Managing startup equity (Equity For Startups)


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Among the more important decisions that an entrepreneur makes is that of raising capital. Many choices have to be made in this context: Debt versus Equity. Own funds versus Funding from outside investors and so on. These choices have long term implications for the entrepreneur as well as the start-up. Equity funding is essential for the growth of a startup. Apart from providing critical funding equity investors also often bring added value by way of connections and strategic advice.

At the same time raising equity capital means sharing control and sharing wealth with the investors in the firm. Allowing investors to engage with the management of the startup calls for a certain degree of compatibility between the investor and the management of the enterprise. Absence of such compatibility can lead to unhappy relationships between the investor and the management team.

All things considered, managing the equity of a start-up is among the most critical decisions that an entrepreneur needs to make. It involves many trade-offs on the entrepreneurial journey. Which makes Managing the Equity of A Start Up a challenge. What does dilution of equity mean? How does the arithmetic of dilution work? How does an entrepreneur decide on when to raise equity? And how much of equity to raise?

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Managing startup equity (Equity For Startups)

  1. 1. Dr. G. Sabarinathan Managing Startup Equity Presentation at 4startups August 3, 2013
  2. 2. Agenda 1. Why is it important to pay attention to the equity capital of a firm? 2. The Growth vs Dilution Dilemma 3. The notion and arithmetic of dilution 4. When should firms raise capital? 5. Equity as currency for resource acquisition
  3. 3. Disclaimers • No canned solutions • Pointers to think • Questions to ask Managing Startup Equity: Dr. G. Sabarinathan 3
  4. 4. Startup: The Investor’sView • High risk – not enough information to go by • High level of information asymmetry • Interests may not always align • The entrepreneur is in control • Incomplete organisation • Most often expects return and liquidity – in a reasonable time frame Managing Startup Equity: Dr. G. Sabarinathan 4
  5. 5. Startup: The Entrepreneur’sView • Pursuit of a passion or vision • Needs – Resources – Manoeuvering room – Control? – Mentoring / Sounding board – Network – Financial reward – Funding consistent with these needs/aspiration Managing Startup Equity - Dr. G. Sabarinathan 5
  6. 6. Enter…Equity Capital • The great invention that allows investors and entrepreneurs to share risk and reward equitably • The most common form of funding startups across the world – in the developed world at least • Two important rights attached to equity: The right to • Share wealth – “Rich” side • Vote – “King” side • One of the key challenges in managing equity mobilisation • Resolving the “Rich vs King” dilemma* • The entrepreneur may not always have a choice, though! * expression courtesy Professor NoamWasserman, Harvard Business School Managing Startup Equity -Dr. G. Sabarinathan 6
  7. 7. What happens when a company issues shares to raise capital? Managing Startup Equity: Dr. G. Sabarinathan
  8. 8. The Growing Pie Metaphor • Sharing ofWealth • Sharing of Control Founder Ownership Before Sharing Founder Ownership After Sharing Equity split after raising external equity Managing Startup Equity: Dr. G.Sabarinathan Investor’s share
  9. 9. Equity Dilution Illustrated…I No of shares 1,000 Value of Assets 10,000 Value per share 10 Founder's share 100% Position of HiGrow Ltd., prior to raising any external equity Managing Startup Equity: Dr. G. Sabarinathan
  10. 10. Equity Dilution No of Shares Pre Fund Post Fund Rs/ lakhs Rs/ lakhs Founder 1000 1000 Investor 0 250 Total 1000 1250 % Equity Founder 100% 80% Investor 0% 20% Total 100% 100% Value Rs/ lakhs Rs/ lakhs Founder 10,000 20,000 Investor 0 5,000 Total 10,000 25,000 • Value of the equity before funding is Rs 10,000 • Funding causes • Drop in founder’s % equity • Increase in value of firm’s equity • Increase in founders’ wealth => “Growing pie” paradigm • Dilution is good from founder’s wealth perspective – assuming it makes the firm more valuable! Managing Startup Equity: Dr. G. Sabarinathan
  11. 11. The Story of Neuronautica • Founded by three neuro-psychiatrists with collective experience of forty years in dealing with children with Selective Learning Disabilities • Series of products lined up around FocuScienceTM, the “Science of Focussing”. • Products claimed to bring about slow transformation in the biochemistry of the brain without the help of chemical-based pharmaceutical products. • Collection of exercises, games and devices to help improve retentivity and problem solving capability through improving concentration • Target: Children in the age group of eight to fourteen years • Non-pharma product: Does not require clinical trials or approvals • Sourcing / manufacturing arrangements tied up • Distribution / marketing possibilities under consideration – Own channel of FocuZonesTM – high investment /risk / return/ model – Distribution through toy stores, supermarkets and malls – Moderate investments in advertisements, inventories and marketing collaterals – Institutional marketing through schools – Low investment, low margin, low volume model Managing Startup Equity : Dr. G. Sabarinathan
  12. 12. Stage I Stage 2 Stage 3 0-12 months 12-24 months 18- 36 months Stage 4 Product Development Test MarketingActivity Cash 100 500 2000 Market Development Mfg / Sourcing Stabilisation Biz Expansion Exit for Early Investors? Elapsed Time BizGrowth Neuronautica Development Roadmap and Funding Plan Managing Startup Equity : Dr. G. Sabarinathan
  13. 13. Evident Funding Implications • Needs infusion of cash over a 36 month period • Absence of funds can derail growth plans • It is very likely that the company will be burning cash up until the first 24 months • Requirement of funds is growing during this period • Biz subject to numerous risks throughout the period • Risk highest at start, each stage will reveal new information
  14. 14. Financial Challenges in A Startup • Demand side Challenges – Product development challenges – Unpredictable cashflows – Invariably investment is in intangibles / assets with low resale value – Uncertain market responses and revenue prospects – Staging fund raising resolves uncertainties, addresses investor worries • Supply-side challenges – Raising capital is a very, very, costly process – Over time investors could lose interest in a given sector – Valuation varies as market conditions change – Market seizes as macro outlook worsens – Inability to garner any other form of financing • Debt / Suppliers’ Credit / Customer funding / Partner funding Managing Startup Equity : Dr. G. Sabarinathan 14
  15. 15. Managing Startup Equity: Dr. G. Sabarinathan Kakofonix – Proforma P&L Year 1 2 3 4 Sales 1,800 12,600 36,000 68,400 Total Costs 2,140 10,030 27,000 50,520 PBIDT (340) 2,570 9,000 17,880 PAT (1,440) (30) 2,988 5,928 Cash from Ops (1,540) (3,430) 200 1,928 Cumu Investment 1,200 7,200 16,800 28,800 All figures in thousands of rupees Funding Strategies and Dilution Implications • Rs 7.2 m: 14% dilution • Rs 16.8 m: 30% dilution • Rs 28.8 m: 52% dilution
  16. 16. Managing Startup Equity: Dr. G. Sabarinathan 16 Kakofonix – Proforma P&L Year 1 2 3 4 Sales 1,800 12,600 36,000 68,400 PAT (1,440) (30) 2,988 5,928 Cash from Ops (1,540) (3,430) 200 1,928 Cumu Investment 1,200 7,200 16,800 28,800 All figures in thousands of rupees Business Strategy – Financing Link: What the forecasts say • UptoYear 2 Kako needs external funding • InYear 3 it covers all its cash costs and a little more • InYear 4 Kako is comfortable in terms of cash • Questions: How good are the forecasts? • What will work for Kako: Invest and Grow vs Grow and Invest • Caveat: Speed of execution important in consumer marketing
  17. 17. Now vs Deferred Now • Money in the bank – focus on building business • Saves cost of raising capital • High level of dilution – penal provisions may be harsher with larger funding • Lock into one funding partner Deferred • “Power of penury” effect • Saves dilution • Bringing in more than one partner, each serving a different purpose • Worsening terms • Availability? Managing Startup Equity: Dr. G. Sabarinathan 17
  18. 18. Resolving Growth vs Dilution Conflict • The key issue in today’s workshop • Valuation is a key variable – More cash , more dilution – Better valuation leads to lower dilution • ManagingValuation: Link to performance – Convertible instruments – RatchetedWarrants / buyback options to founders – Floor on dilution, cap on investor equity • Dropping “invasive clauses” linked to performance
  19. 19. Terms that matter • From a Control perspective – Differential voting rights – Veto rights – Drag along and put options – Board nomination rights – Key executive nomination rights • From a Wealth perspective – Valuation – Option pools Managing Startup Equity : Dr. G. Sabarinathan
  20. 20. Equity as Currency • Extraordinarily expensive – use it only for what money can’t buy – External equity poses “holdup costs” • Tie it to Delivery: Defer or vest – Ratchet: Raise the bar for every additional unit of equity • ESOPs – Unregulated for unlisted companies, SEBI guidelines for listed companies • Who to allot shares to? – Socialistic – a few shares to all – Seriously golden handcuffs to a few? • Depends on – Objective – Stage of evolution? – Write your contracts carefully – Take back equity from “defaulters”
  21. 21. THANKYOU Managing Startup Equity: Dr. G. Sabarinathan