves pledging an asset (such as a car, house) as collateral for the loan. If the borrower defaults, or doesn’t pay back the loan, the lender takes possession of the asset. These loans enjoy a level of safety because of the collateral attached to them.

An unsecured loan is the one which doesn’t have any security attached to it and supported only by the borrower’s creditworthiness. Though there is a risk of non-repayment of money attached to it, but it is easy and less time taking for a company to raise an unsecured loan. The process does not generally require too much paper works and is easy to execute.

A Private Company can take unsecured loan from its Directors or his relatives ONLY. “Relatives” include the ascendants and descendants of the director and their spouses.

CONVERTIBLE NOTES

The concept of Convertible Notes was recently introduced by the Companies Act making this option exclusively available to Startup Companies.

Convertible notes can be defined as a type of loan or debt security issued in the form of some document or certificate to the investor in return of the money lent to the Company. The amount raised in exchange of Convertible Notes has to be repaid or be converted into equity shares of such startup company at the option of the holder. It should be repaid or converted within a period not exceeding 5 years from the date of issue of the Note. It can also be repaid or converted on occurrence of specified events as per the terms and conditions agreed upon between the parties.

These notes can also be issued to NRIs subject to conditions mandated by RBI in this regard. The minimum amount that has to be raised against issue of Convertible Notes is Rs. 25 lakhs or more in one tranche.

A company can enter into a legal agreement with the Investor at the time of issue of these notes specifying the details of the issue and the terms and conditions of repayment.

Choosing an appropriate mode of funding:

Before choosing an appropriate mode of funding, the pros and cons of each of the methods have to be carefully evaluated. Following points can be kept in mind while choosing the appropriate mode-

  • Whether the company wants to dilute the ownership of the promoters in the Company.
  • Whether the company can afford to include the investors in the management of the entity.
  • Whether the company can afford to pay a fixed sum as interest on debt or loan.
  • Conditions relating to compliances required under different Laws and the cost for the same.
  • Tax benefits available- Interest paid on debt financing is allowed as deduction from profit whereas dividends are paid out of the profits earned and dividend distribution tax is to be paid.

Understanding Employee Stock Option Plans (ESOP)

Startups have set a certain benchmark when it comes to providing employees with more than just a salary. One such policy that has caught the attention of all is ESOP or the Employee Stock Option Plans.

In the recent era, companies are adopting many employee-friendly policies in order to retain good employees who is up the ante when it comes to company performance and growth. From providing extended maternity leave and women-friendly policies to adopting flexi timings, corporate organizations are leaving no stone unturned to be the leaders and trendsetters in their field of work.

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Employee Stock Option Plans (ESOP)

ESOPs were never as popular until a few years back. Traditionally, these stock options were awarded to senior employees by companies to acknowledge their loyalty and performance. However, in the era of startups, ESOPs are being used as candy to attract good talent at affordable salaries. They are a way of keeping employees focused on company performance and share price appreciation.

ESOPs are not as simple as they seem. Most employees who are given this option believe that they have unlocked a treasure chest! Let us highlight some basic concepts behind this scheme and dispel misnomers.

What are ESOPs?

An ESOP is a qualified, defined employee benefit plan that allows employees to purchase a specific number of shares in a company at a predetermined discounted price in lieu of salary. They are in strict compliance with the Companies (Capital and Debenture) Rules, 2014. There is a vesting period (a waiting period) before they can actually exercise their right to purchase the shares. If an employee leaves the organization during this lock-in period then the ESOPs get lapsed and the benefits stand null and void.

Who is entitled to ESOPs?

As per the Companies Rules, 2014, ESOPs can be given out to the following.

– A permanent employee working in or outside India

– A whole-time or part-time director of the company

– An employee of a subsidiary in India or abroad, holding a company or an associate firm A promoter or a director holding more than 10% of the share equity of a company will not be entitled to participate in this scheme.

The trend was in fact set by software firms like Infosys and Wipro who presented these options to even their clerical staff. There are known examples of even drivers, office assistants, and personal secretaries employed by these IT companies, who turned millionaires, thanks to this scheme.

A motivating sense of ownership:

Offering stocks of the company to employees instills a sense of pride and partnership in them. It keeps them motivated to give their best to the organization thereby building a better value for the company. The participants often push their limits as the growth of the company translates to their own.

Saving on cash:

  For startups, it is a good tool to maintain liquidity. In the early days, ESOPs were smartly presented by small companies to their employees as part of their compensation package to make the overall pay look more attractive without actually affecting the company’s cash reserves.

The tax deal:

How the Indian tax department looks at ESOPs has changed in the past two decades. When ESOPs are issued, the benefits arising out of the scheme are taxed as perquisites and form a part of the employee’s salary. The perquisite value is calculated as the difference between the market value of the stock and the exercise price (ie, the price at which the Company shares are purchased by the employee through the ESOP scheme).

If the employee sells these shares subsequently, then Capital Gains Tax is applicable on the proceeds of sale of stock options. The capital gain is calculated as the difference between the sale price and the price of issue of stocks. The tax applicable also depends on the period for which ESOPs are held. Gains arising out of stocks that are held for more than 12 months from the date of issue are exempted from Capital Gains Tax.

A word of caution Both as an employer and an employee, care must be taken while handling ESOPs. As a company, you have to do the following.

– First, create an ESOP pool and allocate the number of shares that you would like to give out as part of this scheme. Then draft an ESOP scheme, get it approved by the shareholders through an ordinary/special resolution, and file with the Registrar of Companies (ROC).

– While handing over this offer to an employee, a Letter of Grant must be issued in his name, clearly specifying the number of options being granted to him, the vesting period, and other terms and conditions. Remember, when employees exercise their option, the company’s share holding gets diluted.

As an employee, take care to of the following points.

– Ask your employer for a copy of the scheme while accepting the stock options.

– Present an Exercise Application to the employer in case you wish to exercise the option.

– Look for the vesting period clause carefully. There is also an exercise price that is to be paid to the employer in order to exercise the vested options.

The options will not be converted into equity in case you do not wish to pay a price. It is safer to look at ESOPs as an added bonus and not as a part of the salary component. Even though ESOPs are a great incentive for employees, the best rewards can be reaped as part of high growth companies or big multinationals.

VenturEasy can help you with issuing ESOP to your employees. Get in touch with us at ventureasy.com

Valuation of a Company – Discounted Cash Flow Method

How to derive valuation of your company or startup after detailed analysis and projections? How do investors determine which stock to put their money on?

When it comes to determining the absolute value of a company, discounted cash flow (DCF) gives you the answer. In simple terms, DCF tries to work out the present-day value of a company, based on future projections of cash available to the investors.

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Valuation of a Company – Discounted Cash Flow Method

The word ‘discounted’ arises from the concept of ‘time value of money’. If the value thus arrived at, is higher than the current value of cash invested, then it is considered to be a good investment opportunity. Some of the terms used in DCF analysis are as follows.

  • Free cash flow (FCF) Cash generated by both tangible and intangible assets of the firm that is available to investors. It is calculated as operating cash flow minus expenditure.
  • Terminal value (TV) This is the value of cash at the end of the forecast period.
  • Discount Rate The interest rate used to determine the present value of future cash flows by taking into account the time value of money and the risk involved. Greater the uncertainty and risk, higher the discount rate.

How DCF works The method involves projecting cash flows (FCF) over a certain period, calculating the terminal value (TV) at the end of that period, and then discounting the cash flows and the TV using an appropriate interest rate. The value thus obtained is called the Net Present Value (NPV) of the company.

The formula This can be better understood with the help of an example. Let us calculate the worth of a Company A using DCF analysis. Firstly, we would assess the company’s future cash flow growth. Let us assume that the company’s 12-month FCF is Rs 50 million.

Some other factors to be considered here include the company’s previous year FCF, growth, and factors for growth to assess sustainability.

The company is assumed to grow at 10% per annum in the first 5 years. For calculating the TV, let us assume the long-term growth rate to be 5% and the calculated Weighted Average Cost of Capital (WACC) or discount rate to be 8% (actual calculation is not done here).

The terminal value is calculated as below.

Terminal value = projected cash flow for final year (1+ long-term growth rate)/ (discount rate- long-term growth rate)

Year 1 = 50*1.10 55

Year 2 = 55*1.10 60.5

Year 3 = 60.5*1.10 66.55

Year 4 = 66.55*1.10 73.20

Year 5 = 73.20*1.10 80.52

Terminal value = 80.52 (1.05) / (0.08-0.05) = 2818.20

Now, the DCF of Company A can be calculated by adding each projected cash flow after adjusting it using WACC, as shown below.

DCF (Company A) = (55 / 1.08^1) + (60.5 / 1.08^2) + (66.55 / 1.08^3) + (73.20 / 1.08^4) +(80.52 / 1.08^5) + (2818.20 /1.08^5)= 2182.22

Thus, Rs 2.18 billion is our estimate of Company A’s total market value. In order to compare the company’s share value in the market, we need to subtract the net debt and divide the result by the number of shares outstanding.

For example, if the company has 10 million shares, the value of fair equity per share will be Rs 218.22. If this value is higher than the actual current stock price of the company, then we can say that Company A is a good investment.

In addition to being cumbersome and complex, a major disadvantage of this method of analysis is that the accuracy of values varies greatly based on the assumptions made, and the values are often expressed as a range.

Any small changes in inputs can lead to widely fluctuating results. However, the main advantage of DCF analysis lies in the fact that it is the closest to intrinsic stock value. It is also a futuristic and fundamental method of evaluation.

VenturEasy can derive valuation of your company after detailed analysis and projections. Get in touch with us at [email protected]

Top Startup Investors in India

For a start-up in its growth stage, the next most important requirement is undoubtedly a backing by reliable Startup investors and an ample amount of funding to scale up. This investment can be provided by individuals, entrepreneurs or organizations with the motive of profits.

Startup Investors provide funds to those start-ups which are socially and economically viable, have the capacity to scale up and are backed by a good team. These perspectives may vary from investor to investor.

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Top Startup Investors in India

Here is a lowdown on some such Startup investors and capital funds in India along with their investment capacity, investment structure, investment industries and some of their most notable portfolio startups.

Venture Capitalists

A venture capitalist is an investor who provides capital to startup ventures or small companies with a distinct and innovative idea, that wish to expand but do not have access to funds.

Some well-known Venture Capitalist firms in the Indian startup scene are:

1) Helion Venture Partners A $605-million Indian-focused company investing in technology-powered and consumer service businesses. They are an early to mid-stage venture fund participating in future rounds of financing in syndication with other venture partners.

Investment Structure: Between $2 million and $10 million in each company with less than $10 million in revenues.

Industries: Outsourcing, Mobile, Internet, Retail Services, Healthcare, Education, and Financial Services.

Funded startups: Yepme, MakemyTrip, NetAmbit, Komli, TAXI For Sure, PubMatic.

2) Accel Partners They have a presence in Palo Alto, London, New York, China, and India. They make multi-stage investments in internet technology companies.

Investment Structure: Between $0.5 million and $50 million

Industries: Internet and Consumer Services, Infrastructure, Cloud -Enabled Services, Mobile and Software.

Funded Startups: Flipkart, BabyOye, Freshdesk, Book My Show, Zansaar, Probe, Myntra, CommonFloor.

3) Sequoia Capital India Sequoia specializes in investments in startup seed, early, mid, late, expansion, public, and growth-stage companies.

Investment Structure: Between $100,000 and $1 million in seed stage, between $1 million and $10 million in early stage and between $10 million and $100 million in growth stage companies.

Industries: Consumer, Energy, Financial, Healthcare, Outsourcing, Technology.

Funded Startups: JustDial, Knowlarity, Practo, iYogi, bankbazaar.com

4) Nexus Venture Partners They invest in early stage and growth stage startups across India and US.

Investment Structure: Between $0.5 million and $10 million in early growth stage companies. They also make investments worth $0.5 million in their seed program.

Industries: Mobile, Data Security, Big Data analytics, Infrastructure, Cloud, Storage, Internet, Rural Sector, Outsourced Services, Agribusiness, Energy, Media, Consumer and Business services, Technology.

Funded Startups: Snapdeal, Housing, Komli, ScaleArc, PubMatic, Delhivery.

5) Global venture capital They invest in people with visionary ideas and specialize in all stages of development, seed financings, start-ups, growth and early stage investments, typically Series A and B financings.

Investment Structure: The firm typically invests between $0.05 million and $80 million in its portfolio company. It prefers to exit its investments within 7 to 10 years.

Industries: Technology- Advertising & Marketing, Big Data/Cloud, Consumer, Enterprise/SaaS, FinTech, Hardware, Healthcare – Biopharma, digital Health & MedTech.

Funded Startups: Naaptol, Bharat Matrimony, iYogi, Happiest minds, mCARBON, CarTrade, Surewaves.

6) SAIF Partners They have been investing in India since 2001 and specialize in private equity and venture capital across Asia.

Investment Structure: Between $10 million and $100 million in one or more rounds of financing with investments between $200,000 to $500,000 in early stage companies and between $30 million and $35 million in more mature unlisted ventures.

Industries: IT, ITes, Industrials, Financial Services, Internet, Consumer Product, Mobile

Funded Startups: Justdial.com, Paytm, Network18, HomeShop18, Book My Show.

7) Inventus Capital Partners This is a venture capital fund managed by entrepreneurs and industry-operating veterans.

Investment Structure: They do not invest in capital-intensive companies and typically lead the first venture round with $1 million to $2 million. As the businesses grow, they invest between $0.25 million and $10 million.

Industries: Consumer, Hotels, Restaurants and Leisure, Media, Internet and Catalog Retail, Healthcare, Information Technology, Hardware and Equipment, Telecommunications etc.

Funded Startups: Poshmark, Savaari, Farfaria, Policy Bazaar.com, Insta Health Solutions, CBazaar.

Seed Funds

Let us understand it this way: as we need seeds to plant a tree, we need money to plant (start) a business. So the very initial amount of capital needed for a startup is called the seed money or seed fund.

They help founders quit their day jobs, build a team and get to their first revenue as also help lay the foundation for many more future investments to come.

Top seed funders of India are given below.

1) Blume Ventures (founded in 2011) . Fresh from their Zipdial exit, they are quite easy to reach at @arpiit.

2) Unitus Seed Fund (founded in 2012) . With an impact agenda in place, they are great to approach for startups in education, health, payments, and “inclusive” business ideas, in general. They have also launched an accelerator program called Speed2Seed.

3) India Quotient (founded in 2013) . These people are also entrepreneurs in their own right and very accessible.

4) Orios Venture Partners (founded in 2014) This was started by successful angel investor Rehanyar Khan. The website features many of his past angel investments like Olacabs. They have already made 12 investments but only announced Yumist amongst their seed bets.

5) Kae Capital (founded in 2011)  The founder of Kae started Mumbai Angels in 2006. They are also super accessible.

6) Seedfund (founded in 2006)  They were India’s first in this sector and led some very successful investments with redBus and Carwale.

7) Jungle Ventures (founded in 2012)  Run by a person who was an active angel investor way before he started running Jungle. The team makes investments across Asia and has great operating experience. They are series A seed funders though.

What Investors look for in a Startup?

Early funding option for startups can usually be limited. Though there are ways like bootstrapping, crowdfunding or receiving help from family members and friends, startups need angel investors or VCs to scale up fast. Investors want to become the primary backers of the next game-changing venture. There are many things that investors look for in a prospective investee. The merits of an idea, market need and size, vision for execution of these ideas, are just some of these. These aspects should definitely be in your pitch deck!

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What Investors look for in a Startup?
Strong Team

The team behind any idea needs to work together and work well. Investors would ideally ensure this as the first check. They would look at whether the team is capable of delivering on their ideas and has an assembly of strong and like-minded people with knowledge of what they are doing.

Scalability/Market Size

Investors need worthwhile returns on their investment. They ideally look for products or services in larger markets that offer the most potential for profits. They need assurance that at some point, the startup can become a large company and there would be significant returns on their investment. Only scalable startups can reach this target. One interesting contrast to this point is that sometimes when a startup is in the nascent stages, the market size may not be very clear. Two examples of this are Airbnb and Uber. Airbnb managed to steal clients from hotels. Uber is becoming a logistics company doing more than just cab services.

Traction

While ideas are great, there needs to be some evidence of progress. They would like to see startups signing in customers at the early stages itself or even begin building their product.

Value Proposition

What also affects investor in a startup is its value proposition as chosen by the entrepreneur. While entrepreneurs generally aim at high valuations , investors are usually on the opposite end. If according to an investor, the risk associated with a startup is very high, they will try and own up as much of the startup as possible. This usually pushes down the value proposition of the said startup. Startups that show a high value proposition initially also face the risk of finding it difficult to justify future financing at higher valuation.

Risk taking and clear vision

The entrepreneur needs to have a clear vision and motivation. However, it is also equally important to take risks in order to progress and this is another thing that would attract prospective investors.

Technology and intellectual property

These two go a long way in determining the value of a business. For any startup, there should be a clear ownership of the technology and intellectual property. If your business is in developing products and there is a key IP associated, an investor will definitely be interested to invest. If your products and services depend on certain key IP assets, an investor will undertake due diligence to understand the entrepreneur’s right to use such assets.

Entry barriers

Barriers to entry can be both natural and artificial. A startup’s barriers to entry are some of the unique points that can hinder potential competitors from entering the target market and capturing a major market share. Some such barriers include internal capabilities, government regulations, intellectual barriers, market share, partnerships, first mover advantage, brand name, economic and market conditions, competitors’ reactions, customer relations, etc.

Exit Strategy

Startups need a strong exit strategy meaning the founders either go public, get acquired or get another big round of funding from PE investor. Investors and the initial employee-investors expect returns on capital and this is one important point to consider before approaching possible investors. Venture capitalists usually expect quick returns and therefore they invest in two to three startups at the same time in order to avoid the risk of failure. It is really essential for an entrepreneur to be passionate, optimistic, and hopeful. A final thing to remember is that investors are also people, and you shouldn’t be afraid to approach them as such. Ultimately, investors are going with their gut in investing in businesses just as much as you are in creating yours. So why not give them something to believe in? Things-Investors-Look-For-in-a-Startup