Capital Markets

Pre IPO fund raising

1
 Objective
• Introduction to raising of equity capital in the early
stages of a business unit

2
 Looking for Finance for
your Start up?

You have a You approach Investors

business idea friends/ evaluate the
and are family/investors idea to make
looking for for potential sure everything
funding investment is good to go

If all ok then Investment is

You agree to
investor group made by
give a % of
will list the idea subscribing to
equity in return
for potential the shares or
for the
investors to look buying form
investment
at other investors

3
 Startup stage
• Also called seed capital stage
• Promoter has a “business idea”
• Commercial operations are not established
• “proof of concept” not established
• Funds are required typically for
o Development of new products and services
o Design, R&D for specialized equipment
o Testing
o Market research
o Building a management team

4
 Startup stage
• Limited data available to evaluate the financial viability
and attractiveness
• Typically promoter puts in his own capital
• Some friends/relatives may join the promoter
• Angel investors – high net worth individuals who have
experience and understanding of the business domain
and inclination to mentor and back startups with
appealing business ideas and promising promoters
• “crowd’ funding – getting pre-orders from future buyers
• Incubators – provide capital as well as infrastructure
support for sound business ideas in specific domains such
as “knowledge-based” industries

5
 Angel Investors

• Angel investors invest in small startups or entrepreneurs. Often,

angel investors are among an entrepreneur's family and
friends. The capital angel investors provide may be a one-time
investment to help the business propel or an ongoing injection
of money to support and carry the company through its
difficult early stages.
• Angel investors provide more favorable terms compared to
other lenders, since they usually invest in the entrepreneur
starting the business rather than the viability of the business.
Angel investors are focused on helping startups take their first
steps, rather than the possible profit they may get from the
business. Essentially, angel investors are the opposite of
venture capitalists.

6
 Venture Capitalists
• A venture capitalist is an investor who either provides capital to
startup ventures or supports small companies that wish to expand but
do not have access to equities markets. Venture capitalists are willing
to invest in such companies because they can earn a massive return
on their investments if these companies are a success.

• Venture capitalists also experience major losses when their picks fail,
but these investors are typically wealthy enough that they can afford
to take the risks associated with funding young, unproven companies
that appear to have a great idea and a great management team.

• Venture capitalists look for a strong management team, a large

potential market and a unique product or service with a strong
competitive advantage. They also look for opportunities in industries
that they are familiar with, and the chance to own a large
percentage of the company so that they can influence its direction.

7
 Venture Capitalists
Structure
• VC Fund:
A Venture capital firm, along wealthy individuals, insurance
companies, pension funds, foundations, and corporate pension
funds among others pool money together into a fund to be
controlled by a VC firm. All partners have part ownership over the
fund, but it is the VC firm that controls where the fund is invested,
usually into businesses or ventures that most banks or capital markets
would consider too risky for investment.

8
 Crowd funding
• Crowdfunding is the use of small amounts of capital from
a large number of individuals, typically via the internet to
finance a new business venture.
• Crowdfunding makes use of the easy accessibility of vast
networks of people through social media and
crowdfunding websites to bring investors and
entrepreneurs together.
• Crowdfunding has the potential to increase
entrepreneurship by expanding the pool of investors
from whom funds can be raised beyond the traditional
circle of owners, relatives and venture capitalists.
• Popular crowdfunding websites - Kickstarter & Indiegogo

9
 Startup stage
• How would an investor value the business and the stake
in the business at the start up stage ?
o Not enough data is available for valuing the business
o Usually the investor is treated, at this stage; as the business partner
o Investment is usually at “par value” i.e., no premium per share

• Risks involved for the investor are very high. Hence,

usually venture capital funds do not invest at this stage.
• Angel investors would look at exit once venture capital
or private equity funds start investing in the company.
Since their risks are very high, they expect manifold
increase in the value of their investment (from a low
base) over a period of 3 to 5 years.

10
 Startup stage
• Incubators
o Government of India guidelines under National Manufacturing
Competitiveness Programme
• Capital assistance and infrastructure support
• Hosted at IITs/NITs/other engineering colleges
o There are several other incubators (also called accelerators) set up by
private organizations and state governments
o Incubators make
• laboratory, workshop, data centre, library, etc. facilities available
readily
• Offer office space and office admin support
• Mentoring from experts
• Community of entrepreneurs
• Alumni network of the host institution for marketing and collaboration

11
 Early stage 1
• Company has established “proof of concept”
o One commercial transaction to showcase the concept
o with a reputed buyer
o at a price high enough to indicate financial viability for the company in
the medium to long term

• Commercial operations not yet begun

• Funds are required to invest in capacity build up for
starting commercial production
• Venture Capital Funds (VCs) make investments
typically at this stage

12
 Venture Capital
• It is a source of financing for new businesses which have proved their mettle.
• Venture capital funds pool investors' cash and loan it to start-up firms and
small businesses with perceived, long-term growth potential. This is a very
important source of funding start-ups that do not have access to other capital
and it typically entails high risk (and potentially high returns) for the investor.
• Most venture capital comes from groups of wealthy investors, investment
banks and other financial institutions that pool such investments or
partnerships.
• This form of raising capital is popular among new companies, or ventures, with
a limited operating history that cannot raise capital through a debt issue or
equity offering.
• Often, venture firms will also provide start-ups with managerial or technical
expertise.
• For entrepreneurs, venture capitalists are a vital source of financing, but the
cash infusion often comes at a high price.
• Venture firms often take large equity positions in exchange for funding and
may also require representation on the start-up's board.

13
 Process of Venture
Capital Financing
Step # 1: Deal Origination:
• Venture capital financing begins with origination of a
deal. For venture capital business, stream of deals is
necessary. There may be various sources of origination
of deals. One such source is referral system in which
deals are referred to venture capitalists by their parent
organizations, trade partners, industry association,
friends, etc.

• Another source of deal flow is the active search through,

networks, trade fairs, conferences, seminars, etc. Certain
intermediaries who act as link between venture
capitalists and the potential entrepreneurs, also become
source of deal origination.

14
 Process of Venture
Capital Financing
Step # 2: Screening:
• Venture capitalist in his endeavour to choose the best
ventures first of all undertakes preliminary scrutiny of all
projects on the basis of certain broad criteria, such as
technology or product, market scope, size of investment,
geographical location and stage of financing.

• Venture capitalists in India ask the applicant to provide

a brief profile of the proposed venture to establish prime
facie eligibility. Entrepreneurs are also invited for face-to-
face discussion for seeking certain clarifications.

15
 Process of Venture
Capital Financing
Step # 3:Evaluation:
• After a proposal has passed the preliminary screening, a detailed
evaluation of the proposal takes place. A detailed study of project
profile, track record of the entrepreneur, market potential,
technological feasibility, future turnover, profitability, etc. is
undertaken.
• Venture capitalists in Indian factor in the entrepreneur’s background,
especially in terms of integrity, long-term vision, urge to grow
managerial skills and business orientation. They also consider the
entrepreneur’s entrepreneurial skills, technical competence,
manufacturing and marketing abilities and experience. Further, the
project’s viability in terms of product, market and technology is
examined.
• Besides, venture capitalists in India undertake thorough risk analysis
of the proposal to ascertain product risk, market risk, technological
and entrepreneurial risk. After considering in detail various aspects of
the proposal, venture capitalist takes a final decision in terms of risk
return spectrum. 16
How do VC evaluate the
business
o Scalability of business

o Competitive advantage / inherent strengths vis-

à-vis competition of the target company

o Promoters’ background and intent in terms of

commitment to scale up and business integrity

o Investments would be made by subscribing to

the shares issued by the company and / or
buying the stake of the angel investors

17
 Calculating NPV of a VC
project
An investor can invest INR 2 million in a new project today that will last five years
and will pay INR18 million at the end of the 5th year. His cost of equity for this
project is 14%. He also knows that the project could fail at any time and has given
the following percentages for the failure rate as follows:
Year 1: 35%, Year 2: 30%, Year 3: 25%, Year 4: 20%, Year 5: 20%

Solution:

1) The first step is to determine the probability that the project will work. This equals
(1-.35)(1-.30)(1-.25)(1-.20)(1-.20)= .65 x .70 x .75 x .80 x .80=. 22 or a 22% chance of
success.
Now if the project fails, the NPV = -INR 20,00,000 (the amount invested in the
project); however, if it works out the NPV of the project if it survives five years =
[18,000,000 ÷ (1.14^5)] – 20,00,000 = INR 73,48,637.
So the expected NPV = (.22 x 73,48,637) + (.78 x -2,000,000) = 16,16,700 - 1,560,000
= INR 56,700
Based on these calculations, an investor would take this investment because of
the positive expected NPV.
18
 Process of Venture
Capital Financing
Step # 4: Deal Negotiation:
• Once the venture is found viable, the venture capitalist negotiates
the terms of the deal with the entrepreneur. This it does so as to
protect its interest. Terms of the deal include amount, form and price
of the investment.

• It also contains protective covenants such as venture capitalist’s right

to control the venture company and to change its management, if
necessary, buy back arrangements, acquisition, making IPOs. Terms
of the deal should be mutually beneficial to both venture capitalist
and the entrepreneur. It should be flexible and its structure should
safeguard interests of both the parties.

19
 Process of Venture
Capital Financing
Step # 5: Post Investment Activity:
• Once the deal is financed and the venture begins working, the
venture capitalist associates himself with the enterprise as a partner
and collaborator in order to ensure that the enterprise is operating as
per the plan.

• The venture capitalists participation in the enterprise is generally

through a representation in the Board of Directors or informal
influence in improving the quality of marketing, finance and other
managerial functions. Generally, the venture capitalist does not
meddle in the day-to-day working of the enterprise, it intervenes
when a financial or managerial crisis takes place.

20
 Process of Venture
Capital Financing
Step # 6:Exit Plan:
• The last stage of venture capital financing is the exit to realise the
investment so as to make a profit/minimize losses. The venture
capitalist should make exit plan, determining precise timing of exit
that would depend on an a myriad of factors, such as nature of the
venture, the extent and type of financial stake, the state of actual
and potential competition, market conditions, etc.

• At exit stage of venture capital financing, venture capitalist decides

about disinvestments/realisation alternatives which are related to the
type of investment, equity/quasi-equity and debt instruments. Thus,
venture capitalist may exit through IPOs, acquisition by another
company, purchase of the venture capitalist’s share by the promoter
and purchase of the venture capitalist’s share by an outsider.

21
 People behind VC
Funding
These people are entrepreneurs, financial wizards, and the like set up venture
capital funds which is recognized by the SEBI in India. There are 2 category of the
people in a venture capital fund –

I. General Partners (GP): GPs serve to manage the fund and execute
investments with the capital in order to return that capital to the LPs.

II. Limited Partners (LP): Based on GP’s proposal various different domains
expertise investor will come and commit their money to the venture capital
fund in India.

• LPs invest into the venture capital fund and the GPs manage the venture
capital fund. The venture capital fund invests into the portfolio companies.
• The venture capital fund is governed by a contract between the GPs and the
LPs called the Limited Partnership Agreement (“LPA”).
• The LPA lays out all of the terms for managing the venture capital fund.
• The fund also has a contract with the General Partner to manage the fund.

22
VC Process

23
Stages in VC funding

24
 Early Stage
Early Stage - For companies that are able to begin operations but are not yet at
the stage of commercial manufacturing and sales, early stage financing supports
a step-up in capabilities. At this point, new business can consume vast amounts of
cash, while VC firms with a large number of early-stage companies in their
portfolios can see costs quickly escalate.
o Start-up - Supports product development and initial marketing. Start-up
financing provides funds to companies for product development and initial
marketing. This type of financing is usually provided to companies just
organized or to those that have been in business just a short time but have
not yet sold their product in the marketplace. Generally, such firms have
already assembled key management, prepared a business plan and made
market studies. At this stage, the business is seeing its first revenues but has
yet to show a profit. This is often where the enterprise brings in its first
"outside" investors.
o First Stage - Capital is provided to initiate commercial manufacturing and
sales. Most first-stage companies have been in business less than three
years and have a product or service in testing or pilot production. In some
cases, the product may be commercially available.

25
 Early Stage
• Investment may also be made in the form of
convertible debenture or convertible preference
share
o This method allows valuation to be kept open
o Conversion into equity shares at a pre-specified future date using a
formula linked to the company profits at that time
o Coupon interest / dividend rate will typically be small
o Usually with a floor and a cap on the valuation
o E.g.,
• Investing Rs 50 cr now as convertibles with conversion after two
years @ “pre-money” company valuation of 16 time profit after tax
(PAT)
• If PAT is Rs 25 cr two years later, the company is valued on “pre-
money “ basis at Rs 400 cr
• Investor gets 11.1% stake in the company (50/ 450), as the “post-
money” valuation is Rs 450 cr

26
If your seed capital investor and you agreed through negotiation that your startup
was worth 1 million at the time of the angel investment, then the Pre-Money value
is the 1 million. If your investor then invested 0.5 million in the startup, then the Post-
Money valuation of your startup is 1.5m (the Pre-Money + the Investment) and
your investor would end up with an ownership of one-third of the company
calculated as follows: 500,000/1,500,000 = 33.33%.

Suppose an investor is looking to invest in a tech startup. The entrepreneur and

the investor both agree the company is worth $1 million and the investor will put in
$250,000. The ownership percentages will depend on whether this is a $1 million
pre-money or post-money valuation. If the $1 million valuation is pre-money, the
company is valued at $1 million before the investment and after investment will
be valued at $1.25 million. If the $1 million valuation takes into consideration the
$250,000 investment, it is referred to as post-money.
As you can see, the valuation method used can affect the ownership
percentages in a big way. This is due to the amount of value being placed on the
company before investment. If a company is valued at $1 million, it is worth more
if the valuation is pre-money than if it is post-money because the pre-money
valuation does not include the $250,000 invested. While this ends up affecting the
entrepreneur's ownership by a small percentage of 5%, it can represent millions of
dollars if the company goes public.

27
 Series A
After the business has shown some track record, Series A funding is useful in
optimizing product and user base. Opportunities may be taken to scale the
product across different markets. In this round, it’s important to have a plan for
developing a business model that will generate long-term profit. Often times,
seed start-ups have great ideas that generate a substantial amount of
enthusiastic users, but the company doesn’t know how it will monetize on them.

Investors typically insist on various conditions , such as

o Board seats based on their percentage holding in the company
o Prior approval for change in business, change in capital structure, key
managerial appointment and dividend declaration
o “tag along” – in case promoters are selling their stake, investors would have
right to sell their stake as well to the same buyer (i.e., tag along with the
promoters). In case the buyer is willing to purchase a fixed quantity of
shares, the number of shares of promoters and investors would get
calculated proportionately to their respective shareholding.
o “drag along” – in case investors are selling out and buyer needs more
shares, investors can drag promoters to sell part of their holding
28
 Series B – is for Build
• Series B rounds are all about taking businesses to the next level, past
the development stage. Investors help start-ups get there by
expanding market reach. There’s already a big pie that’s been
cooking up in Seed and Series A rounds. In Series B, venture capitalists
have more of vision around what the pie will look like, and how big of
a slice they hope to obtain.

• Building a winning product and growing a team requires quality

talent acquisition. Bulking up on business development, sales,
advertising, tech, support, and other people costs a firm a few
pennies.

29
 Series C
• In Series C rounds, investors inject capital into the meat of successful
businesses, in efforts to receive more than double that amount back. For
example, let’s say that our fatless, meatless burger and rolls shop from Series B
now has the potential to put all Mac D’s and KFC’s out of business. Series C is
about perfecting, and of course, continuing to scale fast and wide.
Companies raise single digit to hundreds of millions in this final round of fund
raising.
• One possible way to scale a company could be to acquire another. Say our
vegetarian start-up has shown unprecedented success selling their specific
type of fatless meatless burgers and rolls in Mumbai and Delhi. The business
has reached targets both in Mumbai and Delhi. Through confidence in market
research and business planning, investors reasonably believe that the business
would do well in other Metros of the country.
• Perhaps our fatless meatless start-up has a competitor who currently possesses
a large share of the market. The competitor also has the competitive
advantage that we could benefit from. The culture fits and investors and
founders alike believe the merger would be a synergistic partnership. In this
case, Series C funding could be used to buy another company.
• As the operation gets less risky, more investors come to play. In Series C,
groups such as Hedge funds, Investment Banks and Private Equity firms
accompany the before-mentioned investors.
30
 Mezzanine Stage
After reaching this juncture, the company may be looking to go public,
given that its products and services have found suitable traction. Funds
received here can be used for activities such as:
o Mergers and acquisitions
o Price reductions/other measures to drive out competitors
o Financing the steps toward an initial public offering
If all goes well, investors may sell their shares and end their engagement
with the company, having made a healthy return.
Many tech IPOs – think Facebook, Twitter and Yelp – were only possible
after years of VC funding that fuelled user and revenue growth. There’s
a saying that there’s no such thing as a free lunch, and VC funding of
free apps and services is a good case in point.

31
 VC vs. PE
• Venture capital is providing funds to emerging and
early stage companies engaged in new products,
new services, technology or intellectual property
right based activities or a new business model –
registered as Category I AIF with SEBI

• All business growth oriented equity / equity-linked

investments into unlisted companies other than the
venture capital are called private equity
investments – registered as Category II AIF with SEBI.

32
BASIS FOR COMPARISON PRIVATE EQUITY
Meaning Private Equity are the investments,
that are made in those firms which
are not publicly listed on any stock
exchange.
VENTURE CAPITAL
Venture Capital refers to financing
of small business by the investors,
seeking high growth potential.

Stage of Investment Later stage Initial stage

Investments made in Few companies Large number of companies

Companies Funds are provided to matured Investments are made in startup

companies having good track companies.
record.

Focus on Corporate Governance Management Capability

Industries All industries Industries that require heavy initial

investments like energy
conservation, high technology, etc.

Risk Involved Less risky High risk

Fund Requirement For growth and expansion of For scaling up operations
business
Ownership of investor Generally, 100% Does not exceed 49%

33