Funding refers to the money needed to start and run a business. It represents a financial investment in a company to support activities such as product development, manufacturing, expansion, sales and marketing, working capital, and inventory. While some startups opt not to raise funding from third parties and instead rely on funding from their founders to avoid debts and equity dilution, but the majority of startups do raise funding, particularly as they grow larger and scale their operations.
The following information will guide you through the various aspects of Startup Funding, including different funding sources, the funding process, and important considerations for entrepreneurs seeking financial support for their startups.
Why Funding is Required by Startups
It is crucial for entrepreneurs to have a clear understanding of why they are seeking funding before beginning the fund-raising process. Raising funds is not a cakewalk and therefore every startup founder should have a detailed financial and business plan for pitching to the potential investor/lender. An entrepreneur might require funding for one, a few, or all of the following purposes.
- Prototype Creation
- Product Development
- Team Hiring
- Working capital
- Legal and consulting services
- Raw material & equipment
- Marketing & Sales
- Office Space and Admin Cost
Types of Startup Funding
The next question startup founder faces is which type of funding they should resort to. In order to provide an answer, several parameters must be analyzed, including risk assessment, ownership dilution, and involvement in decision making.
| Parameters | Type of Funding | ||
| Equity Funding | Debt Funding | Grants | |
| Brief about | In equity financing the founders have to sell certain portion of their investment in company’s equity to the investors in return of capital. | Debt is an old form of funding involving borrowing of money and repaying with interest to the lenders. | A grant is usually a financial support given by government or any institution to support a goal or incentivize performance. |
| Repayment | There is no component of repayment of the invested funds. | Borrowed funds have to be repaid within the tenure of the loan along with interest. | There is no component of repayment of the invested funds. |
| Risk | –For financer there is no guarantee of return or growth against their investment. –Startups have to give their ownership in business and which can also sometime affect their decision making | — The lender do not have any control on the business and in case of unsecured funding there can be chance of bad debts if startup fail to generate cash. — Startups- They have to provide collateral to obtain funding. | Financer: There is a risk of the startup not meeting the goal or objective for which the grant has been provided. Startup: There is a risk of the startup not receiving a portion of the grant due to several reasons. |
| Growth vs Cash Generation | The startups are continuously trying to achieve growth as they are not under pressure of repayment of fund raised. | Since debt funding involved timely repayment and therefore startups have to focus on generating cash to repay debt. This can affect their growth. | Grants are distributed in different tranches w.r.t the fulfilment of the corresponding milestone. Thus, a status is constantly working to achieve the milestones laid down. |
| Return to Investors | Capital growth and dividend | Interest | No return |
| Involvement in decision making | Equity Investors usually prefer to involve themselves in the decision-making process which sometimes can affect startup operations and founders independence | Debt Funders usually has very less involvement in decision-making | No direct involvement in decision making but donor can ask for details about utilisation of funds. |
| Sources of funding | Angel Investors Self-financing Family and Friends Venture Capitalists Crowd Funding Incubators/ Accelerators | Banks Non-Banking Financial Institutions Government Loan Schemes | Central Government State Governments Corporate Challenges Grant Programs of Private Entities, NGOs |
Various Stages of Startups and Source of Funding
Startups have access to multiple sources of funding. However, the source of funding should typically align with the stage of operations of the startup. It is important to note that raising funds from external sources is a time-consuming process and can easily take months to raise funds.
Below are the various stages of startup operation and funding options:
1. Ideation
This stage is where the entrepreneur has an idea and is working on bringing it to life. At this point, the amount of funds needed is usually small. Additionally, in the initial stage of the startup lifecycle, there are very limited and mostly informal channels available for raising funds which are:
Bootstrapping/Self-financing:
Bootstrapping a startup involves the entrepreneur growing the business with little or no venture capital or outside investment. It means relying on their savings and revenue to operate and expand. Most entrepreneurs consider this as their first recourse since there is no pressure to pay back the funds or dilute control of their startup.
Raising funds from Friends & Family:
Mostly startup founder utilizes this channel of funding since it is not easy to raise funds during ideation and also there is natural trust involved between the founders and investors i.e., friends & family.
Pitching Events:
There are various organisations which organises startup events to judge various business plans and reward to the winners in form of Prize Money/grants. Even though the quantum of money is not generally large, it is usually enough at the idea stage. Having a good business plan makes the difference at these events.
2. Validation Stage
At this stage, a startup has a prototype ready and needs to validate the potential demand of the startup’s product/service. TThis process is known as conducting a “Proof of Concept (POC),” which is followed by a major market launch. Startups must conduct market trials, test their products/services with customers, onboard mentors and a team. To support these efforts, the following sources of funding can be explored:
Incubators
Incubators are organizations set up with the specific goal of assisting startup founders with building and launching their startups. Incubators along with offering a lot of value-added services like office space, utilities, admin & legal assistance, etc., also make grants/debt/equity investments.
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.
Angel Investors
Angel investors are individuals who invest their money into high-potential startups in return for equity. There are various platforms for network of Angel Investors.
Crowdfunding
Crowdfunding involves raising funds from large number of small investors. There are various online crowd funding platforms like Fundable, Kickstarter, Indiegogo, Wishberry, Ketto, Catapoolt, Thehotstart.
3. Early Traction:
The Early Traction stage of a startup refers to a crucial phase in its lifecycle where the business has made significant progress beyond the initial idea and product development, and it starts gaining momentum and attracting early customers. This stage comes after the startup has launched its product or service in the market.
During the Early Traction stage, the primary focus shifts towards validating the product-market fit, acquiring customers, and generating revenue. Key performance indicators (KPIs) such as customer adoption rates, revenue growth, user engagement, number of app downloads, customer visits, and market feedback become essential metrics for assessing the startup’s success.
At this stage Series-A funding is raised to further grow the user base, product offerings, tapping new geographies. Below are the common funding at this stage of startup:
Venture Capital Funds
Professionally managed investment funds known as Venture capital (VC) funds exclusively invest in high-growth startups. Each VC fund has its investment thesis, including preferred sectors, the 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)
At this stage, the startup can raise formal debt from banks and NBFCs since it can demonstrate market traction and revenue, validating 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
A venture debt fund actively provides debt financing to startups and high-growth companies.
4. Scaling Stage of Startups
This is a stage where startups gain the momentum and experience a fast rate of growth and increasing revenue.
At the stage a startup resort to Series B, C, D & E funding.
Venture Capital Fund
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 that have maintained a consistent growth record. Private equity/investment firms actively invest in companies by providing capital in exchange for ownership equity or other financial instruments.
5. Exit from Startups
Any equity investor be it an angel or VC fund they do it with only two motives is to get a high growth of their capital and dividend income. After taking startups to a certain level, they seek for exit options which can be in any of the below form:
Mergers & Acquisitions
For exit the investor may sell their portfolio company to another company in the market. They can opt either merging with another existing company or may acquire another company in full or part.
Initial Public Offer (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, startups with an impressive track record of profits and who are growing at a steady pace generally undertake it.
Selling shares
Investor may take exit from startups by selling their investment to some VCs or private equity firms.
Buybacks
Startups who have enough liquidity can also resort to buyback shares from investors and regain control over the company.
Steps in Startup Fund Raising
In startup fundraising, there are several essential steps to follow. These steps are crucial for securing the necessary funding to support the growth and development of the startup.
Here are the key steps in the startup fundraising process
| Business Plan and Financial Projections: Before seeking funding, it is crucial to have a solid business plan and financial projections that clearly outlines your value proposition, target market, revenue model, and growth strategy. |
| Determine Funding Needs: To meet your startup’s goals, assess capital needed, define funding purpose, and create a milestone-based plan with clear timelines. |
| Assessing Investment Readiness: Investors only consider startups that are confident in their revenue projections and potential returns. They look for revenue growth, market position, time to break even, profitability, uniqueness, competitive advantage, founders’ vision, future plans, and compatibility of the founding team. |
| Pitch Deck Preparation: Create an impressive pitch deck that tells a cohesive story about your startup’s vision, market potential, competitive edge, team, and financial projections. |
| Networking and Building Relationships: Establish connections with potential investors through networking events, startup conferences, and industry gatherings. |
| Investor Targeting: VC firms have an investment strategy called an investment thesis. To understand it, review their website and previous investments, and talk to successful entrepreneurs. |
| Due Diligence: If an investor shows interest in your startup, they will conduct due diligence to confirm your assertions and uncover any potential problems. |
| Term Sheet Negotiation: Negotiate investment terms in the term sheet to align with startup objectives. Includes valuation, investment and management structure, and changes to share capital. |
| Legal and Financial Documentation: After finalizing the terms, legal and financial documentation will be prepared. Seek legal counsel to review and finalize the agreements. |
| Closing the Deal: Once all parties agree on the terms and the necessary legal documentation is completed, the funding round is closed, and the investment is made. |
Conclusion
Remember, the fundraising process can be time-consuming and challenging. Be persistent and open to feedback during the process. It’s essential to find investors who align with your startup’s vision and can provide not only financial support but also valuable expertise and mentorship.
