Your Essential Fundraising Guide

Entrepreneurs in today’s ever-evolving world are always looking to bring something new to society. New ideas, new technology, and new functions are the way forward, and for every one of them to succeed and make an impact, the main requirement is funding. Understanding the fundraising process and the various tools available to startup entrepreneurs is the key to a successful beginning.

Fundraising Instruments

When looking for funding options, entrepreneurs have to make early decisions about the type of capital they will need. This depends upon factors like the type of business and its future requirements. Entrepreneurs have to choose the funding instrument that best matches the needs of their startup. Here are two key funding instruments that can help establish a new startup:

1. Shares

A new business can raise capital by offering shares or equity in the business to potential investors. The startup would essentially be selling part ownership of the company in return for financial investment. Equity fundraising can draw out more investors for startups that have a healthy growth potential.

There are two types of equity fundraising that an entrepreneur may offer:

Equity Shares: These are common shares that are issued to the investors as direct instruments of ownership in the company. An investor purchasing these shares is entitled to vote in company matters and to receive bonuses when applicable. The dividend rates of equity shares are flexible and are decided by the company’s board depending on the business performance.

Preference Shares: Preference shares, as the name suggests, give the holder preferential rights when it comes to dividends and capital repayment. The dividend rate is fixed at a predetermined share price value. Preference shareholders do not receive bonuses and have no voting rights in the business. However, preference shares may be redeemed or converted to equity shares after a predefined period. In case of liquidation, the capital repayment of preference shares is done before equity shares. Preference shares are considered as hybrid securities as they are similar to equity shares for they represent partial ownership and like debt securities, they regularly pay dividends at a fixed rate.

Startups can hold multiple rounds of equity financing through the lifecycle of the business and may also use different types of Securities. However, during the initial fundraising stage, the startup must mandatorily offer equity shares in the company. Preferred shares on the other hand are not binding and can be offered by choice depending on the company’s needs.

2. Debentures

Startups can raise capital by issuing debentures to investors. Debentures are fixed-income loans that investors provide with the guarantee that the money is returned to them with interest. They are usually long-term financial tools and do not require collateral. Debentures are easier to obtain than traditional bank loans. As opposed to equity, when an investor purchases a debenture, they do not become a shareholder in the company. Instead, they become the company’s creditor, having bought a portion of the company’s debt.

Debentures may be a preferred fundraising instrument for two main reasons:

1. It does not dilute the company’s ownership. The startup can retain all of its privileges and decision-making rights internally without having investors on its board.

2. It is cheaper for a business to issue debentures than equity shares since it only involves a fixed loan amount.

There are different types of debentures that a business can issue based on their preferences.

Convertible & Non-convertible debentures: Convertible debentures can be converted into equity shares with pre-specified stock rates while non-convertible debentures remain fixed as per the defined repayment value.

Registered & Unregistered debentures: Registered debentures require the holder’s information to be registered with the issuing company. They can be transferred only via the correct facilitators by making a change in ownership. Unregistered debentures, or bearer debentures, on the other hand, can be easily transferred since the holder’s details are not registered with the issuing company.

Redeemable & Irredeemable debentures: Redeemable debentures give the holder the right to redeem the debentures on the date specified during the purchase. Irredeemable debentures have no fixed date for redemption and only become mandatory if the business is liquidated.

The Fundraising Process

Entrepreneurs need to have a patient and mindful outlook toward fundraising. An important step in achieving that is to thoroughly understand the process involved. Here are the main steps in the fundraising process.

Negotiation between the Parties: Negotiation plays a key role in setting up funding for the business. Thorough research on the investors and an understanding of their style will go a long way in winning the negotiation phase. Make a note of the top priorities for your business and work towards achieving those goals during the negotiation. It is always good to have specific factors that you are willing to be flexible on so that the investor has some room for negotiation too.

The signing of the Term Sheet: A term sheet is a document detailing all the points discussed and tentatively agreed upon by both parties during the early phase of a deal. It is non-binding on both parties and usually details aspects such as investment structure, valuation, management responsibilities, and share capital numbers. It is important to thoroughly analyze the term sheet and understand every clause outlined.

Due Diligence: Once the term sheet is in play, investors perform thorough due diligence on the startup they are potentially going to invest in before making any legal agreements. Startups should ensure the propriety of factors like previous financial decisions, the validity of the proposed business idea, the credentials of all team members, and any other financial dependencies. Investors will verify that the growth and financial numbers that the startup has defined are achievable and in sync with the investor's vision. This is also the step where investors can identify aspects, if any, that don’t align with their ideology. Successful due diligence will progress the fundraising process toward signing the shareholder’s agreements.

The signing of the Shareholders’ Agreements: The shareholder’s agreement is created based on the term sheet and any further updates after the due diligence is completed. This agreement is the legal, binding document that investors and startups have to sign and adhere to for the duration of their partnership. Startups should ensure that their legal counsel reviews the document and discusses any unclear specifics before signing. The agreement will define the relationship between both parties, share values, division of power, and conditions for exit. Once both parties are content with the agreement and all its clauses, the document is signed and legalized.

Documentation & Filings: Once the agreement is signed and in effect, all relevant documentation has to be filed with the regulatory authorities.. These include the shareholder’s agreement, non-disclosure agreements, investment agreements, valuation reports, KYC, compliance certificates, and closing forms.

Issuance of Securities/Share Certificates: The final step is issuing the securities or share certificates to the investors. Share certificates are legal proof of ownership and describe the details of the shareholder’s benefits. The investors now become shareholders in the business and the startup has secured its funding.

Understanding everything related to fundraising is a daunting task. Take it one step at a time and learn each aspect of fundraising instruments, processes, and legalities to achieve successful funding for the business.

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