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Once a start-up reaches a certain size, it cannot grow further without raising capital. While most entrepreneurs will know in advance when such a stage is about to be reached, it is important to know what level and kind of funding is required. While too little money has obvious consequences, too much money (or a valuation that seems too high) can result in subsequent rounds of investment becoming difficult. This article discusses the different stages and types of investment in a startup, and how and when an entrepreneur can go about seeking it.
Pre-seed: bootstrapping, friends and family and accelerators
In the very beginning, a startup is likely to get off the ground with funds pooled in by its co-founders, in order to give shape to their idea. In startup lingo, this is referred to as bootstrap funding. Bootstrapping yourself is a great idea in the beginning, because it makes you cautious of your spending, and will get the most bang for your buck, since there won't be very much to go around. An added advantage, if you get lucky and are able to plough back revenues, will be having a free reign in your company without having to deal with an investor's needs. At the same time, monetary constraints, especially in businesses that may not have a fast growth trajectory leading to an early break-even or profitability, can stifle a business - growth. At this stage, you would want to go out and look to attract external funding for your business.
The term incubator and accelerator are commonly thrown about, sometimes interchangeably, although wrongly so. Although both have somewhat similar outcomes, they do differ in certain critical aspects. In addition to business advice, an accelerator will typically offer you a small amount of initial funding in exchange for a correspondingly small chunk of equity in your company. An incubator on the other hand will usually offer the environment and networks in order for a business to take shape and ready itself for growth and investment.
A friends and family (F&F) round of funding can be likened to a targeted crowdfunding campaign. This round has, as the name rightly suggests, entrepreneurs reaching out to people they know personally, sometimes (if you're lucky) high net worth individuals, and asking them to come on board as investors in exchange for a not-so-large sum of money. An F&F round has some clear advantages and disadvantages. On the upside, both parties are familiar with each other, which brings a certain level of comfort and assurance to the investment. On the flipside, this very relationship can sometimes lead to things getting sour if and when either party is unable to keep up its end of the deal. To make the best of an F&F endeavour, be sure to target people who maybe existing investors in other businesses, or at least, professionals who have experience in their own industries and understand what you're offering, what they've got at stake, and can offer useful business advice when you need it. From an Indian context, although this will vary on the funds required and people approached, entrepreneurs can look to raise between Rs 10 lakh and Rs 50 lakh from an F&F round, with the investors picking up under 5% of your total share capital.
Seed funding
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The first formal funding a startup will receive is in what is called a 'seed round'. The objective of this round will be to enable you to take your product out into the world and see how well it sells. A traditional seed round will see a startup raising capital from angel investors and, in some cases, early stage venture capital (VC) investors. Angel investors are typically people with an industry background, and are regular investors in young businesses. At times, a group of angel investors may invest as a group, with a lead angel investor syndicating the investment, and other angel investors co-funding the investment, with a possible follow on 'pre series A' round of investment, before the 'alphabet' rounds (discussed below) come in. Most angel and early stage VC investors will exit in subsequent funding rounds, and will not be looking to be long-term investors in your business.
More recently, crowd-funding has become a prominent source of raising seed capital for startups globally. However, the law around equity crowdfunding in India is still evolving and in the absence of formal regulation (since it involves raising money from the public in exchange for securities being offered), it is not a prominent avenue for raising funds for the time being.
At a seed funding stage, a promising startup could raise anything between Rs 1 crore and Rs 3 crore, in exchange for around 20% stake in the company. As you receive your first formal round of funding, it is easy to get carried away with the excitement, but it is imperative that you get a fair deal from your initial investors, and don't end up offering them too much stake or too many rights, both of which could come back to haunt your company later. This will be discussed in greater detail in the course of this series.
Growth funding - alphabet rounds
This is where things start to get really interesting. If you have managed to fashion a successful business out of your idea, the world is your oyster and the venture capital brigade will start lining up to fund your business and ride the wave of success with it. Growth funding, or alphabet rounds will see traditional VC investors coming on board to your company and pumping in vast amounts of capital in comparison with earlier rounds. The amount itself will depend on the investor and your company, and Series A investments going into the tens of millions of dollars are well precedented. Series A VC investors will look to pick up 15-30% stake in your company in return for their investment. A following Series B round will bring the necessary funds required to scale up your business further. These rounds of funding come with their own set of nitty-gritties, as structures, rights and obligations get more complex. Things like anti-dilution for existing investors in your business, as well as exit rights for them and new investors are also factors that need careful attention. At this stage, your company is likely to get formal legal advice independent of the incoming investors, on how to best structure the investment to your benefit from a legal perspective. This is also a stage where the founders can start to negotiate their needs a little more aggressively.
Series C and beyond
Matured companies, a few years into their operations once the business has a good track record of revenues and profits, with the promise of further scalability, can look to attract series C investments. At this stage, the key investors are likely to be private equity players and investment banks, and investments can go into hundreds of millions of dollars. As with earlier rounds, the legal complexities around these investments should be carefully addressed in order to make sure the founders' objectives are continuously met, and the investors, both existing and incoming, are able to function harmoniously within your setup.
There is no stipulated cap on how many rounds of funding a company can take, and many go on to raise further funding from existing and new investors, and also explore the option of going public with an IPO down the line.
Shivpriya Nanda - The author is a Partner with JSA, Advocates and Solicitors. The views expressed here are her own.
Arnav Joshi, associate with JSA, Advocates and Solicitors, contributed to this article.
