Understanding Startup Investments

How does startup funding work?

It is necessary to identify the different participants before examining how a round of funding works. First, there are individuals looking to gain funding for their business. As a business matures, it progresses through the fundraising stages; it’s common for a company to begin with a seed round and then continue with A, B and C funding rounds. Startups raise multiple rounds of funding, from their initial ‘seed’ money to Series A, B and so on. Each round is often larger than the previous one and at a greater share price. The company issues new shares in exchange for money from investors in each round. The founders’ stake reduces after each round.

Founders may have a lower stake in mature companies, say less than 10%, but these shares grow in value over time. Founders prefer diluting less with each round. Many founders dilute 15-30% in their initial round, but later sell only 0.5 or 1-2% of their shares because they are now quite valuable. This varies as per the company’s agenda and is subject to change as per the conditions applicable during the funding round.

Does the money come in all at once?

Although it differs from case to case, top entrepreneurs prefer to get funds in one go rather than in installments. In a market where founders set the terms, transferring money in tranches is uncommon, even for large rounds of $100 million. However, this decision to transfer money either in one go or in tranches is subject to vary as per the requirements of the entrepreneurs and their nature of business, amongst other factors.

Some early-stage Venture Capitals (VCs) would want to provide the money in 2-3 installments over the course of a year or two to encourage the entrepreneur to be careful. The entrepreneur may realise the importance of receiving the money in tranches, when they have to carefully decide how to allocate this amount and grow while utilising it to the fullest.

Can investors send all the money in one go?

Yes, they can. However, in some cases, particularly with private equity investments for traditional companies, funding is also conditional on meeting performance targets. The money is raised not only in exchange for company shares, but also in exchange for revenue milestones, market shares or other metrics. Although this is less prevalent in technological firms because milestones are more difficult to achieve, the rationale is that not giving all the money up front keeps the founder/company motivated.

These investments are essentially made based on trusting the founder, which includes giving the money upfront. Investors are interested in winning the greatest deals, wherein they are required to send all the money upfront.

Where does all the money go?

Early-stage startups usually deposit funds in a fixed deposit (“FD”), which is the simplest and least time-consuming method. At the very least, the money will earn interest, which can be utilized for future business needs.

As a startup grows, it hires professional people for finance – a Chief Financial Officer (“CFO”) or Financial Controller to handle the company’s investments. Many online companies even hire professional wealth managers from funds such as Kotak, to help them with their investments.

How do funds determine where to invest?

It is a question of liquidity and returns, just like any other investment decision. Most companies avoid non-liquid assets, such as real estate as well as assets that are too risky, such as bitcoin. The final aim is to preserve the capital while generating whatever possible return on it.

Tax efficiency is also very important. Some businesses make use of the government’s Startup India plan, which provides tax breaks to startups. Loss-making startups can carry losses forward and offset them with profitable investments. Startup India offers a 10-year window during which startups can receive tax exemptions for three years.

In the venture capital industry, the term unicorn refers to any startup that reaches a valuation of $1 billion. 37 Indian startups have made it to the unicorn club. Well over $32 billion has been raised till September this year, with several of the rounds producing Indian unicorns in 2021.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.