29 Sep 2015 16:25 IST

Start-up funding: Getting the debt-equity balance right

This set of Q&As gives entrepreneurs guidance on fund-raising and registering as a company

Considering the scramble for funding among start-ups, what are the factors an entrepreneur should consider while diluting equity for funding? How much should optimally be diluted in the first round, as funding generally happens in multiple rounds?

Managing funding is essentially about balancing ownership against growth opportunities and one’s risk-taking ability. There is no clear-cut answer for the extent of equity to dilute in the first instance. Every entrepreneur must essentially do some self-introspection and take a call on this as it has a number of implications, such as further dilution at the next stage of raising funds and consequent implications for ownership and control.

However, as a thumb rule, it is always better to take only as much money as is absolutely required, without sacrificing growth in the initial stages. What I would strongly recommend is to break up the money requirements by months and not take more than three months of requirement upfront.

This will both ensure that the money is spent prudently and is raised at as close to the value of the business as possible. This is not always an easy proposition as investors would like to take a larger stake at a cheaper rate in the initial stages, if the business is promising as they have to spend the same time and money in due diligence and advisory effort.

Normally, when there is clear vision regarding revenues, debt may be a cheaper option. Equity is by no means cheap. However, this has to be weighed against one’s risk-taking ability, as also strategic issues such as the ability of investors to get in business and / or leverage their networks.

Do not assume that all VCs / funders will bring in business or networks as they promise; oftentimes, they don’t. Irrespective of what is claimed by them, it is better to do one’s own due diligence and take an informed decision based on facts and information received. Very often, the best people to ask are the ones who have taken funding from these folks.

In summary, business valuations are subjective and depend on the perceived growth prospects of the industry and business, besides the management team and flavour of the day.

For the bulk majority of businesses (excluding exceptions such as Flipkart, Ola and Snapdeal, which are a tiny fraction and whose business model in the long run remains to be validated ), it is good idea to have a clear path to profitability and cash-flows before one embarks on venture capital. Till then, it is better to tap angel investors diluting a smaller share, though the distinction between VCs and angels is also fast-changing.

If it a fast-growth, competitive business where you have to establish yourself as the clear No 1 or No 2 as quickly as possible, you may want to look at higher dilutions in the initial stages (smaller share of a larger business but also with the risks of control, for instance, as in Housing.com) while in a more steady-growth business, a gradual approach may be better.

Will a young entrepreneur get any advantage registering a company as a ‘private limited company’ instead of proprietorship, considering the compliance issues related to the former?

Essentially, there are two advantages in registering as a private limited company rather than as a proprietorship

— Limitation on liability

— Requirement if you want to raise angel/venture capital

The regulations in the case of a private limited company are a little more tedious but are a necessity, especially if you want to raise venture capital and /or attract good talent. Normally, professional managers with good experience are a little loath to join proprietorships.

Having said that, proprietorships are fine during the development phase, if you are not looking at outside investments (other than friends/ relatives / known sources) and you want a little more certainty before hitting the market. If you look around the start-up landscape, almost all known entities are organised as private limited companies when they hit the market with outside funding. It is better for the investors as well, as they don’t have individual liabilities if the business does not do well. Remember, success rates in the start-up business are very low — possibly 1 in 10.

The next column will discuss how young entrepreneurs can build their brands and retain employees in labour-intensive businesses.