How to Fund your Start-Up Company

How Funding Works – Splitting Equity

First, let’s figure out why we are talking about funding as something you need to do. This is not a given. The opposite of funding is “bootstrapping,” the process of funding a start-up through your own savings. In this article, we will discuss the ‘easiest to understand’ explanation of the process. Let’s start with the basics, shall we? Every time you get funding from somewhere, you give up a piece of your company in return. The more funding you get, the more ‘company’ you give up. That ‘piece of company’ is ‘equity.’ Everyone you give it to become a co-owner of your company from there on, till they hold their share of the pie.

Splitting the Pie

The basic idea behind equity is the splitting of a pie. When you start something, your pie is really small. You have a 100% of a really small, bite-size pie. When you take outside investment and your company grows, your pie becomes bigger. Your smaller slice of the bigger pie will be bigger than your initial bite-sized pie. Take the example of Google. When it went public, Larry and Sergey had about 15% of the pie, each. But that 15% was a small slice of a really big pie.

Funding Stages

Let’s look at how a hypothetical start-up would get funding.

The Idea Stage. At first it is just you. You are pretty brilliant, and out of the many ideas you have had, you finally decide that this is the one. You start working on it. The moment you started working, you started creating value. That value will translate into equity later, but since you own 100% of it now, and you are the only person in your still unregistered company, you are not even thinking about any equity yet.

Co-Founder Stage. As you start to transform your idea into a physical prototype you realize that it is taking you longer (it almost always does.) You know you could really use another person’s skills. So you look for a co-founder. You find someone who is both enthusiastic and smart. You work together for a couple of days on your idea, and you see that he/she is adding a lot of value. So you offer them to become a co-founder. Soon you realize that the two of you have been eating ‘Maggi Noodles’ three times a day (Although not any more). You need funding. You would prefer to go straight to a VC (Venture Capital), but so far you don’t think you have enough of a working product to show, so you start looking at other options. At this stage, its best to try and work harder and faster to increase your chances with VC’s OR if you think funding is what’s holding you back, look for a rich uncle! Basically, someone who you’ve known for a while and have a mutual manner of trust and understanding.

Registering the Company

But to share your equity, even with a known family member, you must first have a registered company. Tough work right? Grab hold of a good lawyer to help you along. Only a professional and field proven lawyer would know what strings to pull in order to get your work done faster and as per rules and regulations. Now let’s assume that you ended up registering your company & issued some common stock, gave 5% to uncle and set aside 20% for your future employees – that is the ‘Option Pool.’ You did this because 1. Future investors will want an option pool & 2. That stock is safe from you and your co-founders doing anything with it…:-P

The Angel Round

With uncle’s cash in pocket runs out (God, this is really being mean to the ‘Now Poor’ uncle), you realize that you need to start looking for your next funding source right now! If you run out of money, your start-up dies. So you look at the options:

Incubators, Accelerators, and “Excubators” – these places often provide seed money, working space, and business advisors. The cash is tight – about 10 Lacs, for (10-15) % stake in the company.

Angels – These are the high bid high risk investors. That’s the good news. The bad news is that angels usually give money to companies that they valued north of 10 Cr. So, now you have to ask if you are worth 10 Cr. How do you know? Make your best case.  Let’s say it is still early days for you, and your working prototype is not that far along. You find an angel who looks at what you have and thinks that it is worth 50 lacs. He agrees to invest 10 Lacs as seed money, solely on his risk of investment and a trust factor that you happen to have developed with him during your presentation.

Now let’s count what percentage of the company you will give to the angel. Not 20%. We have to add the ‘pre-money valuation’ (how much the company is worth before new money comes in) and the investment which is 50 Lacs + 10 Lacs = 60 Lacs, post-money valuation (Think of it like this, first you take the money, then you give the shares. If you gave the shares before you added the angel’s investment, you would be dividing what was there before the angel joined). Now divide the investment by the post-money valuation which is (10/60) = 1/6 = 16.7% (The angel gets 16.7% of the company, or 1/6).

How Funding Works – Cutting the Pie

What about you, your co-founder and uncle? How much do you have left? All of your stakes will be diluted by 1/6. Is dilution bad? No, because your pie is getting bigger with each investment. But, yes, dilution is bad, because you are losing control of your company. So what should you do? Take investment only when it is necessary. Only take money from people you respect. (There are other ways, like buying shares back from employees or the public, but that is further down the road)

Venture Capital Round

Finally, you have built your first version and you have traction with users. You approach VCs. How much can VCs give you? Let’s say the VC values what you have now at 15 Cr. Again, that is your pre-money valuation. He says he wants to invest 1 Cr. The math is the same as in the angel round, but now, it’s his company, too!

Your first VC round is your series A. Now you can go on to have series B, C – at some point any of the three things will happen to you. Either you will run out of funding and no one will want to invest, so you die. Or, you get enough funding to build something that a bigger company wants to buy, and they acquire you. Or, you do so well that, after many rounds of funding, you decide to go public!

Why Companies Go Public?

There are two basic reasons. Technically an IPO is just another way to raise money, but this time from millions of regular people. Through an IPO a company can sell stocks on the stock market and anyone can buy them. Since anyone can buy you can likely sell a lot of stock right away rather than go to individual investors and ask them to invest. So it sounds like an easier way to get money.

There is another group of people that really want you to IPO. The investment bankers! They will give you a call and ask to be your lead underwriter – the bank that prepares your IPO paperwork and calls up wealthy clients to sell them your stock.  Why are the bankers so eager? Because they get 7% of all the money you raise in the IPO.