Startup Funding- 1 | CMAT Mock Test Series - CAT PDF Download

Why Funding is Required by Startups

A startup might require funding for one, a few, or all of the following purposes. It is important that an entrepreneur is clear about why they are raising funds. Founders should have a detailed financial and business plan before they approach investors.

• Prototype Creation
• Product Development
• Team Hiring
• Working Capital
• Legal & Consulting Services
• Raw Material & Equipments
• Licenses & Certifications
• Marketing & Sales
• Office Space & Admin Expenses

Types of Startup Funding

Working Capital:

• Definition: Funds used for day-to-day operations.
• Nature: No repayment component; used for ongoing expenses.
• Risk: No guarantee for the financer; essential for business operations.
• Sources: Internal funds, short-term loans, trade credit.

Equity Financing:

• Definition: Selling equity for capital.
• Nature: No repayment; investors gain ownership.
• Risk: Startup gives up ownership; investors seek growth.
• Threshold of Commitment: Less pressure on repayment; focus on growth.
• Return to Investor: Capital growth.
• Involvement in Decisions: Investors prefer involvement.
• Sources: Angel investors, venture capitalists, crowdfunding.

Debt Financing:

• Definition: Borrowing money with interest.
• Nature: Repayment with interest over time.
• Risk: Collateral may be required; strict repayment timeline.
• Threshold of Commitment: Constant adherence to repayment.
• Return to Investor: Interest payments.
• Involvement in Decisions: Less involvement from lenders.
• Sources: Banks, financial institutions, government loan schemes.

Grants:

• Definition: Financial awards without repayment.
• Nature: No repayment; based on milestones.
• Risk: Startup may not meet grant objectives.
• Threshold of Commitment: Milestone-based distribution.
• Return to Investor: No direct return.
• Involvement in Decisions: No direct involvement.
• Sources: Government programs, private entities' grant programs.

Stages of Startups and Source of Funding

There are multiple sources of funding available for startups. However, the source of funding should typically match the stage of operations of the startup. Please note that raising funds from external sources is a time-consuming process and can easily take over 6 months to convert.

Ideation

This is the stage where the entrepreneur has an idea and is working on bringing it to life. At this stage, the amount of funds needed is usually small. Additionally, at the initial stage in the startup lifecycle, there are very limited and mostly informal channels available for raising funds.

Pre-Seed Stage

• Bootstrapping/Self-financing: Bootstrapping a startup means growing the business with little or no venture capital or outside investment. It means relying on your savings and revenue to operate and expand. This is the first recourse for most entrepreneurs as there is no pressure to pay back the funds or dilute control of your startup.
• Friends & Family: This is also a commonly utilized channel of funding by entrepreneurs still in the early stages. The major benefit of this source of investment is that there is an inherent level of trust between the entrepreneurs and the investors
• Business Plan/Pitching Events: This is the prize money/grants/financial benefits that are provided by institutes or organizations that conduct business plan competitions and challenges. Even though the quantum of money is not generally large, it is usually enough at the idea stage. What makes the difference at these events is having a good business plan.

Validation

At this stage, a startup has a prototype ready and needs to validate the potential demand of the startup’s product/service. This is called conducting a ‘Proof of Concept (POC)’, after which comes the big market launch.

A startup will need to conduct field trials, test the product on a few potential customers, onboard mentors, and build a formal team for which it can explore the following funding sources:

• Incubators: Incubators are organizations set up with the specific goal of assisting entrepreneurs with building and launching their startups. Not only do incubators offer a lot of value-added services (office space, utilities, admin & legal assistance, etc.), they often also make grants/debt/equity investments. You can refer to the list of incubators here.
• Government Loan Schemes: The government has initiated a few loan schemes to provide collateral-free debt to aspiring entrepreneurs and help them gain access to low-cost capital such as the Startup India Seed Fund Scheme and SIDBI Fund of Funds. A list of government schemes can be found here.
• Angel Investors: Angel investors are individuals who invest their money into high-potential startups in return for equity. Reach out to angel networks such as Indian Angel Network, Mumbai Angels, Lead Angels, Chennai Angels, etc., or relevant industrialists for this. You can connect with investors by the Network Page.
• Crowdfunding: Crowdfunding refers to raising money from a large number of people who each contribute a relatively small amount. This is typically done via online crowdfunding platforms.

Early Traction

At the Early Traction stage startup’s products or services have been launched in the market. Key performance indicators such as customer base, revenue, app downloads, etc. become important at this stage.

Series A Stage

Funds are raised at this stage to further grow the user base, product offerings, expand to new geographies, etc. Common funding sources utilized by startups in this stage are:

• Venture Capital Funds: Venture capital (VC) funds are professionally managed investment funds that invest exclusively in high-growth startups. Each VC fund has its investment thesis – preferred sectors, stage of the startup, and funding amount – which should align with your startup. VCs take startup equity in return for their investments and actively engage in the mentorship of their investee startups.
• Banks/Non-Banking Financial Companies (NBFCs): Formal debt can be raised from banks and NBFCs at this stage as the startup can show market traction and revenue to validate its ability to finance interest payment obligations. This is especially applicable for working capital. Some entrepreneurs might prefer debt over equity as debt funding does not dilute equity stake.
• Venture Debt Funds: Venture Debt funds are private investment funds that invest money in startups primarily in the form of debt. Debt funds typically invest along with an angel or VC round.

Scaling

At this stage, the startup is experiencing a fast rate of market growth and increasing revenues.

Series B, C, D & E

Common funding sources utilized by startups in this stage are:

• Venture Capital Funds: VC funds with larger ticket sizes in their investment thesis provide funding for late-stage startups. It is recommended to approach these funds only after the startup has generated significant market traction. A pool of VCs may come together and fund a startup as well.
• Private Equity/Investment Firms: Private equity/Investment firms generally do not fund startups however, lately some private equity and investment firms have been providing funds for fast-growing late-stage startups who have maintained a consistent growth record.

Exit Options

• Mergers & Acquisitions: The investor may decide to sell the portfolio company to another company in the market. In essence, it entails one company combining with another, either by acquiring it (or part of it) or by being acquired (in whole or in part).
• Initial Public Offering (IPO): IPO refers to the event where a startup lists on the stock market for the first time. Since the public listing process is elaborate and replete with statutory formalities, it is generally undertaken by startups with an impressive track record of profits and who are growing at a steady pace.
• Selling Shares: Investors may sell their equity or shares to other venture capital or private equity firms.
• Buybacks: Founders of the startup may also buy back their shares from the fund/investors if they have liquid assets to make the purchase and wish to regain control of their company.