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Choosing the Right Funding Instrument: Types and Considerations

Introduction:


Entrepreneurs often think that equity financing is the only option to raise funds. However, there are many alternatives to consider, especially for early-stage startups that have different milestones at each stage of their journey. As your startup grows, you might need larger sums to achieve multiple objectives and plan for long-term growth. Understanding your funding needs is crucial and this requires thorough financial planning to determine how much capital your company needs to achieve its short-term and long-term goals. Sometimes, you might only need a small amount, which could come from a grant or a personal loan from friends and family. At other times, you might need a significant investment from venture capitalists.


In addition to traditional equity financing, there are several other options that do not require immediate valuation of your startup. For example, Compulsory Convertible Debentures (CCDs) and Convertible Notes allow you to raise funds without the urgent need to determine your company's future valuation. These instruments can be particularly useful in the pre-revenue stage of your startup. Another critical aspect to consider is the need for working capital. Many investors, after making an initial investment, wait for future expansion opportunities and often overlook the necessity of working capital funds. Therefore, ensuring a steady flow of working capital is crucial to maintaining operational stability and supporting short-term assets such as accounts receivable and inventory.


Entrepreneurs today have access to funding from a variety of capital providers. These include lenders (banks, NBFCs, debt funds), equity investors (Venture Funds, Angel investors, Private Equity), and grants from foundations and governments or even research bodies. These investors can help your company raise capital with a variety of funding instruments. Often the implication of choosing one funding instrument over the other is not known to founders given the complexity of each instrument.

Our deep dive into these funding instruments should help you understand the implications of raising funds from these varied sources.


Equity:

Equity financing refers to raising capital by selling shares of the company to investors who are funding the company. This allows the company to run business operations or to grow and develop without relying on debt financing. In other terms, it simply means selling a portion of the company's equity in return for capital. This type of financing is typically provided by investors such as venture capitalists, private equity firms, angel investors, and incubators/accelerators.


Advantages of raising equity:

  • Unlike loans, equity financing does not require the company to repay the capital, thereby reducing financial pressure.

  • Investors bring valuable experience, mentorship, and business connections, providing guidance to navigate challenges and accelerate growth.

  • Having reputable investors on board can enhance the credibility and visibility of the startup, which further helps in attracting the customers, partners and future investors.

  • Equity capital is utilized for strategic scaling, early-stage working capital, team expansion, and achieving product-market fit.


Debt:

Many entrepreneurs think they will not be eligible for debt because their companies are not profitable. However, over the past few years, there has been a proliferation of options from both banks and NBFCs. Banks are supposed to lend up to 5 crores without any collateral as per the CGTSME scheme, and all nationalized and private banks have the authority to provide loans. This scheme aims to support small and medium enterprises by making credit accessible without the stringent requirement of collateral, thus fostering entrepreneurship and innovation.

 

In addition to traditional banks, there are many sector-specific NBFCs that can help startups raise working capital loans quickly, enabling them to grow their businesses. These NBFCs often have more flexible lending criteria and quicker processing times compared to banks. However, to obtain debt, directors need to ensure they have a proper CIBIL score, as lenders check this in addition to other requirements. Maintaining a good CIBIL score demonstrates creditworthiness, which can significantly enhance a company's chances of securing the necessary funds to achieve their business goals.


Advantages of Debt Financing:

  • Opting for debt offers tax benefits, as the company's interest payments are often tax-deductible, reducing its taxable income.

  • Debt financing provides immediate access to funds, enabling businesses to pursue growth opportunities without delay.

  • Lenders cannot influence the company's operations, as there is no loss of ownership in debt financing.

 

Convertible Notes:

A Convertible Note basically refers to a short-term debt instrument that can be converted into equity. These are often used by seed investors who invest in startups. They are structured as loans that can be converted into equity of the company in the future after a certain duration. Investors benefit from favorable terms like discounts and valuation caps, that offer them equity at a potentially lower price. This benefits both the company and the investor by deferring valuation negotiations until the company gets more established.


Advantages of Convertible Notes:

  • The primary advantage of issuing convertible notes is that share valuation is not required which makes it easier for startups to raise funds.

  • Investors generally do not have any control or voting power when they subscribe to convertible notes.

  • Convertible notes allow for negotiation in a variety of terms, such as interest rates, conversion discounts, valuation caps, and maturity dates, benefiting both startups and investors.


Grants:

Grants are basically financial awards provided by any government/private institution to entrepreneurs/founders to help them develop their business that would result in a change in the economy. These grants are often issued without expecting the obligation of repayment. Examples of grants include government grants, Non-Profit Organization Grants, Corporate Grants, Academic and Research grants. Companies will have to research the organization that is providing grants, understand the procedure and get benefited from those who are providing grants for businesses.

Advantages of Grants:

  • Grants are typically monetary awards provided by various institutions and stand out as a non-repayable form of capital. This is particularly beneficial for startups that are in the early stages and not yet established.

  • Grants also benefit as they are specifically targeted towards supporting R&D efforts, encouraging business to push the boundaries of knowledge and create ground-breaking solutions.

  • Securing grants involves a rigorous application process where companies present their ideas, plans, and strategies to experts. This process provides market validation, enhancing the company's credibility and reputation.

  • Grants are not just limited to monetary benefits, they also offer access to specialized resources like mentorship programs, industry experts, research facilities or technical expertise.

 

Revenue-Based Financing:

Revenue-Based Financing (RBF) or Royalty-Based Financing refers to a type of funding where investors provide capital to your business in exchange for a percentage of its ongoing gross revenues. This financing model is designed to align the interests of the business and the investors, as repayments are directly tied to the company’s revenue performance. Unlike traditional loans or equity investments, RBF does not require giving up equity or providing collateral.


Advantages of Revenue-based financing:

  • RBF investors do not take equity or control decisions, allowing founders to retain full ownership and decision-making power. This means no dilution of ownership and no board seats for investors.

  • It doesn’t require personal assets as collateral, unlike bank loans that demand personal guarantees. Founders can secure funding without risking personal assets.

  • Payments adjust to monthly revenue, ensuring you are not burdened with large payments during low-revenue months.


Compulsory Convertible Preference Shares (CCPs):

Compulsorily Convertible Preference Shares (CCPS) refer to a type of preference shares issued by a company with a mandatory conversion feature. These shares are essentially a hybrid financial instrument, combining elements of both preference shares and convertible debentures.


Advantages of CCPs:

  • CCP holders have first claim on company assets during liquidation, offering investors added security.

  • Conversion of CCPS to equity is tied to company performance, aligning investor interests with business success.

  • Initial investment in CCPS can be at a lower valuation, potentially leading to higher dividends upon conversion.

  • CCPS functions as equity, eliminating the need for debt repayments and reducing financial strain on the startup.


Compulsory Convertible Debentures (CCD):

Compulsorily Convertible Debentures (CCDs) are bonds that must be converted into equity upon reaching their maturity date or when specific events occur. CCDs are often used by startups and growth-stage companies that need capital for growth but are not yet ready to give up equity. According to the RBI’s guidelines, CCDs are treated as equity but not as part of the company's share capital. Therefore, they offer security to investors in the form of debt repayments, while ultimately being converted into shares.

Advantages of Compulsory Convertible Debentures (CCD):

  • Investors have no voting rights until shares are converted or a default occurs.

  • CCDs can be zero-coupon, eliminating the obligation for interest payments.

  • Investors receive liquidity preference over equity holders during liquidation.

  • Equity dilution is deferred, as conversion occurs at a future date.


 

Conclusion:


Choosing the right type of funding for your startup depends on various factors such as the stage of the business, growth objectives, and investor preferences. Regardless of the chosen funding mode, it's crucial to evaluate funding options, considering factors like cost, control, and long-term strategic alignment with investors to determine the most suitable approach for achieving growth objectives.


Additionally, by staying informed about industry trends and seeking guidance from experienced advisors, startups can navigate the complex funding landscape more effectively. Ultimately, the most effective funding strategy for a startup often involves a combination of different sources tailored to the company's stage of development and growth trajectory.

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