managing startup equity (equity for startups)

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Dr. G. Sabarinathan Managing Startup Equity Presentation at 4startups August 3, 2013

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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?

TRANSCRIPT

Page 1: Managing startup equity (Equity For Startups)

Dr. G. Sabarinathan

Managing Startup Equity

Presentation at 4startups

August 3, 2013

Page 2: Managing startup equity (Equity For Startups)

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

Page 3: Managing startup equity (Equity For Startups)

Disclaimers

• No canned solutions

• Pointers to think

• Questions to ask

Managing Startup Equity: Dr. G. Sabarinathan 3

Page 4: Managing startup equity (Equity For Startups)

Startup: The Investor’s View

• 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

Page 5: Managing startup equity (Equity For Startups)

Startup: The Entrepreneur’s View

• 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

Page 6: Managing startup equity (Equity For Startups)

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 Noam Wasserman, Harvard Business School

Managing Startup Equity -Dr. G. Sabarinathan

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Page 7: Managing startup equity (Equity For Startups)

What happens when a company

issues shares to raise capital?

Managing Startup Equity: Dr. G. Sabarinathan

Page 8: Managing startup equity (Equity For Startups)

The Growing Pie Metaphor • Sharing of Wealth

• 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

Page 9: Managing startup equity (Equity For Startups)

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

Page 10: Managing startup equity (Equity For Startups)

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

Page 11: Managing startup equity (Equity For Startups)

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 FocuScience TM, 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

Page 12: Managing startup equity (Equity For Startups)

Stage I

Stage 2

Stage 3

0-12 months

12-24 months

18- 36 months

Stage 4

Product Development

Test Marketing Activity

Cash 100 500 2000

Market Development

Mfg / Sourcing Stabilisation Biz Expansion

Exit for Early

Investors?

Elapsed Time

Biz

Gro

wth

Neuronautica Development Roadmap and Funding Plan

Managing Startup Equity : Dr. G. Sabarinathan

Page 13: Managing startup equity (Equity For Startups)

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

Page 14: Managing startup equity (Equity For Startups)

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

Page 15: Managing startup equity (Equity For Startups)

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

Page 16: Managing startup equity (Equity For Startups)

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

• Upto Year 2 Kako needs external funding

• In Year 3 it covers all its cash costs and a little more

• In Year 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

Page 17: Managing startup equity (Equity For Startups)

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

Page 18: Managing startup equity (Equity For Startups)

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

• Managing Valuation: Link to performance

– Convertible instruments

– Ratcheted Warrants / buyback options to founders

– Floor on dilution, cap on investor equity

• Dropping “invasive clauses” linked to performance

Page 19: Managing startup equity (Equity For Startups)

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

Page 20: Managing startup equity (Equity For Startups)

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”

Page 21: Managing startup equity (Equity For Startups)

THANK YOU

Managing Startup Equity: Dr. G. Sabarinathan