Article by Eshani Jain.
All businesses need a consistent and predictable stream of finance for their daily as well as long-term operations. Finance for short-term operations is known as working capital financing and long-term financing helps you manage and improve your startup’s finances.
In this article, I will go through various ways in which your startup can raise money for itself. I will also break down each of the fund-raising processes and analyze the pros and cons of each steps.
I will also briefly touch upon the legalities involved in each of the fund raising routes that startups can take.
Startup Funding via Equity Finance
Equity finance is the way of raising capital by selling the ownership of the company in the form of shares.
In course of the initial stages of a company’s growth, when it does not have sufficient revenues, cash flow, or assets to act as collateral, equity financing can attract capital from early-stage investors who are ready to take risks along with the entrepreneur.
Regulations guiding Equity Financing for Businesses in India
Equity financing for private companies is regulated by the Companies Act, 2013 and the Companies (Share Capital and Debenture) Rules, 2014.
However, for startups going public, they fall into the regulatory ambit of The Securities & Exchange Board of India (SEBI) under the SEBI Act, 1992.
Businesses looking to raise capital from outside India, fall under the regulatory ambit of RBI under the Reserve Bank of India, which has issued several regulations on the matter under the Foreign Exchange Management Act.
There are several regulations on the subject, so it is advised that you consult a lawyer in case you are thinking of raising funds from outside India.
That said, here are the businesses and individuals who provide startups with investments so as to fund their operations –
#1. Angel Investors or Angel Investment Funds are Help Provide Investment to Startups in the First Leg of their Journey
These are individuals who provide capital for a business start-up in exchange for ownership equity or convertible debt in the company.
Angel investors support firms in their initialization stage when it’s difficult for them to obtain funds from traditional sources of finance such as banks, financial institutions, etc.
They usually invest online through equity crowdfunding or by organizing themselves into angel groups or angel networks to share investment capital.
Keep in mind that the Angel Funds and Angel Networks in India are regulated by the SEBI (Alternate Investment Funds) Regulations, 2012.
There are various Angel Investors and Angel Investment Networks in India that are actively working to fund startups, such as:
- Indian Angel Network
- Chennai Angels
- Mumbai Angles
#2. Venture Capital are Key in Startup Funding
It is a form of private equity investment made in start-up companies at their early stage. Venture capital firms or funds invest in startups that they expect to have high growth potential in return for equity or ownership stake in these companies.
Since startups face a high rate of uncertainty, Venture Capital investments face a high risk of failure. The startups they invest in are usually in the field of software, information technology, biotechnology, and other high technology industries.
Venture capitalists generally invest in a company for a duration of three to seven years or till the company goes for an IPO. Venture Capitalists act as great guides to the entrepreneurs in making important decisions related to the startup.
Venture Capital Financing has been classified into 3 types based on its application at various stages, which are:
- Early Stage Financing – This comes with high risk, as usually you have an untested product or just a proof of concept
- Expansion Financing – This comes with moderately lower risk as your MVP has most likely been accepted by the masses and therefore you are trying to expand.
- Acquisition Financing – This is when a startup owner is trying to sell his startup to a venture capital firm.
How Venture Capitalists See-Through a Deal for Funding a Startup
If you want to capture a deal with a venture capitalist, you need to see his side when he makes a deal. For that, you need to understand how a venture capital process works. Here’s the steps broken down for you.
#1. Establish Fund
It involves planning for investment objectives and exploring ways to generate capital for investment.
Why is this important for you?
This is important, as you need to ensure you are pitching to the right venture capital investors. A venture capital fund geared for investment in infrastructure startups is unlikely to invest in a SaaS startup.
This is why you need to do your research thoroughly and ensure you are pitching to a venture capital investor who invests in your niche and in your startup’s growth stage.
#2. Deal Flow
Venture Capitalists carry out activities to create opportunities or to find the best ones available.
Why is this important for you?
Here’s where you need to outshine the competition. You need to understand the venture capitalist has a limited budget and is going to invest in businesses with the maximum ROI.
That’s why you need to have an MVP that’s tested and a startup that is ready to grow and has the seven marketing functions aligned with it.
#3. Decisions for Investment
This stage involves screening and evaluating the deal. Investors may look into the entrepreneur’s personality and if the startup suffers from any form of marketing myopia or is aligned with the 21st century marketing principles and mix.
It also involves negotiating the structure of the deal.
#4. Monitoring and Value Addition
They develop various strategies regarding their working pattern in the company and take up certain rights and duties. They may also ask for advisory shares in the startup.
Also, you may need a share purchase agreement for your startup.
#5. Exit Plan
It is the last stage in venture capital financing.
Here, they develop the plan for exiting the company based on the nature of investment, extent, and type of financial stake, etc. The main motive of the plan is to make minimum losses and maximum profits.
Pros and Cons of Equity Financing
As with any form of startup funding in India, there are both benefits and drawbacks involved.
Pros of Startup Funding via Equity Financing
- The biggest advantage is that the investor assumes all the risk and if by chance the business does not succeed, you don’t have to pay back the money. Thus, making it way less risky than debt financing.
- Since there are no loans to be paid back, all the cash and profit available can be reinvested in the business.
- Equity financed businesses don’t have to pay interest to their shareholders; they only have to share a part of their profits.
- There is no obligation to repay the money acquired through equity financing.
- It does not take funds out of the business and so has no impact on the cash flow of the startup.
Cons of Startup Funding via Equity Financing
- The business is required to share the control and ownership of the company with the investors.
- The company may have to share its profits in the form of dividends with the investors.
- Availing equity finance is a complex process and it requires the business to share its monthly, quarterly as well as annual reports with the investors and shareholders as well as fulfill several compliances as agreed to by the original shareholder in the share purchase agreement.
- It can lead to a conflict due to deferring interests of the investors.
- Approaching investors is time-consuming and expensive.
Debt Financing for Funding Startups in India
It is a way by which a company raises capital by borrowing money from an external source for a specific period and has to repay the principal amount along with a sum of interest at an interest rate depending upon the agreement.
The interest may be paid throughout the period of the contract or when the contract for debt ends.
Such borrowing doesn’t result in loss of ownership of the company like that in equity financing.
Various Methods of Debt Financing for Indian Startups are as follows:
Indian credit system is fairly new as creditors had a tough time recovering loans. With the advent of the Insolvency and Bankruptcy Code, 2016, this has changed and credit financing for startups have opened up.
#1. Loans from Banks and Financial Institutions
It is one of the most popular forms of debt financing.
Businesses borrow money from the banks or financial institutions for a specific period on expiry of which they have to return the borrowed amount along with the sum of interest charged.
Usually a startup has to provide a collateral and/or a guarantee to the bank as a security against the loan.
A person with low income can also use a mutual fund as collateral for the loan. However, loans do not result in any sort of loss of equity stake in the company or dilution of controlling and managing power.
Loans generally have many tax benefits as well. There are various types of loans based on the requirements of the business such as:
- Unsecured Business Loans
- Secured Business Loans
- Small Business Loans
- Equipment Loans (You would be better off using a manufacturing contract or a finance lease, if you are too short of money.)
Loans can also be short-term, intermediate, and long-term based on the need of the business.
A short term loan is a loan with a tenure of one to twelve months, a medium-term/ intermediate loan has a tenure of one to five years and a long term loan has a tenure of more than five years and is generally a secured loan.
#2. Credit Guarantee Fund Trust for Micro and Small Enterprises
CGTMSE, a government launched initiative by the Ministry of Medium, Small and Micro Enterprises (MSME) in association with the Small Industries Development Bank of India (SIDBI).
Its motive is to provide hassle-free and collateral-free loans to the rising entrepreneurs and helping them to realize their dreams.
All designated commercial banks and Regional Rural Banks (RRBs), including NSIC, NEFDi, and SIDBI are eligible lending institutions under the CGTMSE scheme and both new and existing micro and small enterprises including service enterprises are eligible for a maximum credit capacity of Rs. 200 lakhs.
#3. Micro Units Development and Refinance Agency Ltd. (MUDRA)
It is an NBFC supported the development of the micro-enterprise sector of the country. It provides refinance support to Banks/NBFCs/MIFs for lending finance to micro units having a loan requirement up to 10 lakhs of rupees. The various schemes of loans are categorized into 3 types:
First, ‘Shishu’ covering loans up to 50,000. Second, ‘Kishore’ covering loans above 50,000 up to 5 lakh and third ‘Tarun’ covering loans above 5 lakhs up to 10 lakhs.
It provides refinance under the Scheme of Pradhan Mantri MUDRA Yojana.
The objective of the MUDRA loan is to promote entrepreneurship among the youth of the country. It extends loans for numerous purposes such as:
- Loans for Vendors, Traders, and other Service Sector activities
- Working Capital loans
- Equipment Finance
- Transport vehicle loans (commercial only)
- Loans for agriculture allied non-farm income-generating activities, etc.
- Textile Products Sector / Activity
- Food Products Sector
#4. External Commercial Borrowing (ECB)
This is an instrument that facilitates access to foreign capital by Indian enterprise and PSUs. It is a loan made by non-resident lenders to Indian businesses in the form of foreign currency.
It comprises of commercial bank loans, buyers’ and suppliers’ credit, floating-rate notes, etc.
ECB’s also includes credit from formal export credit agencies and commercial borrowings from the private sector window of multinational financial institutions such as International Finance Corporation (Washington), ADB, AFIC, etc.
However, funds raised from ECBs cannot be used for investment in the stock market or speculation in real estate. The ECB guidelines and policies are regulated and monitored by the Department of Economic Affairs.
However, startups cannot borrow money through ECB by Overseas branches or subsidiaries of Indian banks according to the RBI. The maximum interest rate at which startups can raise money depends upon the agreement between the lender and the borrower. ECBs are regulated by the Foreign Exchange Management (Borrowing and Lending) Regulations, 2018 and the Foreign Exchange Management (Guarantees) Regulations, 2000.
The master circular (link here) issued by the RBI provides details on funding your startup via ECB.
Pros and Cons of Debt Financing for Raising Capital for Startups in India
Debt financing is a riskier form of financing, but is much more rewarding. That’s because you still have your startup’s ownership with you and your stake does not get diluted. Here’s an analysis of the benefits and drawbacks associated with debt financing –
Pros of Debt Financing for Funding Startups in India
- The entrepreneur/organization retains full ownership and control.
- It provides a tax benefit as the interest paid on debt is tax-deductible; thereby it reduces the net obligation.
- It allows you to retain profits since your only obligation is to repay the money to the lender.
Cons of Debt Financing for Funding Startups in India
- It has various qualification requirements, such as good credit ratings and a multitude of documentation.
- You are often made personally responsible for the repayment of the entire debt amount along with the interest as you are made a personal guarantor for the loan, thus defeating the reason behind using a corporate personality for doing business.
- Since banks are very conservative, it is difficult for a new startup to easily get a loan.
- Collateral is the almost always required to be mortgaged to be granted a loan.
- A business needs to be sure that it will be able to generate continuous cash flow cause it will have to repay the interest and principal amount on the exact due date or else face penalty.
- High-interest rates
- Debt hinders the growth of a business as most of the revenue is utilized in repaying the debt.
- If a company has a high debt, it becomes difficult to attract equity investors because high debt is associated with high risk.
Unconventional Financing Mediums for Startups to Raise Capital
The finance industry is pivotal to the economic world has developed immensely over the past few years and so has given birth to various new modes of financing other than the traditional methods of debt and equity financing.
These unconventional and contemporary methods of finance have spread upon their roots and created a high reputation and a huge market for themselves.
Few of these unconventional methods of funding are as follows:
Crowd Funding for Startups
It is a form of crowdsourcing and alternative finance.
In crowdfunding, an entrepreneur showcases his idea on an online venue like Wishberry, BitGiving, Fuel a Dream etc., before a large group of people and convinces them about the utility and success of the idea by sharing with them his vision and mission.
As an entrepreneur, you also need to showcase the impact of your business on the community, as well as potential rewards, and returns for the crowdfunding participants, etc.
This allows an entrepreneur to fund his venture by raising small amounts of money from various sources. Crowdfunding is used to fund a wide range of entrepreneurial projects such as creative and artistic projects, medical expenses, community-oriented social projects, etc.
It is not only a great place to market your product and attract the required media attention but also to get instant access to market feedback.
It allows an entrepreneur to benefit from information flow and accrue low-cost capital from around the globe by selling their product and equity.
Four general types of Crowdfunding are as follow:
- Rewards-based Crowdfunding: It is a form of funding campaign under which the investors are given different rewards in the form of services or products which the company produces depending upon their amount of investment. Generally, there are 3 levels of rewards based on the levels of contribution.
- Equity-based Crowdfunding: In this form of crowdfunding an investor expects to receive a part of ownership in the company in return for his amount of investment.
- Debt-based Crowdfunding: In this type of funding campaign people lend money to the entrepreneur on the commitment that he will repay it along with interest after a certain period.
- Donation-based Crowdfunding: In donation-based crowdfunding, the entrepreneur doesn’t have to give anything in return to the investors for their funds since they invest to support the idea or cause of the company.
Startup Incubators for Providing an Alternate Means of Finance?
Startup incubators are generally non-profit entities that are run by both public and private entities.
They are often associated with universities and business colleges. A business incubator helps startups through their early stages of development by providing workspace, seed funding, support staff, mentoring, business advice, contacts, and capital.
They also help with regulatory compliance, technological commercialization, and intellectual property management. Incubators also assist in accounting and financial management and business etiquette.
In return for providing various services, incubators either own a stake in the company or charge a monthly fee that covers the major services provided by them.
Incubators are very selective in admitting companies to their programs and their acceptance criteria vary through each program.
The 3 stages of Business Incubation Development are as follows:
- Pre-Incubation Stage: includes the activities carried out to shape the business idea, model, and plan into a reality.
- Incubation Stage: includes all activities carried out to support the startup to reach the expansion stage.
- Post Incubation Stage/SME: includes activities that are carried out at the point when the startup is ready to walk on its own feet.
Accelerators are a Great Option for Startups in Dire Need of Financing
Accelerators for startups also known as seed startups are fixed-term, cohort-based, and mentorship-driven programs. Accelerator program offers seed money to startups in exchange for equity shares in the company.
Startups not only benefit in the form of seed money under this program but they also get to learn about the legal side of the business, the practice of pitching, and a multitude of valuable information about how a company works through various seminars and workshops organized.
They invest in the business only at their early stage and for a duration not more than 3-6 months.
Accelerators have primarily evolved from incubators yet they both have many differences and are affected by different environmental factors. Accelerators have gained immense popularization lately because of their positive impact on regional entrepreneurial ecosystems.
They are considered unique because of their 4 distinct characteristics, which are:
- they are fixed-term,
- culminate in graduation, or “demo day.”
These 4 characteristics collectively are not possessed by any other early-stage financing programs listed here.
Bootstrapping – A Viable Way for Startups to Fund Themselves?
Hint: Not always!
It is a method of financing in which the entrepreneur finances himself, putting to use his personal savings, sweat equity, lean operations, and quick inventory turnover.
It is beneficial since it allows the entrepreneur to maintain full control over his business and operations and provides him a sense of freedom of experimentation, as he is not answerable to any other investor.
It also allows the entrepreneur to focus all his energy and efforts on the business model and business idea as well as SWOT test them and the product instead of pitching for venture capitalists and other sources of capital.
However, it places a huge financial risk on the entrepreneur and may limit the growth of the company due to restricted finance.
Restricted finance can undermine the quality of the product and prevent promotion. Here’s how you can test if bootstrapping will be right for you or not.
A few of many successful examples of Bootstrapping are Spanx, Tough Mudder, Electronic Data Systems, etc.
Questions to Ask Yourself before Deciding Your Ideal Startup Financing Medium-
- How much equity of my company am I comfortable giving up?
- Am I comfortable giving up a part of the ownership of my company in return for advice and services?
- Do I want to raise funds from a platform that is open to the public (in the context of crowdfunding)?
- Does my business fit the investment program profiles?
- Will my business be able to generate the necessary cash flow if I opt for debt financing?
- Do I have a good credit rating?
- Do I have enough savings that will give an opening push to my business?
- Am I prepared to share the controlling power of my company?
- Do I only need funds or guidance as well?
- How much capital do I need to achieve my goal?
- Are there any tax benefits?
- What business category does my startup fall in?
- What do I want to risk for raising funds?
- What will be my method of repayment?
- What are the market interest rates?
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Author Bio: Eshani Jain, the author of this article is an analyst at KPMG. She was an intern at WinSavvy.