In this blog I will be explaining the process on how startup investment rounds work. Money is required to scale your business and there’s a way to get that money which will help you in scaling your venture to heights.
I am going to explain it with an example, in order to make it easier for you to understand. I am going to give an example of you and your friend who plan to start a company in a particular industry.
To begin with, let’s assume you are having an idea of starting an e-commerce business. You along with your friend decide to start a company. You both have complimentary skills, one being a techie and the other being a business guy. You both decide to be equal share holders of the company (50-50).
[ Please have a note: I will indicate the company by the balance sheet. In general Assets = Equity (e.g. stocks/shares, cash) + Liabilities(e.g. loan). If we don’t decide to take loan then we don’t have any liability that means Assets = Equity. Equity is basically what the owners of the company have a right to. Got it? Cool! ]
So, Let’s assume you and your friend decide that you won’t take any loan as you don’t want to have any liability of giving back money to someone else.
So, to begin with let’s assume that you introduce 10,000 shares in the company at a minimum valuation of 1 lakh rupees (i.e. 10rupees/share, got it?). That means you will have 5000 shares and your friend will have 5000 shares.
You alone with your friend can’t start the company. You need employees for building the product, for marketing, for making an online presence of the company.
So for all this you need to raise money. Then comes the concept of investment in picture.
STAGE 2 (Angel Round)
You approach an angel investor and try to show him that the industry in which you are working has a huge market, your team is great, have an ability to build a good product and market it.
[Please have a note: At a very early stage, successful entrepreneurs or a person who has money to invest at personal level invests in your startup – he is called an angel investor.]
So you approach the Angel Investors with your idea and try to sell it. If the Angel Investor is impressed with the idea he will be ready to put in money.
So now when the Angel Investor agrees to invest, there will be negotiations on what he will get in return for the investment made. This process is called as ‘Valuation’.
You need to come up with a Pre-Money Valuation of your company before you get the investment. So let’s assume (on the basis of your market size, team and other factors) that the Pre-Money Valuation of your company is INR 1.8 crores. You need INR 20lacs to build a basic product and get first 100 customers on board. To do that, you will be hiring new employees, you will buy a basic office space. This funding will be used for 1 year
Now suppose the Angel Investor agrees on the Pre-Money Valuation.
Now the Post-Money Valuation is INR 2 cr i.e. the total assets = INR 20 Cr, with no liabilities yet.
As members of the board of the company, you will issue shares. Let’s say now total shares are 10 Lacs. So, on the basis of the valuation, the investor will have 20lacs/20CR*100 = 10% shares in the company
You and your partner now get diluted by 10%, so now you have 45% each.
STAGE 3 (VC SEED ROUND)
With the help of Angel Investment, you work hard to build a product, do sales, get more customers. So now you need more money to expand throughout the country. As your company has become more mature because of better product, more sales & revenue, the valuation of your company has now increased.
You start approaching the Next Stage, The Venture Capitalists are the professional people who give you money in return for the stake in the company but at a later stage.
You start talking with the VCs. This is the real professional institutional Funding. Consider You are able to convince them and you raise INR 5 Cr at a pre money valuation of INR 15 Cr.
So, the post money valuation will now be 20Cr and the Venture Capitalists will own 25% of the total shares. You, your partner and your angel investor will get diluted by 25%, that means you and your partner will now own 0.75*45%=33.75% of the company.
Interestingly, as you see in the figure, Angel investor had invested INR 20 lacs and now his shares value is INR 1.5Cr, more than 500% increase in his shares’ value. Startup investment is always great but riskier as well.
You need funding to scale your company faster. You lose shares of the company but the valuation of your diluted shares keep on increasing with the growth of your startup. Some people take the zero funding route (great example is Mailchimp) but not all startups grow so rapidly without money. At the end, as my great friend Deepak Diwakar says It’s better to own 20% of something than owning 100% of nothing.