This article was written by Deepak Parashar, pursuing the Diploma in Advanced Contract Drafting, Negotiation, and Dispute Resolution Course from LawSikho, and edited by Koushik Chittella.

This article has been published by Shashwat Kaushik.

Introduction

Every year, hundreds to thousands of startups are incorporated. According to a press release by DPIIT (Department for Promotion of Industry and Internal Trade), there were over 1,17,254 recognised startups that had generated 12.42 lakh jobs as of December 31, 2023. Some of them grow big, very big, headline-grabbing valuations, while others shut down their operations. Startups are all about turning innovative ideas into industry leaders, but to become these leaders, a startup requires fuel. Investments are the fuel for startups. Just like a child goes through different stages of development, a startup also experiences distinct phases, each with its own funding needs, thus attracting a specific type of investor with a unique mindset. Let’s understand these stages and explore the intricate funding landscape for Indian startups.

Idea stage (building the foundation)

The idea is the inception of every startup journey. It’s where a spark of inspiration transforms into a potential solution for a real-world problem. But turning that spark into a flame requires resources, and for many aspiring entrepreneurs, bootstrapping becomes the launchpad. This stage is often characterised by a focus on market research, validating the problem-solution fit, and building a Minimum Viable Product (MVP). Bootstrapping essentially means financing your startup using your own resources. This could involve:

• Personal Savings:  This is the most common form of bootstrapping. Founders turn to their personal savings to cover initial expenses like market research, building a basic website or prototype, and initial marketing efforts.
• Sweat Equity: Initially, founders handle various tasks like coding, designing, marketing, and even customer service. This dedication and hard work are also a form of investment in the idea’s future success.

Bootstrapping offers several advantages for a startup:

• Maintaining Control:  By bootstrapping, founders retain complete control over decision-making and the direction of the company because they haven’t diluted any part of their equity yet. This is crucial when the idea is still evolving and requires agility.
• Validation and Learning:  Bootstrapping forces founders to be resourceful and make the most use of their limited resources. This develops a culture of frugality and helps validate the problem-solution fit before seeking external funding.

However, if the initial requirement of funds can’t be satisfied using personal resources, founders usually turn to family, relatives, or friends to support the business. It is the family or friends who believe in the founder’s dream and support the business by either giving investment in return for a very low equity stake or by giving credit to the founders at minimal rates of interest.

Seed stage

After the startup has built a basic, functional version of the product that has been tested by a small group of users and received positive feedback, and after the founder has a clear understanding of the problem he’s looking to solve, the target market, and how his product or service addresses market needs, it’s time to take the business to the next level, and this is where angel investors come into the picture. 

Angel investors are the rainmakers of the seed stage. They are wealthy individuals, often successful entrepreneurs themselves, who invest their own money in very promising early-stage ventures. Angel investors understand that seed-stage ventures are inherently risky. However, they are also attracted to the potential for high returns if the startup becomes successful. Many angel investors are passionate about innovation and supporting new ventures that can disrupt existing industries. They enjoy being a part of the startup ecosystem and helping ideas become big businesses. Angel investors not only provide funds, but there are some other benefits to securing angel investors that go beyond just the money. Here are some additional advantages:

1. Angel investors often have a vast network of contacts in the industry. They can connect a startup with potential customers, partners, and advisors, opening doors that might otherwise have remained closed.
2. Because angel investors themselves were founders or entrepreneurs, they also provide invaluable guidance on everything from product development and marketing to fundraising and team building.
3. If a startup succeeds in securing investment from a respected angel investor, it can validate its idea and give the startup credibility in the eyes of future investors and potential customers. Many prominent Indian angel investors, like Sachin Bansal and Sandeep Aggarwal of Flipkart, actively support promising startups.

Beyond angel investors, incubators and accelerators can also play a crucial role at this stage. These organisations provide startups with mentorship, workspace, access to potential investors, and industry connections. Prominent Indian incubators and accelerators include NASSCOM Startup Warehouse, T-Hub, and Y Combinator India.

Early growth stage (Scaling up operations):

After the startup has gained traction, with a working product and an initial customer base, venture capitalists (VCs) come into play. VCs are firms that manage pooled funds from various investors, like pension funds, insurance companies, and high-net-worth individuals.  Unlike angel investors, who take calculated risks on individual ventures, VCs invest in a portfolio of startups, aiming to achieve high returns through multiple successes. VCs are driven by a primary objective, to maximize returns for their investors. However, their investment decisions are influenced by several factors:

• High-Growth Potential:  VCs look for startups with the potential for explosive growth and the ability to scale rapidly. They typically invest in sectors with high projected growth rates, like technology or biotechnology.
• Strong Management Team:  VCs invest in people as much as they do in ideas. They look for a passionate and experienced founding team with a proven track record of success. If the founder has a record of building decent businesses, it becomes easier to get investments from the VCs.
• Exit Strategy:  Because VCs have to give returns to their investors, they look for a clear exit strategy for their investment. This could involve an initial public offering (IPO), where the company goes public, or an acquisition by a larger company.

VC funding typically follows a staged approach known as “series funding rounds.” Each series (Series A, B, C, etc.) represents a distinct stage of growth for the startup and comes with progressively larger investment amounts and stricter criteria. The number of series funding rounds a startup goes through can vary depending on the industry, business model, and funding requirements. Some startups may only require Series A funding, while others might go through multiple rounds (C, D, and E) before an exit.

Indian VC firms like Sequoia Capital India, Kalaari Capital, and Blume Ventures have been instrumental in the success of many Indian startups. It’s important to note that the funding landscape at this stage can be competitive.  Founders need to craft a compelling pitch deck that clearly articulates the problem they are solving, their target market, the competitive advantage, the business model, the go-to-market strategy, the financial projections, and the team’s experience.

Expansion stage (reaching new markets):

After securing funding from venture capitalists, a high-growth Indian startup might find itself at  a crossroads.  The company is well past the initial stages, but a final push is needed to solidify its position or achieve a successful exit. This is where growth equity investors or private equity firms step onto the scene.

Growth Equity investors: Fueling the final ascent

Growth equity investors are firms or individuals who specialise in investing in companies experiencing rapid growth. They bridge the gap between venture capital and private equity, providing larger sums of capital than VCs but focusing on slightly later-stage companies. Growth equity investors are drawn to the following factors:

1. Proven Business Model: They invest in companies with a demonstrably successful business model and a clear path to continued growth.
2. Strong Market Position: The company should be a leader or strong contender in its target market.
3. High-Quality Management Team: A proven and experienced management team with a track record of success is crucial.
4. Exit Potential: Just like VCs, growth equity investors seek a successful exit, typically through an IPO or acquisition.

Private Equity: The endgame investors

These firms operate investment funds on behalf of institutional and accredited investors. They acquire private companies or even public ones entirely, often as part of a consortium. Unlike venture capital firms, which typically invest in startups, private equity firms focus on mature companies with a strong track record of profitability. Their primary goal is to acquire a controlling interest in a company, drive further growth, and then achieve a lucrative exit within a defined timeframe (typically 3-5 years). Private equity firms are motivated by:

• Strong Financial Performance: They invest in companies with established revenue streams and high profitability.
• Untapped Potential: They may see opportunities to unlock further value through operational improvements or strategic acquisitions.
• Exit Strategy: Their primary focus is maximising returns through an IPO or a strategic sale to another company.

Advantages for startups:

The advantages of getting connected to growth investors or private equity firms can be as follows:

• Large-Scale Funding: Growth investors and private equity firms provide massive capital injections to fuel large-scale acquisitions, market consolidation, or even international expansion.
• Operational Expertise: These firms often have a team of experts who can help optimise operations and improve efficiency.
• Exit Strategy Guidance: Private equity firms have extensive experience in structuring and executing successful exits, which can be invaluable for founders.

Beyond growth equity and private equity firms, companies at this stage might also attract strategic investors. These are established companies, often within the same industry, that see potential benefits from a partnership or eventual acquisition. Strategic investors provide access to new markets, distribution channels, or valuable partnerships. A strategic investor might also be a potential acquirer, offering a clear exit strategy for the startup.

Maturity Stage (Debt Financing & IPO):

The maturity stage represents the pinnacle of a successful startup journey. The company is well-established, generating significant revenue and profitability. Here, the focus shifts from rapid growth to maintaining market share, optimising operations, and potentially preparing for a public offering.

Debt Financing:  Fueling strategic moves

While equity financing has driven the startup’s growth so far, debt financing becomes a viable option at the maturity stage.  This involves taking out loans from banks or other financial institutions. Debt financing can be used for several purposes:

1. Strategic Acquisitions:  Funds can be used to acquire smaller competitors, expand into new markets, or consolidate market share.
2. Product Development: Debt financing can fuel the development of new products or technologies that can further solidify the company’s position in the market.
3. Shareholder Repurchase: Mature companies might use debt to repurchase shares from existing investors, increasing ownership for remaining shareholders.

The reasons why debt financing is preferred in mature stages are as follows:

• Preserves Ownership: Unlike equity financing, debt doesn’t dilute ownership for founders and existing investors.
• Tax Benefits:  Interest payments on debt are often tax-deductible, reducing the company’s overall tax burden.
• Flexibility:  Debt financing can be tailored to specific needs, with varying repayment terms and interest rates.

However, debt comes with its own set of considerations, as debt repayment includes interest, which can impact profitability. Also, excessive debt can burden the company and limit its financial flexibility in the event of unforeseen circumstances.

Public offerings: Taking the company public

The ultimate goal for many successful startups is an initial public offering (IPO). An IPO involves selling shares of the company’s stock to the public on a stock exchange. This allows the company to raise a significant amount of capital and gain access to a wider pool of investors.

Here are some benefits of an IPO:

1. Increased Capital:  An IPO can provide a massive influx of capital that can be used for further expansion, debt repayment, or strategic acquisitions.
2. Enhanced Credibility:  Going public signifies a company’s success and stability, attracting new investors and talent.
3. Liquidity for Investors:  An IPO provides an exit strategy for early investors and founders who can sell their shares on the stock market.

However, an IPO is not the only exit strategy for a mature company.  Here are some alternatives:

1. Acquisition:  A larger, established company might acquire the startup for its technology, market share, or talent.
2. Merger:  Two companies might merge to create a stronger entity with a wider market reach and combined resources.

Conclusion

The Indian startup world is booming with ideas! This article was an attempt to highlight the different ways in which startups get funding, from the very beginning (using your own savings and help from friends) to when the company becomes big and successful.

Remember, different investors look for different things. Angel investors love passionate founders with unique ideas, while VCs want companies that can grow really fast. Therefore, it is important to understand what investors want so a founder can convince them to give him the money he needs to turn his dream into a reality.

References

1. https://www.forbes.com/sites/alejandrocremades/2019/01/02/8-types-of-investors-for-startups/?sh=7d14ee984a3e
2. https://startupsavant.com/startup-finance/types-of-investors
3. https://www.cemexventures.com/startup-stages-phases/