This report’s idea came when I read the report Start-Up India and is at best a primer on startup ecosystem.
To invigorate latent Entrepreneurship Talent In India, Mr. Modi unveiled the flagship Startup India Venture on 16 January in New Delhi. The venture started with a corpus of INR 10,000 crore with an initial corpus of INR 2500 to be invested over a period of four years. The plan has many innovative reforms which we look briefly later on in the article.
Let’s begin our journey by taking a look at the Startup landscape in 2015. According to NASSCOM’s “Startup-India: Momentous Rise of Indian Startup Ecosystem” report, India ranks third globally with over 4200 startups (Source: Hindu). The growth in the Startups has been stellar with a growth of 40% in 2015 alone. According to an article by Hindu publication, the funding in 2015 alone accounted for $9bn which is a 125% jump over 2014. The funding in 2015 alone accounted for more funding for Startups for the period 2010-2014. The NASSCOM estimates that these ventures have grown to 110 a 40% jump over 2014 with almost half of them outside the dominant metros Delhi, Bangalore and Mumbai. India serves as the fastest growing startup-base worldwide and stands third in technology-driven product startups just after the US and UK respectively. The startups contributed employment of 80000 to 85000 people in India.
The best part of investing is that the investment in the late stage of ventures, as well as Series A, increased drastically. Incubators help in providing mentorship, basic infrastructure, and capital to start a venture. Seed and Angel Funding is much lower than venture capital funding which comes at a later date compared to the former form of funding. The difference between Angel Investors and VCs is that typically Angel Investors are High Net Worth Individuals with net surplus more than $1mn, earning $200000 for individuals or earning $30000 for couples as per the definition in the US while Venture Capital fund as limited partners towards contributing capital to ventures. VC usually exits either through IPOs or selling their stake to other Private Equity players or businesses as a strategic sale. Sequoia Capital and Kleiner Perkins invested in Google when Larry Page and Sergey Brin were struggling to raise funding for their search engine while still at the Stanford University. The rest is history as Google became the Quintessential Technology Company of our era and in many ways the most innovative company in the world. Read book Google Way to know more about the story of genesis of Google. (If I remember correctly Sequoia Capital and Kleiner Perkins had invested $5mn in Google when its founders were struggling to raise capital). Source: IAMWIRE.COM
Series A is part of Venture Capital funding when the company starts earning revenues, still is not making a profit but needs capital to expand its business. Venture capital forms the major form of funding in Series A funding. “ 2015 has been a landmark year for India’s tech startup landscape, with a total of 114 startups that filed Series A rounds by December in the calendar year, with total funding amounting to $542 million (roughly Rs. 3,595 crores). If you do the math, the average funding round in a Series A comes to $4.75 million (roughly Rs. 31.5 crores).” Source: gadgets.ndtv.com
Hey Dude what’s the difference between Private Equity (PE) and VC
Investing in Series A is not easy if the venture is not making money and the future cash flows are not easy to predict. During this time it is not easy to compute the valuation of a company while Private Equity usually employs Free Cash Flow (FCF) models to value the company. (FCF models are made from the income statement of a venture/business and the basic model is listed in one of the tutorials uploaded on this blog). Private Equity come at a later stage of the venture when the venture has up-scaled their business model and are usually profitable with a stable stream of free cash flow.
Depending on the type of Private Equity: Growth and Buyout, a PE could even invest up to 100% to take management control and streamline the business or in many cases divide the venture/ business into different strategic units and sell it off individually. Remember the book, Barbarians at The Gate. In the case of a buyout, PE employs a lot of leverage which is very rare in VCs. PE usually target companies which might be undervalued due to financial or working inefficiencies with the aim of restructuring the company to make it more profitable. PE also invest in companies which are listed on stock exchange while VCs only invest in unlisted companies. Buyout private equity type is not allowed in India.
Hey, is VC funding riskier than PE funding ?
Yes absolutely correct. Let’s look at in a different perspective. It’s like a Call Option. We look at an example. ABC stock is trading on a stock exchange at a price of $50 (spot price). You have the option to buy ABC at $50 also known as strike price at a premium of $3. This is a right but not an obligation and this feature is known as a call option. Here the strike price and the spot price is the same. You are bullish on the stock but do not want to buy the stock. The best way forward would be to buy a call option and square off the option once the stock price goes above $53. The higher the price above $53, the higher the profit. In the above example, let the option expiration be three months with a lot size of 50. Within three months if the stock of ABC reaches $60 and if you feel its time to exit, you have two options. First, take delivery of the option by buying the stock at $50 plus paying a premium of $3 and selling the stock in the market for $60. In this case, you would be taking delivery of 50 stocks and making a profit after adjusting for the premium paid for the call option. Buying a call option is also known as long call option. Second, instead of taking delivery, square off the option, which is to sell off your right to another investor on the stock exchange. Here, the profit would be that implied by the Black Scholes model used for pricing the option. It would depend on many variables including the volatility of the stock, interest rates, time to maturity etc. Black Scholes model of option pricing uses implied volatility as an input variable which is usually more than the real volatility. Usually, options are sold in contracts of 50, 100 etc. and have a different time to maturity ranging from 1 month, 2 months, 3 months to one year. (Here we are talking of options listed on stock exchanges).
Think VC funding is like a Call Option, the first investment is like the premium and the downside is only limited to the investment while the upside is unlimited. Depending on the post IPO price, (in case of listing) the value of the venture/ company could be immense.
Growth Private Equity (PE)
Companies need capital to expand their operations, enter new markets or buy strategic units in their business sectors also known in the parlance of Marketing…Concentric Diversification. Companies go for this kind of funding when they have limited options for raising capital. In this case of private equity funding, private equity does not have majority stake in the company or shareholder majority for managmnet control. However, the private equity takes some measures to protect the downside in terms of covenants which are deal specific. One of the ways in which PEs fund the ventures/companies is through a type of Hybrid Funding known as Mezzanine Funding and Convertible Bonds.
Convertible Bonds are bonds which are issued as debt securities: face value, coupon (interest rate) etc. The redemption value is usually converted into equity depending on some preset conditions which could include the price value of the stock or debt ratios. They have embedded call options on the underlying security price of the company. The stock price is the traded price of the company on any exchange. The company issues these bonds to PE with an equity kicker.
Conversion Value = market price of share * conversion ratio.
Mezzanine like the name suggests is a type of funding which is in between Debt and Equity.