Startup Investment Journey- “From Zero to Billionaire”
As we have discussed in the article ‘Types of Startup Investors” that both bootstrapping as well as raising funds has its own pros and cons. If bootstrapping gives you the freedom to decide the fate of the company, funding gives you the wings to fly in volumes and big numbers. Let’s take a hypothetical startup case to understand the Startup investment journey- “From Zero to Billionaire”
STAGE 1: IDEA STAGE- You are the 100% owner of nothing
Founder’s eureka moment! You have an idea you think can give you billion dollars. If it is really that big an idea, one thing is sure that you need money and you need people. If you have sufficient savings to handle the operations, employee cost, server cost, product cost, marketing cost and thousands of such costs, then bootstrapping could be an option.
Depending upon the type of business you are in, the initial startup capital may vary. Let’s say you start with $ 15,000 (approx. INR 10 lakh). With this little amount you may kick start but running the business is not possible and very soon you will realize that you need a partner in crime.
STAGE 2: CO-FOUNDER STAGE- 50% owner of something
You may need a co-founder from the very beginning or may be a little late. Until and unless you have proven your idea’s worth, roping in a co-founder is equally costly, meaning, losing 50%. You cannot afford to let your co-founder feel being exploited. Now that you are offering 50 % partnership you can expect you cofounder to bring an equal amount of money with which you can little bit upgrade your technology to next level, invest in marketing and taping customers.
First thing first, gets your company registered. Suppose you both issued 10 lakhs of common shares for yourselves and divides equal amount. Now, from nothing you are the owner of 50% shares of a company.
Set aside a specific percentage of your stocks as Option Pool (share of stocks reserved for employees of a company) so that it is safe from both the co-founder’ and investors’ hands. This option pool is the thing, which will help, in your worst time. Cash crunch will keep bothering the founders but good brains need money so, the only option left to pitch in brains is to share equity and salary combination. This works otherwise as well, the employees feel a sense of ownership and does not give up easily.
Setting aside option pool in the start is imperative for two reasons
1- Initially you don’t have cash but the startup desperately need brainy people to show results to investors. So you can offer equity for their efforts. It is also called “sweat equity”.
2- Investors would not be able to poke their nose in deciding the share of option pool
In order to simplify and make things more understandable, I am keeping Option Pool outside the purview of our calculations.
Two are still too less to gear up. Now search your contact list for riches. Rich family members and friends are the low hanging fruits. Approach them. Now things are becoming formal. Make sure it is a completely formal process. Your rich friend has to be rich enough to qualify SEBI’s definition of accredited Investors. SEBI defines Accredited Investors” includes: (i) Qualified Institutional Buyers (“QIB”), (ii) Indian companies and high net-worth individuals having a net worth of INR 200 million (approx. USD 3.33 million) and INR 20 million (approx. USD 0.33 million), respectively, and (iii) Eligible Retail Investor (ERI), who is an Indian citizen / NRI complying with the proposed criteria.
Suppose you convinced a rich friend of yours to invest $ 20,000 (INR 12 lakh) in exchange of 10% equity. That means your friend valued your company at $ 2 lakh (approx. 1.2 Cr). Here is how your equity will dilute.
It is easily misunderstood that the founders give their shares to the new entrant, but in actual, the founder’s shares remain the same (5 lakh each) only the percentage of equity varies. As, the company issues new preferred shares to the friend the total value of the company increases and hence you have a little lesser percentage of a bigger amount. Since the founder’s equity has been diluted by 10% (5% each), both the founders hold 45% shares of the company.
Calculating how many shares the company should issue?- Since founder 1 holds 5 lakh share (which remains constant) which is now 45% of total. Let the total number of shares be X
45% of X = 5,00,000
X = (5,00,000 x 100) /45
X = 1111111.1
Rounding off we can say 11,00,000 (eleven lakh)
Since both the founders hold 10 lakh out of the total shares of the company, the company now issues 1 lakh-preferred shares to the friend.
Although your percentage of shares has shrunk but watch the difference between the sizes of the two pie charts. The overall size of your circle is increasing. Earlier you were the owner of 50% of something and now 45% of $ 200,000 i.e, $90,000.
By this stage, you have made yourself a $ 90,000 man from nothing.
STAGE 4: RAISING FUNDS- THE SEED CAPITAL
With your friends money, many things become happy and dandy for you, but this money will not last a lifetime. With growth and expansion plans on cards, you will soon come back to the previous situation. You are doing a real business now growing leaps and bound, much more confident. You have numbers to show, brainy employees to flaunt. Yes, you are ready to compete for angel funding.
Now suppose angel agrees at a valuation of $ 1 million (6 Cr) and agrees to give you $ 0.2 million (1.2cr). Does it mean he gets 20% equity? No! Equity is decided not on pre-money valuation but post-money valuation.
Computing equity of the angel investor- post valuation:
Now your company is worth $ 1 million (valued by angel)+ $ 0.2 million (money promised) = 1.2 million.
Now angel’s share= 0.2/ 1.2= 1/6
Hence, everybody’s share will be diluted by 1/6
|Co-founder 1||Co-founder-2||Rich friend||Angel investor|
|5 lakh shares||5 lakh shares||1 lakh shares||2 lakh shares.|
* For simplification, the above figures have approximated.
If the decreasing percentage of shares you are holding in the company is teasing you then please mind the size of the circle. With each step, you are having a smaller share of a bigger circle from the previous stage.
STAGE 5: THE FOLLOW-UP ROUNDS
Similarly, the process goes on for further rounds of funding. With each round of funding, the radius of the circle increases and you get a smaller pie of larger circle.
STAGE 6: GOING PUBLIC
Going public means issuing IPO and then anybody can buy your stock. This is one of the things your investors want from your company because after a company is public investors get an exit route.