November 15, 2013
While it is natural for founder(s) to think about putting up their entire savings into the start-up, there is a natural risk of failure in such a glorified endeavor. Under such circumstances, risk can be substantially reduced by borrowing capital from external entities. Whilst such a process does minimize the risk, it often comes at the price of reduced control and burden of interest. Detailed below are some mechanisms for raising external funding.
Family and Friends
Considered the cheapest source of funding, money up to the tune of Rs. 1 Crore can possibly be borrowed at little or no cost through family and friends. However, this requires maintaining healthy relations with family members as well as a strong circle of friends. Furthermore, one should have sufficient convincing power to enable them to share your vision. This option has the lowest risk, as in case of failure, debt obligations are mostly written off.
An angel investor is an affluent individual who provides capital for a business start-up. This is the second step in raising capital after seed funding from family and friends has been done. An angel investor typically invests his own money into the business in exchange for a convertible debt or ownership equity. Funding up to the tune of five crore rupees can be achieved if one is able to persuade the investor about the profitability of the business. Such a significant funding comes at the cost of the high returns that the investor anticipates for bearing an extremely high degree of risk. On an average, one out of ten start-ups fails within a year of operation (by Redin at dresshead online). Thus an angel investor seeks very high returns from his investments. He mostly looks to make an exit anywhere between three to five year of operations and expects his investment to become five to ten times during that period.
A venture capitalist is an individual or firm who invests money pooled from other people into business start-ups. Since they manage money from third party investors, venture capitalists only take into consideration those start-ups that have already received one round of prior funding and have been operating for at least a couple of years. There is no set limit for the money that can be raised through venture
capitalists, but on average, they invest anywhere from Rs. 5 to Rs. 20 Crore. In return, they take a controlling stake in the business and bring technical as well as managerial expertise into the business. The aim of the venture capitalists is to grow the firm to a reasonable size so that they may make an exit through an IPO or private equity sale.
If one has a good credit history or sizeable collateral, then a bank loan is an alternative to angel investors, as the interest charged by banks is not as steep. Interest rates range from ten to twenty percent based on prevalent economic conditions and an audit report conducted by the bank on the business. The only drawback is that banks are very stringent in their evaluation, especially in India and the paperwork often causes long delays before the funds are available.
The vehicle of choice for acquiring funding is at the discretion of the founder(s) and largely depends on their requirements. Each mechanism has its own set of advantages and drawbacks. Whereas, some are out rightly risky, others demand one to give up substantial control. Thus a choice should be made keeping in mind the anticipated outcome from the use of funds and the direction one wishes for the business to head to.
In the following blogs, we will explain the technical and mathematical aspects involved in Financing a Start-Up. So stay tuned!