From the outside, financing rounds look like a simple two-step process: investors provide funds to companies and companies issue securities in turn. But is that all? Is it really as simple as it appears?
If you’ve seen the TV show, Shark Tank, you’d understood that raising capital is no easy task. Investors want more than just proof of concept (whether it’s a product prototype or users of the product). Sure, they believe in the company’s potential and founders’ ability, but they ask for a stake in the company, usually as equity, because they’re taking a risk on an early-stage business. Giving up shares, of course, dilutes current shareholders’ ownership percentages. So, there’s a lot of negotiation, several offers and counter offers are made before a deal is reached and hands are shaken.
In reality, giving up equity to raise funds is a hugely significant step. It involves deciding not just how much of the company an investor will own, but also choosing the right investor, who can provide the most value to grow the company. Then there’s the process of valuing a company, business, legal, and accounting due diligence, documentation, and regulatory compliance to deal with.
So, before raising capital, what are some essential decisions to be made? Who are the people that need to get involved? Do start-ups get any support from the government? Do business leaders or professionals mentor them through the process? This series will answer some of these questions and more.
How do companies and investors look at debt and equity financing?
Companies and investors look at their options from different lenses. Investors are more likely to consider, ‘What am I getting?’ whereas companies’ approach is to be mindful of it as ‘What am I giving up?’
While companies seek to reduce the cost of capital, investors aim to get the maximum returns on the funds they invest. So, how do companies and investors decide and negotiate the right kind of financing that’s beneficial to both?
Why do companies seek external funds? Why not simply plough back the revenue earned?
A basic amount needed to set up the company is invested by the founders. It’s usually a nominal amount. As the company grows, funds are needed to develop the product/service, hire employees, acquire customers and so on. Given the sums usually involved and the frequency with which they are required, relying on internal sources of financing is not an option. More so because, companies may also need to maintain reserves to meet any unanticipated cost. This is when external investors are sought. Since every financing round has an impact on the cap table and the company’s finances, it is very important that these rounds are structured meticulously.
What are the components of a round and how should companies be prepared?
i. Type of funding round: priced or non-priced
Financing can be completed with or without valuing the company. Raising funds through a fixed valuation (i.e., fixed price per share) is a priced round. Linking the valuation to a future round of financing or an operation-based metrics is a non-priced round.
II. Type of financing and securities
Companies and investors structure the terms of investment, based on law, regulations, investment amount, stage of investment, etc. An essential factor is to decide the type of financing – debt or equity. Over the years, hybrid investment structures, with components of both debt and equity, have been used.
- Equity financing is when companies raise funds by issuing equity shares in return for capital. Offering equity dilutes the existing shareholders’ ownership. Companies that are more established and are in the later stages of growth prefer debt to avoid the risk of dilution when the equity could be worth more in the future.
- Debt financing is essentially borrowing by the company, usually for a specific duration. Companies must return the principal, along with interest, on completion of the term. Since this creates an obligation to pay, either periodically or when the term ends, it adds to a company’s expenses. This means companies with strong revenue streams can opt for debt financing. Debentures, redeemable preference shares (RPS), and non-convertible debentures (NCD) are commonly issued debt-based securities.
- Hybrid securities have the features of both debt and equity. Their main feature is the option to convert to equity in the future. These can be convertible notes or optionally convertible preference shares (OCP). The holders of these shares enjoy the comfort of debt without the risk of equity.
It is very important for all parties to understand the nature and features of securities being offered, as well as the rights and obligations that come along with it. Whatever the security chosen for each round, applicable terms of issue must be negotiated before the investment deal is signed. For example, if the security to be issued in a particular round is a preference share or a debenture, then interest, liquidation preference, anti-dilution, and other applicable terms must be negotiated and finalised. The type of security determines the rights and returns enjoyed on the investment.
Investors for the round
All investors aim to earn maximum returns on their capital. Since founders steer the company’s ship, when investors consider an investment deal, they evaluate factors such as who are the founders, what is their ability to execute the business idea, will they achieve results, and so on.
Investors also look at:
The main aim of the investors is to understand:
- Founders’ vision and their potential
- Business and revenue model
- Market position and size
- Potential return on investment
- Break-even point and profitability
- Competitor and industry analysis
A good pitch deck with these details will decide if the founders will get a follow up call/meeting or not.
It is important to approach the right investors, who have an understanding of the service/product domain, market and industry, along with the ability to provide networking, and marketing assistance. Essentially, investors that can make more than a monetary contribution.
The private equity market has many incubators and accelerators, each with a portfolio of companies from different backgrounds. While incubators provide funding and assistance in the early stages of the company, accelerators come in at a later growth stage.
To give a boost to the start-up ecosystem, the Indian government has also taken various steps, such as introducing accelerators and incubator programmes, and mentorship and networking facilities, to assist companies in the ideation, development, and growth stages.
Well known incubators and accelerators in India are:
A term sheet is the first of the many documents that get signed in an investment deal. The founders, investors, and the company lay out the terms of investment, which provides the framework for future documentation. Clauses address:
- Company’s value
- Class of security being issued
- Investors’ shareholding percentage
- Investors’ and founders’ rights
- Liquidation preference rights
- Shares reserved in the stock option pool
- Exit rights
The term sheet must be executed and signed by the founders, existing investors (if any), and the new investors. Once the term sheet is signed, the company and founders agree to not approach any other investor, engage in discussions, or enter into any agreement with respect to fundraising or sale for an agreed duration, usually 60- 120 days.
After signing the term sheet, investors ask to conduct a due diligence. Due diligence is a detailed verification of the company’s financial, legal, and business-related compliances to confirm authenticity of the details provided by the company before entering into the investment deal. Due diligence helps investors identify risks and check for compliance, and investors’ satisfaction is important condition to closing the deal. If the diligence results reflect that compliances are not in place or the investor deems the deal to be too risky then the deal can get called off. If risks can be mitigated or non-compliance remedied, these become conditions included in the agreements (these are called ‘conditions precedents’ or CPs), which the founders and the company must complete before the investor transfers the funds.
Documents evaluated during due diligence are:
- Charter documents – certificate of incorporation, and memorandum and articles of association
- Current shareholding structure
- Assets and properties of the company
- Financial and tax information
- Intellectual property registrations
- Commercial contracts with third party
- Statutory registrations and compliance with applicable labour and environmental law
- Employee records and agreements with employees
- Disputes and litigation (if any)
Post due diligence, if the investors are satisfied with the company’s data, the final terms of the investment deal are discussed, and definitive agreements are drawn up.
Definitive agreements include:
- Investment / share subscription agreements
- Share purchase agreements
- Shareholders’ agreements
- Amended and restated articles of association
- Non-compete agreements
- Employment agreements
The terms defined in the shareholders’ and share subscription agreements must always be within the scope of the articles of association. If there are any terms that are not in alignment with the articles of the company, the articles will need to be amended to give effect to such terms.
The non-compete and employment agreements ensure that the founders/employees do not engage in any activity that could directly or indirectly create competition to the company’s business. It also helps to secure the intellectual property of the company.
How does fundraising affect the cap table of the company?
A shareholder’s ownership stake in the company is determined by the ratio of the number of shares they hold to the total shares issued by the company. When capital is raised against the company’s equity, the total number of shares issued increases. In the case of convertible instruments, since the conversion to equity happens in future, there is no immediate dilution of current shareholders’ equity. This is why most cap tables consider shareholding percentages on a fully diluted basis (FDB). FDB basis assumes that all convertible securities, such as preference shares, convertible debentures, convertible notes, and warrants (including the unallocated stock reserved in the stock option pool) have been converted to equity. This shows the exact value of equity/ownership stake an investor would have after all conversion rights have been exercised.
Support from advisors
As you can see, multiple parameters must align and connect for an investment deal to be successful. Since investors receive hundreds of applications for funding each day, founders have to put all efforts to make their business stand out. The whole process needs attention to detail, and it is best that founders are prepared with all the necessary information from the beginning. They must also consult with advisors such as lawyers and investment advisors to be negotiate the best deal for themselves and the company. All this requires a great deal of commitment and hard work; it can also be time-consuming. Having a good team to support the founders is absolutely key, especially if the company is still small.
If you have any questions on fundraising and want any assistance, reach out to us at firstname.lastname@example.org