This article is written by Bhavna Hemajani, pursuing a Diploma in M&A, Institutional Finance and Investment Laws (PE and VC transactions) from Lawsikho.com. Here he discusses “Why do Companies have Multiple Funding Rounds?”.
Startup: The Ministry of Commerce & industry vide notification dated February 19, 2019, has amended the definition of a Startup. It states:
Only that an entity will be called a Startup, whether it is incorporated as a private limited company, a limited liability partnership or a registered partnership up to 10 years of its incorporation; turnover has not exceeded Rs. 100 crore in any of the previous financial years; it is working towards either innovation, development or improvement of goods/ processes/ services or if it has a nature of a scalable business model, it works towards employment generation or wealth creation. It does not include that entity which is a result of splitting off or reconstruction of an existing business.
Funding for Startup
For any Startup to stay afloat and grow it will require funding, either from an external or internal source. In a narrow sense, the term ‘fund’ signifies ‘capital’. Funding is the fuel on which a business operates. The internal source of funding includes self-financing and financing from family and friends. While the external source of funding includes investors. For the investors, it is a risky proposition but investing in Startups requires low capital input which when combined with high upside potential, makes it lucrative and attractive for the investors to put their bets on Startup.
A Startup shall raise its funds in multiple rounds. These multiple rounds are the following:
- Seed capital/ Angel investor funding
- Series A/B/C- Venture capital financing
- Mezzanine Financing & Bridge Loans
Even before a Startup decides to enter the first phase of funding, it may indulge in pre-seed funding round. The pre-seed funding involves funds being raised by the founders and friends & family members. Once some operation has commenced, a Startup may raise a seed capital funding, which is also called Series rounds. Usually, it is the angel investors that seek to invest in Startups at this stage.
The SEBI (Alternative Investment Funds) Regulations, 2018 defines an angel investor u/s 19A(2). Angel investor may invest in or fund those Startups where it will see a potential for growth. Currently, there are various groups and individuals who have identified themselves as angel investors and their efforts are resulting in various success stories. The Indian Angel Network is a network of angel investors who invest in early stages businesses having the potential to create disproportionate value. The members of the Network are leaders in the Entrepreneurial Eco-System as they have had strong operational experience as CEOs or a background of creating new and successful ventures. The AngelList, an US-based curated closed marketplace for startups and investors, has launched an India focused fund – The Collective. The Collective will invest about INR 1 Cr each in 60-80 startups annually. This fund will also give quick capital access to AngelList’s Syndicate leads.
Startup India Initiative was launched by the Modi Government in January 2016 to provide support to entrepreneurs and ensure sustainable economic growth in India. Under the initiative, one of the key pillars of support to Startups is ‘Exemption on Income Tax & Capital Gains Tax for all eligible startups’. The Startups are exempted from tax liability imposed u/s 56 (2)(viiib) of Income Tax Act i.e. on considerations received for issue of shares that exceed the face value of such shares. This provision is called the Angel Tax exemption provision.
Series A/B/C Funding
It is a common phenomenon that most of the Startups face is that they fail after their seed round. But if a business manages to pick up operations in a positive manner, it shall become eligible to enter into the next phase of funding. Series A funding usually comes from venture capital firms, although angel investors may also be involved.
With limited operating history and high risk involved, Startup does not seek to raise funds from institutions. The Venture capitalist in exchange for the high risk by way investing in smaller and less mature companies, they receive certain protective rights in the company with respect to management decisions, in addition to a significant portion of the company’s ownership (and consequently value). Since the high per cent of venture capital investors is from outside India, their investment activities are regulated by the SEBI (Foreign Venture Capital Investors) Regulations, 2000.
It has been stated that investors particularly venture capitalist (VCs) add value to Startups in various ways, namely:
- Ensure smooth operations by the leading company board.
- Provide assistance in recruiting high-quality human resources for the job.
- Provide aid in achieving efficiency and effectiveness.
Equity crowdfunding has also become one of the sources for Series round of funding. It refers to raising funds, particularly at an early stage, by offering equity interests in the business to investors on an online platform. Businesses seeking to raise capital through this mode typically advertise online through a crowdfunding platform website, which serves as an intermediary between investors and the start-up companies. Some examples of equity crowdfunding platforms are Syndicate Room, Crowdcube and Seedrs. However, SEBI considers it to be as ‘unauthorised, unregulated and illegal’.
Mezzanine Financing & Bridge Loans
A Startup seeking to expand will require mezzanine or bridge funding. Mezzanine finance is a collective term for hybrid forms of finance: it has features of both debt and equity. The most common forms of mezzanine finance include
- subordinated loan;
- participating loan;
- ‘silent’ participation;
- profit participation and
- convertible bonds.
Mezzanine financing is a preferred option over equity holders. Consequently, mezzanine investments generate returns that are higher than traditional bank lending rates and lower than the returns required by most equity investors. Thus, one can say that mezzanine financing acts as a catalyst in the growth and development of the Startup.
Bridge financing is undertaken by the Startup to bridge the gap between investments where the Startup is trying to keep the company afloat. It is a round of funding involving taking short term loan in order to reach the next round of funding. Bridge financing allows Startup to merge, or gather financing for an IPO.
Initial Public Offering (IPO)
SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2018 defines IPO as ‘an offer of specified securities by an unlisted issuer to the public for subscription and includes an offer for sale of specified securities to the public by any existing holders of such specified securities in an unlisted issuer.’
SEBI recently amended the regulations on Issue of Capital and Disclosure Requirements and expanded the scope for companies to can list their securities. A company involved intensively, in providing products or services or having substantial value addition in relation to use of technology, IT, IP, data analytics, biotechnology is also eligible to list their securities on Innovators Growth Platform. With this amendment, SEBI seeks to attract more and more investors and boost the growth of Startups.
Case Study: Flipkart
Flipkart is the ideal Indian Startup success story. It is to be noted that though it does not fall within the scope of the current definition of Startup, it started as one. It started its operations with Rs. 4 lakh as initial capital in 2007. In 2009, Accel India, the venture capital firm invested $1 million which marked the Series A stage of funding. Finally, after various rounds of fundings, it was in 2010-2011 when Flipkart became a Unicorn Startup with valuation at USD 1 Billion. Now, as India’s leading e-commerce major, it has undertaken to support the ecosystem to build innovative solutions for the next wave of internet users with the launch of a venture fund.
Every entrepreneur seeks to develop a business plan that caters to the need of the masses and the means to serve this identified need is a Startup. It can be a company or a partnership. But every business requires some capital funding to stay afloat, operate and grow in future. Funding of any Startup is undertaken in different stages to serve the current need and the immediate future growth plan. At each stage, there are different categories of investors. Each investor can be distinguished from the other on the basis of their nature, the risk undertaken by them and the scale of funding they put. The Indian scenario is booming with successful Startup stories e.g. Flipkart, Oyo Rooms, Byjus, Swiggy etc. The statutory authorities have also recognised the growing trend along with the difficulty faced by the Startups in raising funds. Therefore, the Modi government launched the scheme called Startup India, as a platform for investors and startups to connect and achieve their respective goals.
- Black’s law dictionary
- Upwork, 5 Stages of Startup Funding https://www.upwork.com/hiring/for-clients/5-stages-startup-funding/
- Indian Angel Network, About Retrieved from https://www.indianangelnetwork.com/about.
- Yatti Soni, AngelList Launches An India Fund Backed By Flipkart’s Binny Bansal & More, Inc42 Retrieved from https://inc42.com/buzz/silicon-valley-based-angellist-launches-a-fund-for-indian-startups/.
- Notification No. 13/2019/F dated 5th March 2019, Ministry of Finance
- Nishith Desai Associates, Startups and Venture Capital Investments
- FAQs Startupindia Retrieved from https://www.startupindia.gov.in/content/sih/en/about_us/faqs.html.
- SEBI, Consultation Paper on Crowdfunding in India
- European Commission, Mezzanine Finance Final Report
- Upcounsel, Bridge Financing: Everything You Need to Know Retrieved from https://www.upcounsel.com/bridge-financing
- SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2018 § 2(w).
- SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2018 §283(1).
- Term coined by Ms. Aileen Lee in 2013. The term is used to describe a Startup company with a valuation of USD 1 Billion.
- Thimmaya Poojary, Yourstory, Flipkart launches venture fund to invest in early-stage start-ups Retrieved from https://yourstory.com/2019/03/flipkart-venture-fund-invest-early-stage-startup-bnt5qqmfni.