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Startup Funding – What is it and Why do people invest in startups?
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Startup Funding – What is it and Why do people invest in startups?

Burger King India came up with their Initial Public Offering (IPO) last week and investors went nuts over the issue. An IPO is when a private corporation raises capital from public investors by issuing its stock in the share market. The Burger King IPO was subscribed over 156.6 times, which simply means if the company was selling 100 shares, people placed orders for 15,660 shares. The most interesting part of this is that Burger King India has not made a single rupee in profit after taxes. Now, why are people so keen to invest in a business that has a ₹38.27 crores loss in its 2019-20 balance sheet?
Today’s post will shed light on the startup funding and valuations of startups. First, let’s start from the basics.

Startup Funding: refers to the money raised by a new business to meet its initial costs such as inventory, licenses, office space, product development, etc. It can be raised from a variety of sources and used to set up and grow the business. The top startup funding sources include the use of personal savings & credit, friends & family, Venture Capital (VC), Angel Investors, Banks and Crowdfunding.

Before an entrepreneur can go to an angel investor, VC firm or banks to raise capital, they need to have a basic working product and some figures and projections with a working business model. But getting from the idea to building a prototype or business model will require money. And at this stage, you can either use your personal savings and credit to fund your idea or turn to your friends and family to raise capital. When you raise capital from friends and family to build a prototype of your business, it is called seed funding.

Minimum Viable Product (MVP):

When you are investing your personal money or raising seed capital, you might not have access to huge capital to build a full-scale product/business. In this case, you build a minimum viable product (MVP) to understand customer behaviour with the product or service. A key premise behind the idea of MVP is that you produce an actual product that you can offer to customers. Seeing what people actually do with a product is much more reliable than conducting surveys. Based on this data, you can build your product or service around customer preferences and accordingly create a business model.

Once you have an MVP and a business plan, you can raise startup funding from Venture Capital firms or Angel Investors who can provide you enough capital to convert your MVP into a full-scale business.

Venture Capital Firm is an organisation composed of many angel investors and other corporates who pool in their money to invest in businesses with huge growth potentials.
Angel Investors are typically high net worth individuals who look to put relatively small amounts of money into startups, typically ranging from a few thousand dollars to as much as a million dollars.

Registering a company:

Before you go looking for investors, you will first have to get your company registered. Company registration has different costs in different countries and may vary among states of the same country as well:

  • USA: the cost of incorporating a company vary from $25 to a few thousand dollars which include registration fees and legal fees.
  • India: the cost of incorporating a private limited company is just ₹7000 if you incorporate it with the minimum authorized capital of ₹ 1 lakh.
  • UK: the cost of incorporating a private limited company vary from £12 to £100 depending upon the mode of registration. (£12 for online registration. £40 for registration by post.£100 for same day offline registration.)
  • Australia: incorporating a proprietary limited company will cost around $469.

Shares and Valuations:

A company usually issues 100,000 shares initially. These shares are divided among founders, employees and investors. The investors are the ones who actually pay for their shares and based on this, the company/business is valued. For instance, an investor buys a 10% stake (10,000 shares) in a business for $1 million. Then, each share will be worth $100 and hence the company valuation will come out to be $10 million. This valuation is just a number and does not have to do anything with the revenue, profit or assets of the business. It might as well happen that the investor buys the 10% stake for $1 million and might not be able to sell it for even $1, in the off chance the business fails completely.

Why do people invest in startups?

The simple answer – To earn returns that seem impossible in any other form of investments. Imagine if you had the chance to invest in Facebook, Amazon, Google, Apple, Tesla, etc. in their early stages. Your thousands would have turned to millions, if not billions by now. So, investors seek startups that show potential for growth. Even if the business is not generating any revenue, but shows high potential, investors are willing to take a risk. If you think that’s crazy, you need to know Facebook did not run ads (its major source of income) until 3 years after the website was unveiled.

The greater the risk, the greater is the reward.

Risk-Return tradeoff
Exit Strategy

But in order to actually earn money from the investment, the business must have an exit strategy. An exit strategy is a strategic plan of the stakeholders to sell their stake in the business to reap benefits and earn profits. There are two options when it comes to planning an exit strategy:

1. Selling the company to a Corporate Giant: There are a lot of large corporate giants which acquire startups to help their business. Since we are talking a lot about Facebook, it has acquired about 82 other companies, including WhatsApp for $19 billion and Instagram for $1 billion. An exit strategy is planned right from the start. If the entrepreneur and the investors are in the business purely to earn profits and nothing else, this seems the most beneficial option.

2. Initial Public Offering (IPO): A better alternative to selling the company outright is to launch an Initial Public Offering. An IPO is just another form of capital raise which takes place in the stock market and where investors are the real public. Post an IPO, the shares of the company start trading on the stock market. And hence, the investors can sell their stake as and when they want for the current market price.

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