Startup news is generally dominated by headlines of large funding rounds, often at seemingly high valuations. How this money comes in, and how so many millions of dollars are managed by young companies are less known. It isn’t as simple as it sounds. Moneycontrol explains:
How does startup funding work?
Startups raise multiple rounds of funding, from their initial ‘seed’ money to Series A, B, and so on. Each round is generally larger than the previous one and at a higher share price/ valuation. In each round, the company issues new shares in exchange for money from investors. The founders' stake reduces after each round. For mature companies or unicorns, founders may hold a smaller stake- say less than 10 percent, but these shares become quite valuable over time. Founders prefer diluting less with each round. Many founders dilute 15-30 percent for their first round, but may sell only 0.5 percent or 1-2 percent of their shares later on, because those shares are now quite valuable.
When a startup raises money, does the money come in all at once?
Good question. It still varies from case to case, but top founders prefer getting the money in one go, rather than in tranches. In the current environment, where internet startups are spoilt for money, founders dictate terms, and hence, sending money in tranches is uncommon, even for large rounds of $100 million or more.
That said, some early-stage VCs still say they want to give the money in 2-3 tranches over a year or so, to promote frugality from the entrepreneur. One VC says that the founder may not initially appreciate it, but when he/she builds a company frugally and gets the rest of the round when needed, they realise its value.
If an amount of funding is promised, why can’t investors just send all the money in one go?
They can, and that’s what is happening these days. But in some cases, more in private equity investments for traditional companies, funding is also contingent on performance goals. The money raised is not simply in exchange for shares of the company but also sometimes tied to revenue milestones, market share or other metrics. This is less common for technology companies, where milestones are harder to define, but the argument is that not giving all the money upfront keeps the founder/company incentivised.
The flipside is that these investments are inherently made trusting the founder, and that trust also involves giving the money upfront. In the current market, investors also want to win the hottest deals, and are hence likely to agree to terms of sending all the money upfront.
Where does all this money go?
When a company raises $100 million, not all the money is going to be used immediately, right? In fact that’s true of smaller rounds of say $5 million as well, but more relevant for larger rounds, where a lot of the money can remain unused for years.
Most of this capital is invested in liquid assets such as equity and debt mutual funds, fixed deposits and bonds.
That sounds like a lot of work, especially for a small startup.
It is. Early-stage startups generally just put the money in a fixed deposit (FD), which is the easiest option with the least hassle. The money can at least generate some interest, which can also be used for business purposes later on.
And the larger ones?
As a startup gets larger, it hires dedicated people for finance- a Chief Financial Officer (CFO) or Finance Controller to handle the company’s investments. Many internet companies even work with dedicated wealth managers from funds such as IIFL or Kotak among others, who advise them on their company’s investments.
This function, called treasury management can also constitute an important if less-publicised role at a startup, because in many cases- tens to hundreds of millions of dollars are being invested in these short term assets. They need to be spread across assets that will generate a return- but the money should be liquid- be able to withdraw it the moment it is needed.
What else?
Startups raise money from venture capitalists by selling shares and from venture debt funds- by taking a loan. VCs and debt funds both help their portfolio companies with investment management too. Investors want to be more than mere money bags and promise a suite of portfolio services including investment management, hiring for senior roles, and analysts at VC firms often work closely with companies on specific projects- almost like an employee of that company.
How do companies decide where to invest?
It is like any investment decision, a question of liquidity and returns. Any non-liquid assets, say real estate, or anything too risky- say bitcoin, are no-nos for most startups. The point is preserving the capital and earning whatever possible return on it.
Tax efficiency also matters. Some startups make use of the government’s Startup India plan, under which startups can get tax breaks. Loss-making startups (and most startups by design don’t make profits in the early years) can carry forward losses and set that off against profitable investments. Startup India offers a 10-year window, in which for 3 years startups can get tax waivers. Many companies plan their investments keeping these laws in mind.
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