Financing Options For Start-ups
Financing Options Available For Start-ups
One of the biggest challenge the founder of start up faces is in raising finance for the Capital. Your own funds,besides funds from family and friends get used up very quickly. The traditional indian bank is very conservative and may ask the founder of a newly set up start that ” we need last three years balance sheet “. most start ups ar also on an asset light model and do not have any collateral to give to the Bankers. And most of us know that “Banks only lend money to costumers who do not need the money ” . So what is the solution to this problem.
Capital for the business can be raised with a combination of Debt and Equity. Understanding basic finance and legal terms for the founder of any start up is very important.
A. Equity Financing
Startups are usually equity financed/funded by way of angel investors and/or venture capital/ private equity investors.
- Venture Capitalist/Private EquityVenture capital (“VC”) / Private Equity (“PE”) is often the first large investment a startup can expect to receive. Convertible instruments are usually the preferred option and most commonly used securities for VC/PE investment which includes compulsory convertible preference shares and compulsory convertible debentures. The investor and startup will normally enter into a non-binding offer based on the preliminary valuation of the startup usually followed with a financial, legal and technical due diligence on the startup as required by the investors. Upon completion of due-diligence to the satisfaction of investor such investments involve execution of essentially following transaction documents between the investors and startups:
- Term Sheet / Letter of Intent /Memorandum of understanding; Set out the following:
- basic commercial understanding between the VC and the startup; and
- legal terms for the agreements to follow the due-diligence;
- Share Subscription Agreement/ Debenture Subscription Agreement; Usually captures the followings:
- the issuance of shares in the share capital or debentures at subscription amount determined based on the valuation of the startup;
- condition precedents to completion of transaction or conditions subsequent to be completed within the agreed time frame after the completion date;
- sets of representation and warranties and indemnification resulting from due-diligence exercise or otherwise, etc.
- Shareholders’ Agreement; Usually provides for the following:
- Nomination/representation rights on the board of investee;
- Information and reporting right and disclosure obligation of investee to the investors;
- Redemption rights on debenture or preference shares;
- Pre-emption rights, Right of First Refusal or Right of First Offer, Tag Along Right, Drag Along Rights, Lock-in-period for the investor or promoter’s holding, put and call options, affirmative vote rights on certain reserved matters, anti-dilution provisions;
- Exit options to investors after the lock-in-period; etc.
- Term Sheet / Letter of Intent /Memorandum of understanding; Set out the following:
Due-diligence will help the investors to finalize the representation and warranties and also to identify conditions precedents to the completion of investments and conditions subsequent in the aforesaid transaction documents.
- Angel InvestorsAngel investors are usually individuals or a group of industry professionals who are willing to fund your venture in return for an equity stake. Under the SEBI (Alternative Investment Funds) Regulations, 2012 which was subsequently amended in 2013, SEBI has made the following restrictions applicable to angel funds investing in an Indian company:
- An investee company has to be within 3 years of its incorporation, not listed on the floor of a stock exchange, and should have a turnover of less than INR 250 million and not be promoted by or related to an industrial group (with group turnover exceeding INR 3 billion).
- The deal size is required to be between INR 5 million and INR 50 million. Separately, it is required that an investment shall be held for a period of at least 3 years.
B. Debt Financing
- Loan from Banks & NBFCsLoans from banks and NBFCs help finance the purchase of inventory and equipment, besides securing operating capital and funds for expansion. More importantly, unlike a VC or angels, which have an equity stake, banks do not seek ownership in your venture. However, there are several drawbacks of such funding option. Not only do you pay interest on loan but it also has to be done on time irrespective of how your business is faring. They require substantial collateral and a good track record, besides the fulfilment of other terms and conditions and a lot of documentation as follows:
- Application for loan sanction by borrowers;
- Issue of sanction letter by the Bank;
- Agreement of Loan;
- Security/collateral documentation, such as (i) Deed of Mortgage; (ii) Deed of Hypothecation; (iii) Deed of guarantee; (iv) Share pledge agreement; (v) Memorandum of Entry; etc.
- External Commercial BorrowingsExternal Commercial Borrowings (ECB) in form of bank loans, buyers’ credit, suppliers’ credit, securitized instruments (e.g. non-convertible, optionally convertible or partially convertible preference shares, floating rate notes and fixed rate bonds) can also be availed from non-resident lenders to fund the business requirement of a company. ECB can be accessed under two routes, viz., (i) Automatic Route; and (ii) Approval Route depending upon the category of eligible borrower and recognized lender, amount of ECB availed, average maturity period and other applicable factor.ECB raised has also certain end use restrictions such as that it cannot be used for (a) on lending or investment in capital market; (b) acquiring a company in India; (c) real estate sector etc. Under ECB also the borrower needs to create certain charge on immovable assets, movable assets, financial securities and issue of corporate and / or personal guarantees in favour of overseas lender / security trustee, to secure the ECB raised by the borrower, subject to compliance of certain conditions as prescribed under ECB guidelines framed by Reserve Bank of India. The documentation on similar lines as mentioned under bank loan section above will need to be executed.
- CGTMSE LoansUnder the Credit Guarantee Trust for Micro and Small Enterprises scheme launched by Ministry of Micro, Small & Medium Enterprises (MSME), Government of India to encourage entrepreneurs, one can get loans of up to 1 crore without collateral or surety. Any new and existing micro and small enterprise can take the loan under the scheme from all scheduled commercial banks and specified Regional Rural Banks, NSIC, NEDFi, and SIDBI, which have signed an agreement with the Credit Guarantee Trust.
What is sweat equity?
Sweat equity has been in the news recently. Sweat equity shares are equity shares issued by a company to its employees or directors at a discount, or as a consideration for providing know-how or a similar value to the company.
A company may issue sweat equity shares of a class of shares already issued if these conditions are met: The issue of sweat equity shares should be authorised by a special resolution passed by the company in a general meeting The resolution should specify the number of shares, current market price, consideration, if any, and the section of directors /employees to whom they are to be issued As on the date of issue, a year should have elapsed since the company was entitled to commence business.
The sweat equity shares of a company whose equity shares are listed on a recognised stock exchange should be issued in accordance with the regulations made by the Securities and Exchange Board of India (SEBI).
In the case of a company whose equity shares are not listed on any recognised stock exchange, sweat equity shares can be issued in accordance with such guidelines as may be prescribed.
In the case of unlisted companies, sweat equity shares cannot be issued before one year of commencement of operations. Moreover, there is a cap of 15 percent on the number of sweat equity shares that can be issued without a specific central government approval.
Sweat equity shares are no different from employee stock options with a oneyear vesting period. It is essential when a company is formed, to assure the financial investors that the knowhow providers will stay on, or for a start-up with limited resources to attract highly-qualified professionals to join the team as long-term stakeholders.
These shares are given to a company’s employees on favourable terms, in recognition of their work. Sweat equity usually takes the form of giving options to employees to buy shares of the company, so they become part owners and participate in the profits, apart from earning salary.
Section 79A of the Companies Act lays down conditions for the issue of sweat equity shares. For listed companies, there are regulations made by the SEBI. The SEBI also prescribes the accounting treatment of sweat equity shares. Thus, sweat equity is expensed, unless issued in consideration of a depreciable asset, in which case it is carried to the balance sheet.
Sweat equity is a device that companies use to retain their best talent. Usually, it is given as part of a remuneration package. However, start-ups sometimes use sweat equity to retain talent. If the company fails, its employees may end up with worthless paper in the form of sweat equity shares.
Unlisted companies cannot issue more than 15 percent of the paid-up capital in a year or shares with a value of more than Rs 5 crores – whichever is higher – except with the prior approval of the central government. If the sweat equity is being issued for consideration other than cash, an independent valuer has to carry out an assessment and submit a valuation report.
The company should also give ‘justification for the issue of sweat equity shares for consideration other than cash, which should form a part of the notice sent for the general meeting’.
The board of directors’ decision to issue sweat equity has to be approved by passing a special resolution at a shareholders’ meeting later in the year. The special resolution must be passed by 75 percent of the members attending voting for it.
Sweat equity limit for start-ups may be raised to 50% of capital
A committee set up by the government to review issues arising out of implementation of the Companies Act, 2013 has suggested changes to improve ease of doing business encourage start-ups and harmonise various laws.
The Companies Act, 2013 currently restricts issue of ESOPs to promoters or promoter directors even if they are employees of the company. With a view to ease raising of funds for start-ups without additional compliance costs, the limits with regard to raising of deposits from members for ‘start-up’ companies may be removed for the first five years from their incorporation.
At present, private companies are permitted to accept deposits from their members which do not exceed 100% of their paid-up capital and free reserves.
“Major amendments have been recommended to Companies Act 2013 to encourage start-ups. An overhaul of the Act in tandem with government’s Start-Up India vision is likely to be done soon,” said Anshul Jain, partner at law firm Luthra & Luthra Law Offices.
“Other major recommendations include reducing the penalties on auditors, audit rotation relaxations, easing provision for loan to directors, and no approval from government for managerial remuneration of key personals,” he said.
The committee has also recommended that there should not be any need for approval from central government for managerial remuneration for key managerial persons if it has got the approval of shareholders. Provisions related to loan to directors have also been proposed to be relaxed. In a major relief to auditors, the committee has suggested several fines and penalties related to non-compliance of filing be eased. The auditor rotation policy mandated every three years should be applicable from AGM to AGM instead of the calendar year, the committee has recommended.
The committee has also recommended removal of insurance deposit clause for companies raising deposits from public. The change has been recommended as no insurance company provides deposit insurance products in the country. Also, companies that had defaulted on payments will now be allowed to raise money again from public in case they have made the due payments. A certain cool off period may be prescribed, the committee has suggested.
The committee has also suggested introducing a register of beneficial owners by mandating it in the Companies Act so that actual beneficiaries of transaction cannot undertake any money laundering or tax evasion. Easing for procedures and filing requirements have also been recommended for one person and smaller companies.
The Companies Act review panel consisted of the secretary and joint secretary of corporate affairs ministry along with presidents of Institute of Chartered Accountants of India, Institute of Company Secretaries of India and Institute of Cost Accountants of India.
Sweat equity in overseas start-ups
The Reserve Bank of India has permitted Indian software exporters to receive equity up to 25% of the value of their exports to overseas start-up companies that have initial liquidity constraints.
Indian software companies have been asking for this relaxation as it allows them to take equity in overseas start-ups in lieu of work done for them.
Start-ups in the US and Europe outsource their software development work to Indian companies. Most of these start-ups are cash-strapped.
These projects are important for Indian companies as they give them a chance to work with cutting edge technologies and have the potential of developing into bigger projects.
Moreover, equity in this form is the norm in the US and is termed as sweat equity, which is different from stock options.
Sweat equity can be given to any company which is rendering services and can include, among others, a law firm, an investment banker or a software development firm.
Also, stock options, on the other hand, are awarded only to the employees of the firm.
Commenting on the issue, Nasscom president Kiran Karnik said, “This will especially help the small- and medium-sized companies (that do not have overseas listings) to acquire equity stake in overseas start-up companies.” “This will also facilitate building long-term relationships and alliances for mutual advantage,” he added.
Mr Karnik further stated, “As it will be applicable to all companies, even those who do not have subsidiaries or joint ventures, it will be more relevant for the small- and medium-sized software exporters,” he added.
RBI says the companies interested in availing this facility may approach the central bank through their authorised dealers for necessary permission.
RBI also says such equity acquisitions can be done without entering into a joint venture with the overseas entity.
RBI says the objective is to strengthen the competitive edge of Indian software exporters.
- Convertible debt is when a company borrows money from an investor or a group of investors and the intention of both the investors and the company is to convert the debt to equity at some later date. Typically the way the debt will be converted into equity is specified at the time the loan is made. Sometimes there is compensation in the form of a discount or a warrant. Other times there is not. Sometimes there is a cap on the valuation at which the debt will convert. Other times there is not.For startups, convertible debt is a good thing though. It takes off the pressure to value a company early on. “Those largely because the “angel investors” and founders are generally keen to work together more often than not some angel investors are keen to lend not just money but also, their expertise to the startup.
- You can raise money through this route from both domestic and foreign investors (FDI).If raising from foreign investors (FDI), convertible shares have to be compulsorily convertible (they must automatically convert into equity at some point) if you want to do this under the automatic route which does not require RBI pre-approval. If the instrument is not compulsorily convertible it it comes under ECB (external commercial borrowing) rules as it is a debt instrument which would then require RBI pre-approval.In general, raising money through the debt route has restrictions in India
(domestically you can’t raise from the public only from a limited set of people like directors and investors, and foreign investors has to be through ECB rules) but preference shares are technically equity investments and so have more flexibility. CCPS (compulsory convertible preference shares) are used quite frequently at the seed stage as they give investors some more security than equity shares because preference shares have more rights in a liquidation, and they also allow a conversion into equity at a future date which helps bridge the gap between founders’ and investors’ valuations of the Company.