Startup Finance | CA Final SFM
Every startup needs access to capital, whether for funding product development, for initial rollout efforts, acquiring inventory, or paying that first employee. Most entrepreneurs think first of bank loans as the primary source of money, only to find out that banks are really the least likely benefactors for startups. Thus the objective is: maximizing non-bank financing.
Startup financing means some initial infusion of money needed to turn an idea (by starting a business) into reality. While starting out, big lenders like banks etc. are not interested in a startup business. The reason is that when you are just starting out, you’re not at the point yet where a traditional lender or investor would be interested in you. So that leaves one with the option of selling some assets, borrowing against one’s home, asking loved ones i.e. family and friends for loans etc. But, that involves a lot of risk, including the risk of bankruptcy and strained relationships with friends and family.
Some businesses can also be bootstrapped (attempting to found and build a company from personal finances or from the operating revenues of the new company).They can be built up quickly enough to make money without any help from investors who might otherwise come in and start dictating the terms.
In order to successfully launch a business and get it to a level where large investors are interested in putting their money, requires a strong business plan. It also requires seeking advice from experienced entrepreneurs and experts, i.e., people who might invest in the business sometime in the future.
Sources for funding a startup
1. Personal financing
It may not seem to be innovative but you may be surprised to note that most budding entrepreneurs never thought of saving any money to start a business. This is important because most of the investors will not put money into a deal if they see that you have not contributed any money from your personal sources.
2. Personal credit lines
One qualifies for personal credit line based on one’s personal credit efforts. Credit cards are a good example of this. However, banks are very cautious while granting personal credit lines. They provide this facility only when the business has enough cash flow to repay the line of credit.
3. Family and friends
These are the people who generally believe in you, without even thinking that your idea works or not. However, the loan obligations to friends and relatives should always be in writing as a promissory note or otherwise.
4. Peer-to-peer lending (Crowdfunding)
- Peer-to-peer (P2P) lending is a form of crowd-funding used to raise loans for people who need to borrow, from people who want to invest.
- It enables individuals to borrow and lend money without any financial institution as an intermediary, and extends credit to borrowers who are unable to get it through traditional financial institutions.
- The main idea is savers getting higher interest by lending out their money instead of saving it, and borrowers getting funds at comparatively low interest rates.
- It typically uses an online platform where the borrowers and lenders register themselves. Due diligence is carried out before allowing the parties to participate in any lending or borrowing activity.
- All P2P platforms will now be considered non-banking financial companies and regulated by the RBI.
Crowdfunding is the use of small amounts of capital from a large number of individuals to finance a new business initiative. Crowdfunding makes use of the easy accessibility of vast networks of people through social media and crowdfunding websites to bring investors and entrepreneurs together.
Microloans are small loans that are given by individuals at a lower interest to a new business ventures. These loans can be issued by a single individual or aggregated across a number of individuals who each contribute a portion of the total amount.
6. Vendor financing
Vendor financing is the form of financing in which a company lends money to one of its customers so that he can buy products from the company itself. Vendor financing also takes place when many manufacturers and distributors are convinced to defer payment until the goods are sold. This means extending the payment terms to a longer period for e.g. 30 days payment period can be extended to 45 days or 60 days. However, this depends on one’s credit worthiness and payment of more money.
7. Purchase order financing
The most common scaling problem faced by startups is the inability to find a large new order. The reason is that they don’t have the necessary cash to produce and deliver the product. Purchase order financing companies often advance the required funds directly to the supplier. This allows the transaction to complete and profit to flow up to the new business.
8. Factoring accounts receivables
In this method, a facility is given to the seller who has sold the good on credit to fund his receivables till the amount is fully received. So, when the goods are sold on credit, and the credit period (i.e. the date up to which payment shall be made) is for example 6 months, factor will pay most of the sold amount upfront and rest of the amount later. Therefore, in this way, a startup can meet his day to day expenses.
Steps involved in Purchase Order Financing (POF)
- Receive a purchase order form your customer
- Obtain a proposal from the supplier regarding the estimates
- Apply for PO financing and obtain approval from POF Co.
- The Supplier is paid by the POF Co.
- The Supplier fulfills the Customer’s order and deliver goods
- Invoice the Customer for fulfilled order
- The Customer directly pays to the POF Co.
- The POF Co. remits the balance to you
(After deducting its principal and interest)
Pitch Deck Presentation
If you’re raising money for your business, having an impressive pitch deck is a key component in your fundraising toolkit. A great pitch deck gets potential investors excited about your idea and engages them in a conversation about your business, hopefully leading to an investment.
Pitch deck presentation is a short and brief presentation to investors explaining about the prospects of the company and why they should invest into the startup business. So, pitch deck presentation is a brief presentation to provide a quick overview of business plan and convincing the investors to put some money into the business.
Stages Involved in Pitch Deck Presentation
To start with, first step is to give a brief account of yourself i.e. Who are you? What are you doing? But care should be taken to make it short and sweet. Also, use this opportunity to get your investors interested in your company. One can also talk up the most interesting facts about one’s business, as well as any huge milestones one may have achieved.
The next step is to introduce the audience the people behind the scenes. The reason is that the investors will want to know the people who are going to make the product or service successful. Moreover, the investors are not only putting money towards the idea but they are also investing in the team. Also, an attempt should be made to include the background of the promoter, and how it relates to the new company. Moreover, if possible, it can also be highlighted that the team has worked together in the past and achieved significant results.
Further, the promoter should be able to explain the problem he is going to solve and solutions emerging from it. Further the investors should be convinced that the newly introduced product or service will solve the problem convincingly.
It is very important to describe in the pitch presentation as to how the company is planning to solve the problem. For instance, when Flipkart first started its business in 2007, it brought the concept of e- commerce in India. But when they started, payment through credit card was rare. So, they introduced the system of payment on the basis of cash on delivery which was later followed by other e-commerce companies in India. The second problem was the entire supply chain system. Delivering goods on time is one of the most important factors that determine the success of an ecommerce company. Flipkart addressed this issue by launching their own supply chain management system to deliver orders in a timely manner. These innovative techniques used by Flipkart enabled them to raise large amount of capital from the investors.
This is a very important part where investors will be deeply interested. The market size of the product must be communicated to the investors. This can include profiles of target customers, but one should be prepared to answer questions about how the promoter is planning to attract the customers. If a business is already selling goods, the promoter can also brief the investors about the growth and forecast future revenue.
6. Projections or Milestones
It is true that it is difficult to make financial projections for a startup concern. If an organization doesn’t have a long financial history, an educated guess can be made. Projected financial statements can be prepared which gives an organization a brief idea about where is the business heading? In particular, the projections should include,
- Profit & Loss Statement
- Cash Flow Statement
- Balance Sheet
Every business organization has competition even if the product or service offered is new and unique. It is necessary to highlight in the pitch presentation as to how the products or services are different from their competitors. If any of the competitors have been acquired, there complete details like name of the organization, acquisition prices etc. should be also be highlighted.
8. Business Model
The term business model is a wide term denoting core aspects of a business including purpose, business process, target customers, offerings, strategies, infrastructure, organizational structures, sourcing, trading practices, and operational processes and policies including culture.
If a startup business firm has raised money, it is preferable to talk about how much money has already been raised, who invested money into the business and what they did about it. If no money has been raised till date, an explanation can be made regarding how much work has been accomplished with the help of minimum funding that the company is managed to raise.
Modes of Financing for Startups
- Angel Investors
- Venture Capital Funds
Bootstrapping describes a situation in which an entrepreneur starts a company with little capital, relying on money other than outside investments. An individual is said to be bootstrapping when he attempts to found and build a company from personal finances or the operating revenues of the new company. Bootstrapping also describes a procedure used to calculate the zero-coupon yield curve from market figures.
A common mistake made by most founders is that they make unnecessary expenses towards marketing, offices and equipment they cannot really afford. So, it is true that more money at the inception of a business leads to complacency and wasteful expenditure. On the other hand, investment by startups from their own savings leads to cautious approach. It curbs wasteful expenditures and enable the promoter to be on their toes all the time.
Bootstrapping a company occurs when a business owner starts a company with little to no assets. This is in contrast to starting a company by first raising capital through angel investors or venture capital firms. Instead, bootstrapped founders rely on personal savings, sweat equity, lean operations, quick inventory turnover and a cash runway to become successful.
For example, a bootstrapped company may take preorders for its product, thereby using the funds generated from the orders to actually build and deliver the product itself.
Some of the methods in which a startup firm can bootstrap:
- Trade Credit
Angel investors invest in small startups or entrepreneurs. Often, angel investors are among an entrepreneur’s family and friends. The capital angel investors provide may be a one-time investment to help the business propel or an ongoing injection of money to support and carry the company through its difficult early stages.
Angel investors provide more favorable terms compared to other lenders, since they usually invest in the entrepreneur starting the business rather than the viability of the business. Angel investors are focused on helping startups take their first steps, rather than the possible profit they may get from the business. Essentially, angel investors are the opposite of venture capitalists.
Angel investors are also called informal investors, angel funders, private investors, seed investors or business angels. These are affluent individuals who inject capital for startups in exchange for ownership equity or convertible debt. Some angel investors invest through crowdfunding platforms online or build angel investor networks to pool in capital.
Angel investors typically use their own money, unlike venture capitalists who take care of pooled money from many other investors and place them in a strategically managed fund.
Though angel investors usually represent individuals, the entity that actually provides the fund may be a limited liability company, a business, a trust or an investment fund, among many other kinds of vehicles.
Angel investors who seed startups that fail during their early stages lose their investments completely. This is why professional angel investors look for opportunities for a defined exit strategy, acquisitions or initial public offerings (IPOs).
Venture Capital Funds
Venture capital means funds made available for startup firms and small businesses with exceptional growth potential. Venture capital is money provided by professionals who alongside management invest in young, rapidly growing companies that have the potential to develop into significant economic contributors.
Venture Capitalists generally:
- Finance new and rapidly growing companies
- Purchase equity securities
- Assist in the development of new products or services
- Add value to the company through active participation.
Characteristics of Venture Capital (VC) Financing:
1. Long time horizon:
The fund would invest with a long time horizon in mind. Minimum period of investment would be 3 years and maximum period can be 10 years.
2. Lack of liquidity:
When VC invests, it takes into account the liquidity factor. It assumes that there would be less liquidity on the equity it gets and accordingly it would be investing in that format. They adjust this liquidity premium against the price and required return.
3. High Risk:
VC would not hesitate to take risk. It works on principle of high risk and high return. So, high risk would not eliminate the investment choice for a venture capital.
4. Equity Participation:
Most of the time, VC would be investing in the form of equity of a company. This would help the VC participate in the management and help the company grow. Besides, a lot of board decisions can be supervised by the VC if they participate in the equity of a company.
Advantages of bringing Venture Capitalist in the Company:
- It injects long- term equity finance which provides a solid capital base for future growth.
- The venture capitalist is a business partner, sharing both the risks and rewards. Venture capitalists are rewarded with business success and capital gain.
- The venture capitalist is able to provide practical advice and assistance to the company based on past experience with other companies which were in similar situations.
- The venture capitalist also has a network of contacts in many areas that can add value to the company.
- The venture capitalist may be capable of providing additional rounds of funding should it be required to finance growth.
- Venture capitalists are experienced in the process of preparing a company for an initial public offering (IPO) of its shares onto the stock exchanges or overseas stock exchange such as NASDAQ.
- They can also facilitate a trade sale.
Stages of Funding for Venture Capital
Six steps involved in the process of venture capital financing
- Deal Origination
- Deal Negotiation
- Post Investment Activity
- Exit Plan.
1. Deal Origination:
Venture capital financing begins with origination of a deal. For venture capital business, stream of deals is necessary. There may be various sources of origination of deals. One such source is referral system in which deals are referred to venture capitalists by their parent organizations, trade partners, industry association, friends, etc.
Another source of deal flow is the active search through, networks, trade fairs, conferences, seminars, foreign resist etc. Certain intermediaries who act as link between venture capitalists and the potential entrepreneurs, also become source of deal origination.
Venture capitalist in his endeavor to choose the best ventures first of all undertakes preliminary scrutiny of all projects on the basis of certain broad criteria, such as technology or product, market scope, size of investment, geographical location and stage of financing.
Venture capitalists in India ask the applicant to provide a brief profile of the proposed venture to establish prime facie eligibility. Entrepreneurs are also invited for face-to-face discussion for seeking certain clarifications.
After a proposal has passed the preliminary screening, a detailed evaluation of the proposal takes place. A detailed study of project profile, track record of the entrepreneur, market potential, technological feasibility future turnover, profitability, etc. is undertaken.
Venture capitalists in Indian factor in the entrepreneur’s background, especially in terms of integrity, long-term vision, urge to grow managerial skills and business orientation. They also consider the entrepreneur’s skills, technical competence, manufacturing and marketing abilities and experience. Further, the project’s viability in terms of product, market and technology is examined.
Besides, venture capitalists in India undertake thorough risk analysis of the proposal to ascertain product risk, market risk, technological and entrepreneurial risk. After considering in detail various aspects of the proposal, venture capitalist takes a final decision in terms of risk return spectrum
4. Deal Negotiation:
Once the venture is found viable, the venture capitalist negotiates the terms of the deal with the entrepreneur. This it does so as to protect its interest. Terms of the deal include amount, form and price of the investment.
It also contains protective covenants such as venture capitalists right to control the venture company and to change its management, if necessary, buy back arrangements, acquisition, making IPOs. Terms of the deal should be mutually beneficial to both venture capitalist and the entrepreneur. It should be flexible and its structure should safeguard interests of both the parties.
5. Post Investment Activity:
Once the deal is financed and the venture begins working, the venture capitalist associates himself with the enterprise as a partner and collaborator in order to ensure that the enterprise is operating as per the plan.
The venture capitalists participation in the enterprise is generally through a representation in the Board of Directors or informal influence in improving the quality of marketing, finance and other managerial functions. Generally, the venture capitalist does not meddle in the day-to-day working of the enterprise, it intervenes when a financial or managerial crisis takes place.
6. Exit Plan:
The last stage of venture capital financing is the exit to realise the investment so as to make a profit/minimize losses. The venture capitalist should make exit plan, determining precise timing of exit that would depend on an a myriad of factors, such as nature of the venture, the extent and type of financial stake, the state of actual and potential competition, market conditions, etc.
At exit stage of venture capital financing, venture capitalist decides about disinvestments/realisation alternatives which are related to the type of investment, equity/quasi-equity and debt instruments. Thus, venture capitalize may exit through IPOs, acquisition by another company, purchase of the venture capitalist’s share by the promoter and purchase of the venture capitalist’s share by an outsider.
February 02, 2021
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April 04, 2019
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