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.

Nikita Bhatia is the co-founder of VenturEasy, an online platform for Company registration, book-keeping, accounting, tax consultancy and legal compliances in India. A Chartered Accountant and company secretary by profession, she has wide experience in the fields of audit, accountancy, taxation and corporate governance.