Why fund is required by start-ups?

A start-up 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.
Funding increases your visibility and attracts the attention of the market. It adds value to your business and shows to prospective partners and customers, as well as to future investors that you are worth considering.

Types of start-up funding

Working Capital Equity Financing Derbt Financing Grants
Brief Equity 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.
Nature There is no component of repayment of the invested funds. Invested Funds to be repaid within a stipulated time frame with interest There is no component of repayment of the invested funds
Risk Financer: There is no guarantee against his investment.
Start-up: Start-ups need to give up a portion of their ownership to shareholders.		 Financer: The lender has no control over the business’s operations.
Start-up: You may need to provide a business asset as collateral.		 Financer: There is a risk of the start-up not meeting the goal or objective for which the grant has been provided.
Start-up: There is a risk of the start-up not receiving a portion of the grant due to several reasons.
Threshold of Commitment While start-ups are under lesser pressure to adhere to a repayment timeline, investors are constantly trying to achieve growth targets Start-ups need to constantly adhere to repayment timeline which results in more efforts to generate cash flows to meet interest repayments Grants 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 Investor Capital growth for investors Interest payments No Return
Involvement in Decisions Equity Investors usually prefer to involve themselves in the decision-making process Debt Fund has very less involvement in decision-making No direct involvement in decision making
Sources Angel Investors Self-financing Family and Friends Venture Capitalists Crowd Funding Incubators/Accelerators Banks Non-Banking Financial Institutions Government Loan Schemes Central Government State Governments Corporate Challenges Grant Programs of Private Entities

Era of Fund Raising

Now, start-up fundraising methods are evolving. Funds are being raised by start-ups by various modes of investment such as issuing CCPS, CSOPs, CCDs, etc.

Modes of Investment:

I. CCPS (Compulsory Convertible Preference Shares)

CCPS offer fixed income to the investors and compulsorily convert into Equity Shares of the issuing company after a predetermined period. The terms of conversion are also pre-decided at the time of issue.
CCPS are particularly offered to fill the gap between the valuation expectations of the founder and the investors that are generally linked to the performance of the Company. These offer investors the opportunity to participate in the growth of companies while mitigating the risk of lower valuation of companies that underachieve the targets. Issuing CCPS further benefits the Company’s promoters to raise funds without diluting the ownership at the initial period.

II. CSOP (Community Stock Options Pool)

A community Stock Option Pool is an option under which anyone is capable of buying the equity shares of the company. It involves all the financial rights of the shareholder, but does not involve any voting rights and is not present on the cap table.
A CSOP is a contractual agreement between the company and the investor. It is not treated as a security under the companies’ act. It comes under the section of revenue and also involves direct and indirect taxes.

There are two types of CSOP

1. Valuation Cap

The valuation cap of a CSOP means the maximum valuation that can be converted from an investment into equity shares.
For example, if you have invested Rs. 2,00,000 [2 lakhs] in a start-up at a valuation of Rs. 2,00,00,000 [2 crores], then you own 1% of the equity in the company.
Now, if the company goes into the next round of funding with a valuation of Rs 4,00,00,000 [4 crores], you’ll still hold 1% of the equity.
However, if the company decreases its valuation in the next round, let’s say Rs. 1,00,00,000 [1 crore], you will now have 2% of the company’s equity.

2. Discount Cap

Under the discount cap, an investor acquires the equity of the company at a reduced price.
For example, if you have invested Rs.2,00,000 in a start-up at a flat 30% discount cap, you’ll be priced at a discounted valuation when the start-up enters the next round of funding.
If the valuation of the company stands at Rs.2,00,00,000 [2 crores] during the funding round, then you’ll be priced at a 30% discount (0.70×2,00,00,000=1,40,00,000).
Eventually, you will now be owning 1.429% (2,00,00,000/1,40,00,000) instead of 1% (2,00,00,000/2,00,00,000) of the company.

III. CCD (Compulsory Convertible Debentures)

A Compulsory Convertible Debenture is a bond that should be converted into the form of equity shares at a specified date. It is a hybrid security, as it is not purely a stock or a bond.
A Debenture is either a medium or long-term debt security offered by a company to borrow funds at a determined rate of interest.
This does not cover any collateral, unlike corporate bonds, which are of investment grade. This security is issued only on the credibility of the issuing company.

There are four types of CCDs

1. CCDs At Fixed Valuation

Under this type of agreement, the debenture is fully converted into equity shares when the contract expires on a fixed valuation.
During the issuing time, the conversion ratio of the debenture is decided. When these debentures are converted into equity shares on the pre-determined date, these debenture holders automatically become the shareholders of the company.
The interest rate being paid on the debentures is only paid till they are converted into equity. Fully Convertible Debentures carry a lower interest rate than non-convertible debentures.
When the companies don’t have sufficient track records or data, they prefer going for the CCDs at a fixed valuation. This process even increases the equity capital of the company. Thus, these types of instruments are popular among investors.

2. CCDs With Discount Cap

When a Compulsory Convertible Debenture is signed at a discount cap, it means that during the time of conversion, the investor will receive the equity of the company at a discounted price.
This happens mostly when a start-up is unable to determine its value and, thus, offers a CCD to the investor.
For example, if an investor offers a company Rs.1,00,000 at a discounted price of 20%, then in the next round, if the company raises funds at a valuation of Rs.1,00,00,000, then the debenture holder will receive his shares at a price of [Rs.1,00,00,000-20%] Rs. 80,00,000.
This means that instead of receiving 1% of the equity, the investor will have 1.25% of the equity on the date of conversion.

3. CCDs With Valuation Floor/Cap

An investor is liable to receive the equity at the maximum valuation of the company under the valuation cap. Through this, even if the valuation of the company decreases in the future, the investor will receive his share of equity on the maximum valuation.
You can even opt for CCDs with a valuation floor. Under this, the debenture holder is eligible to receive equity on the pre-determined valuation floor no matter how much the valuation of the start-up has gone down.
The valuation floor is meant to protect the investors from suffering extreme losses. It provides a safe and reliable exit on their investments. This option ensures that the share price of the next financing round is set at the present minimum value.

4. CCDs With Both Discount Cap & Valuation Cap

The investors even have the option of opting for the Compulsory Convertible Debenture with both valuation cap and discount cap. The features of both these caps come together on the table.
This means that the investor gets his equity shares in both the maximum valuation of the company and at a discounted price.
This type of investment is considered beneficial and less risky for the investors as they get both the advantages in their investment.

Stages Of Funding:

I. Self-funding

An entrepreneur should ascertain how much amount he/she can contribute from his/her own pockets. Assess all of your investments and savings kept in multiple accounts, and approach your friends and family. This stage involves fewer complexities and documentation, and even your friends and family maybe ready to lend at a cheaper rate. Self-funding or bootstrapping is apt if your start-up requires a little investment earlier.

II. Seed-capital

Seed-capital is an investment made at the preliminary stage of the start-up. This helps the business in identifying and creating a perfect direction for their start-up. Funds raised at this stage are used for knowing the customers’ demands, preferences, and tastes, and then formulating a product or service accordingly. Most of the budding entrepreneurs raise this capital from friends, mentors, and family, while some take up loans in exchange for common stock.

III. Pre-Series A funding

Pre-Series A is typically defined by entrepreneurs as a mid-round between seed and Series A. VCs see pre-Series A round as seed-stage investment. It’s just a new label for start-ups that secured seed round and failed to convince venture capitalists for a Series-A round.

IV. Venture

When the company’s final products or services reach the market, venture capital funding comes into the picture. Regardless of the products’ profitability, every business considers using this stage that further involves multiple rounds of funding

V. Series A

Series A investment, being the very first round of funding, doesn’t ask for external funding. At this stage, start-ups have formulated a specific plan for their product or service. It is mostly used for marketing and improving your brand credibility, tapping new markets and helping the business grow.

VI. Series B

When a business relies on Series B investment, it portrays that the product is marketed right, and the customers are actually buying the product or service, as decided earlier. Such funding helps a business in paying salaries, hiring more staff, improving the infrastructure and establishing it as a global player.

VII. Series C

A start-up can receive as many rounds of investment as possible, there is no certain restriction on it. However, during Series C investment, the owners, as well as the investors, are pretty cautious about funding this round. The more the investment rounds, the more release of the business’ equity.

VIII. IPO (Initial Public Offering)

When a start-up decides to raise funds from the public including institutional investors as well as individuals, by selling its shares, it is known as an IPO (Initial Public Offering). IPO is commonly related to ‘going public’ as the general public now wants to invest in your company by buying shares.
It’s not an obligation for the founders to disclose their financial statements before public if they go for an IPO. But the company must submit information related to financial statements, the purpose of raising funds, etc. to the SEBI. IPO basically helps you grow and diversify in areas of choice. For taking your start-up to the next level, you should know which stage of funding you want to go for, for what purpose. Such decisions made at the right time can be boon for your business.
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