Traditionally-driven business people understand business in the context of buying & selling of products or services only. You manufacture products or purchase products from a manufacturer and then sell them for profit or margin. And when it comes to investments, most people don’t know anything further than just stocks and real estate.
At present, many traditionally-driven businesses like Tata, Reliance and many others are not dependent on the traditional customs only, they utilise their wealth by investing in new-age startups established mostly by the millennials. A great example of which is Embibe, a Bengaluru-based edtech (education technology) startup in which Mukesh Ambani of Reliance Industries has invested twice. The first funding round came for Embibe from Reliance in February and the second one was in April when Mukesh Ambani invested INR 500 crore in Embibe as a part of his revival plans in the wake of COVID-19 crisis.
On this note, let us now talk about all things you need to know if you are thinking of an idea, running a startup or planning to raise funds.
How does startup funding work?
- What is Equity Financing?
- What is Valuation?
- What is Post-Money Valuation?
- How startup founders make money?
- How startup investors make money?
- How do funding rounds work?
- Other Startup funding FAQs
Let’s just talk about startup funding in light of equity financing or equity-based funding since it is an ideal method of raising funds and utilising capital to grow a startup. We’ll learn about it by answering common questions asked by aspiring and newbie entrepreneurs.
1. What is Equity Financing?
Equity financing is simply the funds raised from an investor in exchange for an equity percentage. Let’s understand this with an example: Suppose you raise $100K from an investor and assign her/him a 5 percent or 10 percent equity in your company by issuing 100K shares at the rate of $1 per share.
2. What is valuation?
In layman’s words, valuation is simply the total value of a startup. Suppose you are running a startup for 1 year, then in order to raise funds or sell your entire company, you need to calculate your startup’s valuation. Now there are certain factors that add up to form valuation. Let’s understand how valuation is calculated in case of a bootstrapped startup(a startup that hasn’t raised any funds yet). Suppose you are running a startup for 1 year and haven’t raised funds yet then your valuation or pre-money valuation would be calculated by adding all factors such as:
- User base or subscriber base
- Website traffic
- Revenue earned
- Financial projections moving forward
3. What is post-money valuation?
Suppose you have raised a sum of $100K from an investor then this sum will be added to your pre-money valuation i.e. $130K, and your post-money valuation will come out to be as $230K. And when you expand your operations, user base and scale your revenue, your valuation increases.
4. How startup founders make money?
You must have witnessed that most of the startups start with an idea of raising funds and their initial focus is not on generating revenue but the user base or subscriber base. Why? Because the user base or subscribers are added to a startup’s valuation straight. This is why they have the capacity to offer their products and services very cheap or free initially. Startup founders come up with an idea, a product or service and offer it for cheap or free in order to build pre-money valuation (valuation before raising funds), raise funds, get fixed monthly salary that comes from the funds that they have raised, and after that, they work on scaling their operations and earn revenue. So, startup founders enjoy a dual benefit:
- They get a good sum in the form of funding against the equity they have given to the investors. And they have a fixed monthly salary for themselves and their employees.
- They utilise the capital to earn revenue and the revenue goes into the company’s bank account straight.
5. How startup investors make money?
Now that we know how equity funding works, and how startup founders make money, let’s now dive into ‘how startup investors make money’.
As we discussed above that the valuation of a startup is based on various factors and as you scale your business, your startup’s valuation increases. Hence, the share value of your investor also increases. And to make money out of her/his investment in your startup, the investor sells a percentage of the equity to another investor for a higher amount and gets paid in the bank. This means that a percentage of the equity of your first investor will be transferred to another investor, and now you have another investor sitting in your board.
6. How do funding rounds work?
A startups journey of financing is sub-divided into various funding stages which are called as funding rounds. Here’s the elaboration of each funding round:
A pre-seed round is the very first funding round that applies to a startup that is in the idea stage and aiming to work on building a prototype or MVP (Minimum Viable Product). By raising a pre-seed investment, a startup gains initial capital to create a proof-of-concept and create a salable product or service.
A seed round is the first funding round that applies to startups which have a proof-of-concept and MVP to fulfil market’s need. A seed funding round affirms the proof of concept of business and yield initial boost.
Series A Round
The first round of investment after the seed funding in which angel investors or VCs invest an average of $2 to $10 million in exchange for equity. A startup or company qualifies for Series A round once it establishes a substantial userbase, functional business model and displays certain key performance indicators depending on the business model. Series A funds are raised with the aim of optimising a startup’s offering, pace-up product development and get ready for promotion.
Series B Round
B stands for build, once a startup passes through product development, investors contribute money to help the startup extend its reach into the market and work on product positioning. Companies deploy these funds in rigorous talent acquisition and brand or product promotion.
Series C Round
Startups which pass through Seed, Series A and Series B rounds are successful enough to acquire or acqui-hire other businesses, particularly a smaller competitor. And for that, they need additional funding i.e. a Series C round to attain purchasing power. When a startup passes through the Series C round is able to tackle competition, expand its reach and tap into new markets and products to ultimately establish itself as a market leader in its industry or sector. After raising a Series C round, a startup also gains the potential to establish new subsidiary businesses and headquarters across different geographies.
Most startups usually end up raising funds after Series C rounds to put stop to the external equity, but there are certain companies who go beyond Series C to Series D and further to Series F. For example, Unicorns like India’s OYO and Dubai’s Careem have reached Series F Round.
7. Other Startup funding FAQs
If you’ve read thoroughly till here, I believe most of your questions and doubts related to startup funding have been addressed. Here are a few more questions and answers to create absolute clarity for you:
What is burn rate?
The Burn Rate is the negative cash flow of a company. It shows how quickly the startup is spending its capital. Burn rate is essential for determining how much cash the company needs to keep for operating and growing. The burn rate is usually quoted in terms of cash spent per month. Understanding this with an example: Suppose you raise $120K in a seed funding round to sustain for the next 12 months, then you’ll have the opportunity to deploy $10K every month towards founders’ and employees’ salaries, and all other expenses. In this case, your average monthly burn is $10K. And you can use these simple formulas to calculate burn rate (percentage).
What if a startup doesn’t make revenue?
You raise funds for a stipulated period which is called as your sustainability period. When you run out of funds, you need to raise another round of investment to sustain. However, generating revenue is critical since it adds up to increase your startup’s valuation. And revenue is always good for your existing investors since they want their equity per share (EPS) to be valued hire so that they can sell their equity shares to other investors to get profitable returns on their investment in your startup.
If you don’t focus on making a revenue than you might end up adding more and more investors in your board by giving out a majority of your startup’s stake in the company and in a worst case scenario, you might get voted out of the company if your investors (also your startup’s board of directors) lose interest and faith in you. If you have seen Spiderman-2020, there is a short sequence in which Norman Osborn gets kicked out by the board of his company Oscorp.
Does startup investors become partners or co-founders?
No, an investor invests money for an equity percentage in your company and joins the board. They get their returns by selling their equity to another investor when the valuation of your company increases. However, there is an option for a strategic partner. Various angel groups or angel funds invest in startups for an equity and at the same time, they also give entry to one of their members as a co-founder in your company upon your approval. Such a partner is called as a strategic partner that joins your company to guide you and to drive growth. A strategic partner can take a role based on the gaps your investors identify in your company such as a CEO, CTO, CFO, COO or any other. However, a strategic partner can be a good or bad choice depending on the type of business.
What should be the ideal equity a startup should give out in case of a pre-seed or seed funding round?
Well, if you have watched Shark Tank, you would have ascertained that startup founders feel great pain while giving out stakes like 15 percent or 20 percent in their early stages. Why, because it is not ideal for an early-stage startup to give out heavy equity just for the sake of funding. The ideal range is 5 percent to 10 percent maximum if you are on a pre-seed or seed level.
What factors are considered by the Investors to invest in startups?
Well, this can be a never-ending list since there is no perfect set of rules which investors use. All investors look into different metrics depending upon the sector or types of businesses they invest in. If you actively read startup news and stories, I bet you must have come across startups which look like complete replicas of existing businesses, and they don’t have any sufficient user base and presence online. Still, they claim that they are innovative and unique, they even get funded easily and you couldn’t resist that because you might yourself be working really hard, attained good numbers and still struggling to get funded. But that doesn’t mean that you ignore certain key factors that can help you boost investors’ interest in your startup, such as:
- Establishing a good presence online across different social media channels
- Designing an attractive and user-friendly platform and keep working on scaling traffic or user base
- Accumulating email subscribers
- Work on scaling social media engagement and keep recording the same
- Create a flagship revenue model or at least an MVP (Minimum Viable Product)
- Work on creating and activating additional revenue streams. Investors really love startups already generating revenue since it is the key counterpart of your startup’s valuation.
Do investors have the right to ask for a money-back?
In case of equity funding, an investor can’t ask for a money back since this what they sign up for, giving money in exchange of an equity and the only route for them to make returns on their investment is by selling their entire stake in tranches and take exit from your company some day.
But in the case of debt-based funding, an investor invests in your company in exchange for debentures. These debentures are convertible, meaning that these can be converted into equities partially or fully within a particular time-frame as discussed by the company and the investors. These conditions and guidelines are noted in the term sheet and then in the MoA (Memorandum of Association) which has to signed and approved by a concerned government body such as the Ministry of Corporate Affairs (MCA) in India.
Once the debentures are converted into equity, the investor can’t redeem them but in case of partially convertible debentures, an investor can redeem the amount invested against the non-converted debentures.
Debt-financing is not a recommended means of financing for early stage or even growth stage startups. It is more common among late-stage startups or companies.
What is a Term Sheet?
A document that lists down the basic terms and conditions associated with the investment in a startup or business. Once both the parties i.e. the business and the investors agree to the terms listed in the term sheet, a binding agreement is done between the parties to affirm the details of the term sheet. Your startup’s valuation, the equity that you are offering to the investor(s) and financial projections and other required information is listed in the term sheet.
If you would like to gain absolute clarity on various startup terms such as: Pivot, Vesting, Lean Startup, Lean Canvas, Convertible Debt, Recapitalisation, Soonicorn, Dragon, Bubble, Laggard, Shoestring, then you should read this article on 40+ Startup Terms Every Startup Founder & Entrepreneur should know.
This article is intended to educate and address common yet vital questions among aspiring and newbie entrepreneurs in the simplest language possible. I have drafted this article with the best of my knowledge, but as I believe, there is always scope for improvement. So, if you find any errors or have any suggestions for the content and questions covered in this article, please let me know in the comments below.