As an entrepreneur, there are many things circling your mind. In fact, your mind is 24×7 chock a bloc with ideas and adrenaline levels are constantly high. In this sea of ideas, one thought usually takes precedence and that thought is about capital. How much capital do you have, how much capital are you burning monthly, how many customers have yet to pay up, how will you pay your suppliers, when to raise capital, how much capital to raise, who to approach for capital, etc., all doing cart-wheels in your mind.
Needing capital is one thing, but sourcing capital is quite another. For one thing, it’s widely acknowledged as a “tough nut to crack”. Nevertheless, it doesn’t harm to be ready, at least procedurally. You may ask yourself – what are the various sources through which you can raise capital? Surely, you must have heard of an old adage – “there’s no free lunch”. Therefore, a more pertinent question to ask is this – what is it you can sell to raise capital? You need to give something to get capital.
The simplest answer to this that you can perhaps sell a portion of the company itself in lieu of capital. Well, as the company likely stands, it would not have raised any funds and you and your co-founders likely own 100% of it. What you can do is sell a portion of it, say 20%, for cash. And, depending on the way you structure this deal, the cash will come into the company. This, in investment circles, is known as a primary market equity fund infusion and is the most common way that a start-up accesses capital.
The dynamics of raising equity pivots around an indicative valuation or an assessment of how much is the company, prior to capital infusion, worth. This is not as easy as it sounds. Even though financial models exist to value mature companies, these models are hopelessly deficient in their ability to value of start-ups owing to their dynamic nature of cash flows and lack of predictability. In the end, only one valuation model applies. You guessed it – a company’s value is what someone would pay for it in the open market. Akin to pricing that gets set at auctions, the worth of the company is what the highest bidder would pay for it. This valuation is called pre-money valuation; it’s what the company is estimated to be worth before the fund-infusion.
The process of fund infusion (and consequent change in ownership) is best explained through an example. Let’s say that you and a potential equity investor arrive at a pre-money valuation of, say, Rs 2 crore. Based on your capital requirement, the ask from your side is say an infusion of Rs 50L. Prior to the infusion, you and your co-founders own 100% of the company. Since the infusion goes into the company coffers, naturally, post the infusion, the company should be worth Rs 2.5 cr; this includes Rs 2 cr from the pre-money valuation and Rs 50L which was just added to the company’s bank account. The investor who had put in Rs 50L got a slice from a Rs 2.5 cr pie. In percentage terms, s/he would get Rs 50L/Rs 2.5cr = 20% and you and your co-founders get left with 80%. Presented this way, you may feel a tad short-changed – your holding went from 100% to 80%. Well, you should not despair – you now own 80% of a bigger pie rather than 100% of a smaller pie, plus you have 50L in the bank to invest in the business, plus validation from an investor supporting your cause. It’s a good deal.
That’s the base mechanics of an equity infusion. Then there are other procedural elements as well – term sheets, share subscription agreement, due-diligence, investor rights vis-à-vis rights of promoters, constitution of a board of directors, etc. Needless to say, these are important aspects and appropriate care must be taken. However, if you’ve agreed on a pre-money valuation, agreed upon a quantum of funds to be infused and agreed upon a provisional set of rights for the investor, you’ve reached a stage where a majority of start-ups struggle to get to. You’re already in a select club. Yet, what remains vital is the ability to scale. Funds will only help in that.
And scale, unfortunately, is something that’s not easy to acquire. It has to be painstakingly built, one initiative at a time.
Aniket is a value investor, teaches Finance, Accounting and Economics related courses at Sunstone Business School, and is a Portfolio Manager with Willow Investment Management, LLC where he manages a long-only equity portfolio for Willow India One, a US based hedge fund. Aniket is passionate about capital markets and teaching, and spends most of his time reading or writing. Aniket is a graduate from IIT Delhi and an MBA from The University of Texas at Dallas.
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