How Startup Funding Works? [Explained in Detail]

Sanchit MalikStartup Basics20 Comments

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.

STAGE 1:

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).

Initial Equity Distribution in a startup

Initial Equity Distribution in a startup


[ 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.

Equity Distribution After Angel Investment Round

Equity Distribution After Angel Investment Round

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.

Equity Distribution after VC Seed investment roundEquity Distribution after VC Seed investment round

Equity Distribution after VC Seed investment round

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.

Conclusion:

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.

20 Comments on “How Startup Funding Works? [Explained in Detail]”

  1. Sankalp Dhariwal

    Nice post.. Very informative.. But valuation concept is a bit unclear to me. Can you please elaborate?

    1. Sanchit Malik

      Hi Sankalp,

      Valuation of your company is basically the total value or asset of your company.

      Initial Valuation of your startup is decided by many parameters like
      1) Market Size and its growth
      2) Founding Team
      3) Product Maturity
      4) Competition
      5) How your startup idea is going to execute and many other parameters.

      As your company grows in terms of users, revenue, market share. On that basis your startups valuation keeps on increasing.

      After the first initial Angel Investment(majorly on the basis of founding team, market size), in the VC round it depends on the user/revenue growth rate, maturity of the product. On these parameters pre-money valuation is decided.

      So, in the above example, on the basis of those parameters it was decided as 15CR and the VC invested 5cr. After investing Post money valuation became INR 20Cr

      I hope the concept is clear now! Please let me know if you still have a doubt.

      Thanks!

    1. Sanchit Malik

      Hi Meet,

      Sorry for the delay in my reply. I believe, Venture capital is a growth capital which helps you in scaling up fast. VC i.e. Institutional funding you get it after your market validation is done.

  2. Lokesh Maadhu

    The above explanation is amazing…it’s helped me alot…my question is i’m having an idea and concept how to execute that idea and i’m having my team to execute their respective rolls…but we don’t have single penny to start…we want 20-30lac to start the operations..then how the angel investors will value my idea in valuation process…and how much they will take their share? how i need to repay their loan?with just an idea how me and my team of 4 should distribute the % or share in the company?

    1. Sanchit Malik

      Well from my personal experience! It totally depends, you should ask few of your friends to rich. If you are a well known entrepreneur then anyone will give you money in idea stage. But if you are a first time entrepreneur then it might be very difficult to raise money at an idea stage.

      You could also try to raise loan from the bank initially.

  3. Victor Santos

    Hi.

    Great explanation.

    But when the VC goes in, the Angel Investor will receive any money? All money goes to the company?

    Thank you.

    1. Sanchit Malik

      Hi Victor, Thanks! I am glad you found it useful. Regarding the question you asked, It depends on the deal with the VC which depends on the situation. Many a times the angels also don’t want to exit. Totally depends on the situation. There’s no hard rule for that.

      Sorry for the delay in my reply!

    1. Sanchit Malik

      Hi Shekhar,

      Valuation of your company depends on many parameters like

      1) Market Size and its growth
      2) Founding Team
      3) Product Maturity
      4) Competition
      5) How your startup idea is going to execute and many other parameters.

  4. Sandy

    Great update Sanchit. One question…

    If after the first investment of 20L and valuation of 2 cr (as per your example), assets of the company = 20cr.

    Now is there any relevance of the revenue and profit to 2 cr or 20 cr as per the example

Leave a Reply

Your email address will not be published. Required fields are marked *