Startup Funding Demystified – Stages and Sources

Nowadays, when we talk about funding, we tend to synonimize it with Venture Capital or third party investment. The case, however, is not so. Venture Capital/Angel Funding is only a part of the entire story. I see start-ups blindly running after VCs with their business pitch just after starting their ventures. 9-98.98% times either they return empty handed or compromise by diluting an unwelcome percentage of their stake. As a result all they get is a horde of bitter experiences and a deflated confidence. While in reality the start-up might not even require third party funding at this stage?So, where lays the problem?

 

Plato once said, “A good decision is based on knowledge and not on numbers”. True! If you do not have knowledge about your business, numbers or projections will not help. Through this article, we intend to provide the basic knowledge to start-ups about the various sources of funding available for financing their business along with their associated pros and cons.

Let us first analyze your start-up. Every venture typically goes through the following stages in its life cycle:

• Prototype: A better word for this might be “idea”. Basically this is the stage in which you start visualizing your product/service.

•   Starting Up: This is the stage wherein your idea gets validated and you move on with setting up your entity. You register your private limited company/Limited Liability Partnership (LLP). The main focus here is to build your product/service. It generally consists of the first one-two years of an entity.

             Related Article: What type of entity should I start with- Private Limited Company or LLP?

• Warm-Up Stage: This stage wherein actually revenue starts flowing into the entity. This is when you struggle to get the right kind of team and market your products.

            Related Article: Hire and Retain Top Employees for your Start-Up…Try ESOP!

• Expansion/Diversification: This is the stage wherein you have your set team, a ready market and steady revenue inflow to support your expenses. Now you start eying new product lines and new market capturing tactics.

•   Saturation: This is when your start-up is no longer a start-up. A large dedicated customer base, a well defined business model and set hierarchy. Your start-up has indeed come a long way!

Now, why am I giving you all these details and not even started on the funding sources? To put in plain and simple- If you do not know the disease, which medicine will you take? The type of funding required in Stage 1 will definitely not be same as that of Stage 5. Then why run after the same source for all stages? Makes sense, isn’t it?

Now, let us analyze the different sources of funding in detail:

1)  SEED CAPITAL:

As the name suggests, this is the initial amount invested is Stages 1 and 2. This amount can be introduced from Founder’s own savings or by way of loans from friends and family (legal consultation required).

Pros:

• You can retain ultimate control of your business.
• Funds are obtained quickly mostly due to personal relationships and hence no lag period.
• Investment terms are way too flexible.
• Since your money is invested into the business, it keeps you more involved in the business.

Cons:

• Founders might not have enough resources.
• Friends and Family may start interfering in the operations of the business.

Solution: Numerous seed funds are being started every day. A possible solution may be to connect with them. They not only assist with initial capital but also provide necessary insights and mentorship.

2)  INCUBATORS/ACCELERATORS/ENTREPRENEURSHIP CELLS:

These are entities run by Government organizations, seasoned entrepreneurs or leading educational institutes of the country. They usually invest in your idea, provide you a working space and help you connect with prospective investors. This sort of funding in very suitable for Stages 1 and 2.

Pros:

• You can retain control of your business since these organizations demand a marginal stake in your concern.
• They provide you with the much needed infrastructure for your entity.
• Investment terms are more or less flexible.
• Connecting with the right kind of accelerator paves the way for obtaining better investment in future.

Cons:

• Some accelerators demand huge stake in the company.
• Some accelerators do not really provide you with much inputs or value addition.

Solution: This is indeed a very good source of finance. However, a background check of the accelerators is advisable.

3)  BANK FINANCING:

This is a very good source of funding for stages 3,4 and 5. Bank loans are the most common source of financing. This is a flexible mode of securing funds without any pressure on equity.

Pros:

• Since this is a component of debt capital of the company, hence the equity structure remains unperturbed.
• Funds are obtained quickly mostly if your records are credible.

Cons:

• Paperwork may be tedious.
• You owe money to bank. Hence, interest pressure on company remains.

Solution: Special care should be taken while availing term loans. It is advisable to apply for short-term working capital loans as and when required.

4)  VENTURE CAPITAL:

These are generally investment firms who have the potential of pumping large amounts of money in exchange of for equity in the company. VCs are professional investors.

ROUNDS OF VC FINANCING:

There can be multiple rounds of VC funding. Each round is typically denoted by a letter of the alphabet (Series A, B, C).

Interesting thing about VC financing is that usually it is received in exchange of convertible preference shares or Cumulative Convertible Preference Shares (CCPS). Hereby, the investors are secured about their privileges and enjoy preferential rights till they gain equity ownership.

The different VC rounds reflect different valuations. Usually a Series B funding will see a higher valuation than that of Series A. There can also be a “Down Round”, wherein the valuation of the current round will be lower than the previous series. However, this is not a very common scenario.

Pros:

• VCs can provide you with large sum of money. This fuels the growth of the company at much faster pace.
• Not only funds but sometimes they also provide the technical expertise and other assistance.
• Generally VC funded companies enjoy great degree of credibility in the market.
• Connection with a VC in turn opens the window for multiple other connections.

Cons:

• They generally do not look for Stages 1 and 2 start-ups.
• They can be ruthless about the results of their investments.
• They can even replace the Founders if they feel they are not up to the job.

Solution: VC Funding is your big ticket to enter into the big corporate arena. However, you must be very careful while striking the deal with them.

          Related Article: Side Effects of Funding

5)  MEZZANINE FINANCING & BRIDGE LOANS

Once a company receives VC funding, the start-up feel is washed away. The next important stage that would be in the horizon is Initial Public Offering (IPO). The need of the company grows and the funding sources for Stages 1, 2, 3 and 4 can no longer suffice the requirement. Usually the following options are now considered:

• An IPO (initial public offering)
• An Acquisition of a Competitor
• A Management Buyout

Till the time the company carries out either of this, the company may opt for mezzanine financing or “bridge” financing. As the name suggests, these are short term financial assistance which are often used 6 to 12 months before an IPO.

These are some of the most common sources of funding for a start-up. As you can see now, every stage in the life cycle of a start-up is unique. So are the choices.

Taxmantra has been impacting a number of start-ups in Funding Related matters like choosing the right source of funding, review of term sheets, due diligence check and preparation of business plans.

Are you planning a pitch next? Make sure you have analyzed your options well.

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