Tue. Jan 31st, 2023

Startup Funding

Funding refers to the money required to start and run a business. It is a financial investment in a company for product development, manufacturing, expansion, sales and marketing, office spaces, and inventory. Many startups choose to not raise funding from third parties and are funded by their founders only (to prevent debts and equity dilution). However, most startups do raise funding, especially as they grow larger and scale their operations. This page shall be your virtual guide to Startup funding. 

Why Funding is Required by Startups

A startup might require funding for one, a few, or all of the following purposes. It is important that an entrepreneur is clear about why they are raising funds. Founders should have a detailed financial and business plan before they approach investors.

Prototype Creation

Product Development

Team Hiring

Working Capital

Legal & Consulting Services

Raw Material & Equipments

Licenses & Certifications

Marketing & Sales

Office Space & Admin Expenses

Types of Startup Funding

Working CapitalEquity FinancingDebt FinancingGrants
BriefEquity financing involves selling a portion of a company’s equity in return for capital.Debt financing involves the borrowing of money and paying it back with interest.A grant is an award, usually financial, given by an entity to a company to facilitate a goal or incentivize performance.
NatureThere is no component of repayment of the invested funds.Invested Funds to be repaid within a stipulated time frame with interestThere is no component of repayment of the invested funds
RiskFinancer: There is no guarantee against his investment.
Startup: Startups need to give up a portion of their ownership to shareholders.
Financer: The lender has no control over the business’s operations.
Startup: You may need to provide a business asset as collateral.
Financer: There is a risk of the startup not meeting the goal or objective for which the grant has been provided.
Startup: There is a risk of the startup not receiving a portion of the grant due to several reasons.
Threshold of CommitmentWhile startups are under lesser pressure to adhere to a repayment timeline, investors are constantly trying to achieve growth targetsStartups need to constantly adhere to repayment timeline which results in more efforts to generate cash flows to meet interest repaymentsGrants are distributed in different tranches w.r.t the fulfilment of the corresponding milestone. Thus, a status is constantly working to achieve the milestones laid down.
Return to InvestorCapital growth for investorsInterest paymentsNo Return
Involvement in DecisionsEquity Investors usually prefer to involve themselves in the decision-making processDebt Fund has very less involvement in decision-makingNo direct involvement in decision making
SourcesAngel Investors Self-financing Family and Friends Venture Capitalists Crowd Funding Incubators/AcceleratorsBanks Non-Banking Financial Institutions Government Loan SchemesCentral Government State Governments Corporate Challenges Grant Programs of Private Entities

Stages of Startups and Source of Funding

There are multiple sources of funding available for startups. However, the source of funding should typically match the stage of operations of the startup. Please note that raising funds from external sources is a time-consuming process and can easily take over 6 months to convert.

Ideation

This the stage where the entrepreneur has an idea and is working on bringing it to life. At this stage, the amount of funds needed is usually small. Additionally, at the initial stage in the startup lifecycle, there are very limited and mostly informal channels available for raising funds.

Pre-Seed Stage

Bootstrapping/Self-financing:

Bootstrapping a startup means growing the business with little or no venture capital or outside investment. It means relying on your savings and revenue to operate and expand. This is the first recourse for most entrepreneurs as there is no pressure to pay back the funds or dilute control of your startup.

Friends & Family

This is also a commonly utilized channel of funding by entrepreneurs still in the early stages. The major benefit of this source of investment is that there is an inherent level of trust between the entrepreneurs and the investors

Business Plan/Pitching Events

This is the prize money/grants/financial benefits that are provided by institutes or organizations that conduct business plan competitions and challenges. Even though the quantum of money is not generally large, it is usually enough at the idea stage. What makes the difference at these events is having a good business plan.

Validation

At this stage, a startup has a prototype ready and needs to validate the potential demand of the startup’s product/service. This is called conducting a ‘Proof of Concept (POC)’, after which comes the big market launch.

Seed Stage

A startup will need to conduct field trials, test the product on a few potential customers, onboard mentors, and build a formal team for which it can explore the following funding sources:

Incubators:

Incubators are organizations set up with the specific goal of assisting entrepreneurs with building and launching their startups. Not only do incubators offer a lot of value-added services (office space, utilities, admin & legal assistance, etc.), they often also make grants/debt/equity investmentsYou can refer to the list of incubators here.

Government Loan Schemes

The government has initiated a few loan schemes to provide collateral-free debt to aspiring entrepreneurs and help them gain access to low-cost capital such as the Startup India Seed Fund Scheme and SIDBI Fund of Funds. A list of government schemes can be found here.

Angel Investors

Angel investors are individuals who invest their money into high-potential startups in return for equity. Reach out to angel networks such as Indian Angel Network, Mumbai Angels, Lead Angels, Chennai Angels, etc., or relevant industrialists for this. You can connect with investors by the Network Page.

Crowdfunding

Crowdfunding refers to raising money from a large number of people who each contribute a relatively small amount. This is typically done via online crowdfunding platforms.

Early Traction

At the Early Traction stage startup’s products or services have been launched in the market. Key performance indicators such as customer base, revenue, app downloads, etc. become important at this stage.

Series A Stage

Funds are raised at this stage to further grow the user base, product offerings, expand to new geographies, etc. Common funding sources utilized by startups in this stage are:

Venture Capital Funds

Venture capital (VC) funds are professionally managed investment funds that invest exclusively in high-growth startups. Each VC fund has its investment thesis – preferred sectors, stage of the startup, and funding amount – which should align with your startup. VCs take startup equity in return for their investments and actively engage in the mentorship of their investee startups.

Banks/Non-Banking Financial Companies (NBFCs)

Formal debt can be raised from banks and NBFCs at this stage as the startup can show market traction and revenue to validate its ability to finance interest payment obligations. This is especially applicable for working capital. Some entrepreneurs might prefer debt over equity as debt funding does not dilute equity stake.

Venture Debt Funds

Venture Debt funds are private investment funds that invest money in startups primarily in the form of debt. Debt funds typically invest along with an angel or VC round.

Scaling

At this stage, the startup is experiencing a fast rate of market growth and increasing revenues.

Series B, C, D & E

Common funding sources utilized by startups in this stage are:

Venture Capital Funds

VC funds with larger ticket sizes in their investment thesis provide funding for late-stage startups. It is recommended to approach these funds only after the startup has generated significant market traction. A pool of VCs may come together and fund a startup as well.

Private Equity/Investment Firms

Private equity/Investment firms generally do not fund startups however, lately some private equity and investment firms have been providing funds for fast-growing late-stage startups who have maintained a consistent growth record.

Exit Options

Mergers & Acquisitions

The investor may decide to sell the portfolio company to another company in the market. In essence, it entails one company combining with another, either by acquiring it (or part of it) or by being acquired (in whole or in part).

Initial Public Offering (IPO)

IPO refers to the event where a startup lists on the stock market for the first time. Since the public listing process is elaborate and replete with statutory formalities, it is generally undertaken by startups with an impressive track record of profits and who are growing at a steady pace.

Selling Shares

Investors may sell their equity or shares to other venture capital or private equity firms.

Buybacks

Founders of the startup may also buy back their shares from the fund/investors if they have liquid assets to make the purchase and wish to regain control of their company.

Steps to Startup Fund Raising

The entrepreneur must be willing to put in the effort and have the patience that a successful fund-raising round requires. The fund-raising process can be broken down into the following steps

The startup needs to assess why the funding is required, and the right amount to be raised. The startup should develop a milestone-based plan with clear timelines regarding what the startup wishes to do in the next 2, 4, and 10 years. A financial forecast is a carefully constructed projection of company development over a given time period, taking into consideration projected sales data, as well as market and economic indicators. The cost of Production, Prototype Development, Research, Manufacturing, etc should be planned well. Basis this, the startup can decide what the next round of investment will be for.

What do investors look for in startups? 

Objective and Problem Solving: The offering of any startup should be differentiated to solve a unique customer problem or to meet specific customer needs. Ideas or products that are patented show high growth potential for investors.

Management & Team: The passion, experience, and skills of the founders as well as the management team to drive the company forward are equally crucial in addition to all the factors mentioned above.

Market Landscape: Market size, obtainable market share, product adoption rate, historical and forecasted market growth rates, macroeconomic drivers for the market your plans to target.

Scalability & Sustainability: Startups should showcase the potential to scale in the near future, along with a sustainable and stable business plan. They should also consider barriers to entry, imitation costs, growth rate, and expansion plans.

Customers & Suppliers: Clear identification of your buyers and suppliers. Consider customer relationships, stickiness to your product, vendor terms as well as existing vendors.

Competitive Analysis: A true picture of competition and other players in the market working on similar things should be highlighted. There can never be an apple-to-apple comparison but highlighting the service or product offerings of similar players in the industry is important. Conside…

Sales & Marketing: No matter how good your product or service may be, if it does not find any end-use, it is no good. Consider things like a sales forecast, targeted audiences, product mix, conversion and retention ratio, etc.

Financial Assessment: A detailed financial business model that showcases cash inflows over the years, investments required key milestones, break-even points, and growth rates. Assumptions used at this stage should be reasonable and clearly mentioned.

Exit Avenues: A startup showcasing potential future acquirers or alliance partners becomes a valuable decision parameter for the investor. Initial public offerings, acquisitions, subsequent rounds of funding are all examples of exit options.

Why do investors invest in startups? 

Investors essentially buy a piece of the company with their investment. They are putting down capital, in exchange for equity: a portion of ownership in the startup and rights to its potential future profits. Investors form a partnership with the startups they choose to invest in – if the company turns a profit, investors make returns proportionate to their amount of equity in the startup; if the startup fails, the investors lose the money they’ve invested.

Investors realize their return on investment from startups through various means of exit. Ideally, the VC firm and the entrepreneur should discuss the various exit options at the beginning of investment negotiations. A well-performing, high-growth startup that also has excellent management and organizational processes is more likely of being exit-ready earlier than other startups. Venture Capital and Private Equity funds must exit all their investments before the end of the fund’s life.

Mergers and Acquisitions: The investor may decide to sell the portfolio company to another company in the market. In essence, it entails one company combining with another, either by acquiring it (or part of it) or by being acquired (in whole or in part).

IPO: Initial Public Offering is the first time that the stock of a private company is offered to the public. Issued by private companies seeking capital to expand. It is one of the most preferred methods by investors to exit a startup organization

Selling shares: Investors may sell their equity or shares to other venture capital or private equity firms.

Distressed Sale: Under financially stressed times for a startup company, the investors may decide to sell the business to another company or financial institution.

Buybacks: Founders of the startup may also buy back their shares from the fund/investors if they have liquid assets to make the purchase and wish to regain control of their company.

SOURCE https://www.startupindia.gov.in/content/sih/en/funding.html

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