Various ways of forming a business organization

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Common Stock and Preferred Stock

Stock represents the equity ownership of a company. In the startup world, there are two types of stock broadly: common stock and preferred stock. Common stock is usually something is given in exchange for your effort (sweat stock) whereas preferred stock is something that is given in exchange of the money that you invest in the company. So, usually founders initially have common stock and investors have preferred stock.CommonandPreferredStock.pngInitially, both these stocks have different values. The usual norm is to start with a common stock of $0.01 or $0.001 per share. As the company spends more time and it starts to build some assets or market performance, then the common stock will be slowly gaining in value. Common stock is usually priced at 10% of the preferred stock. The initial common stock is typically issued for some past work that the founders might have done, technology and any other assets.

If the company goes to IPO, all the stock is converted into common stock. Therefore, before going to an IPO the common stock and preferred stock converge. Following are some charts showing the various ways of converging common and preferred stock.

CommonandPreferredStock-1.png

A very aggressive common stock pricing strategy looks like the below

CommonandPreferredStock-2.png

A conservative common pricing strategy looks like the below

CommonandPreferredStock-3.png

 

 

 

 

Why the team means more than the idea in a start-up?

Ideas are a dime a dozen, at least in the start-up world.

Paul Graham once said that ideas mean something, but execution means far more. He also said that if he provided the entire idea to a team and the team executes the idea, he would still be entitled to less than 10% of the company. 

“What matters is not ideas, but people who have them” – Paul Graham.

In the context of this post, when I say ‘idea’ it is not only the raw idea like lets build a social network for kids, but an idea that also includes answers to questions like – will customers buy/use you and how do you know it?, how will you make money?, how will you go-to-market?, etc.

If one spends little time around start-ups, then one will very soon realize that the idea doesn’t matter much, and it is actually the people behind the idea that matter so much more.

Here are five reasons why the team matters more than the idea?

1. An idea doesn’t have any saleable or usable value. Ideas alone don’t hold any value to the end customer, because the customer has to solve a particular problem by using a product or a service and not by using the idea itself. If you don’t believe this, try selling your start-up ideas.

2. Ideas are relatively easy to arrive at. This is probably the reason why almost everybody has start-up ideas, even including people who think they don’t have one. On the other hand, execution (tech/business) demands a certain depth of know-how and a good amount of motivation for a long period of time.

3. An idea is not the reality, it is a wishful piece of organized thought. A startup is not about the idea, but it is about the  team that actually transforms an idea into a product or a service with their know-how and their motivation. Therefore, if the people behind an idea are good and motivated, then chances are that the idea might translate into a good product or a service eventually.

4. Ideas change with time, but the team might not change. Or I can say that it is much easier to change the idea than to change the team. If you put a good team behind any idea, they would at least bring out the best possibilities out of the idea. So, what happens to the idea is actually dependent on the team that is behind the idea.

For example, I am not saying that Mark Zuckerberg would’ve made a multi-billion dollar company out of any idea during his collegeBut, I am saying that if Mark got interested in an idea, he would’ve seen it through into a product or a service, trying to come up with the best possibilities to do so.

5. In the startup world, there are so many ideas floating around perennially that the startup community is not very excited to listen to only ideas anymore. Having an exciting idea doesn’t really separate you from the crowd. Investors actually almost every time look at the execution (the growth or the product or the people) behind the idea, because it is very difficult to judge an idea in isolation. You either have to have the product (or traction) or you have to be a highly motivated team with a strong reputation for execution and know-how or probably balance out the previous two, in order to have a small chance of success in the start-up world.

We all have ideas; it just doesn’t matter!

How start-up equity dilution works for Founders and Early Investors ?

Startups typically have three broad ways of funding their companies. They are incubators/accelerators, angel investors, and venture capitalists (institutional investor). Generally, Incubators and Accelerators help the start-up team to set-up the company, and shape the start-up’s Go-To-Market strategy. This article is limited only to explain how the equity dilution works and won’t get into the details of valuations of start-ups.

The typical amount of money different investors pump in and the equity they take is as follows.

Startup Fundraising Options

Understanding Equity Dilution with an Example

Let us take a start-up named XYZ Labs, and we shall walk through how the equity of the founders and the early investors gets diluted as the company goes through various rounds of investment. For the sake of simplicity, lets say the company has gone through an Angel round and one VC round (Series-A). Let’s say the angel investor took 20%, and the venture capitalist took 25% of the company for $N and $M post-valuations respectively. Let’s see how the equity gets diluted.

In any round of investment, if an investor is taking x% of equity, then the equity of all the existing equity holders will come down by x%. So, if I say y% goes down by x%, then the calculation is:     y%*(100-x)%     Or      y%*(100-x)/100

Let’s start with Founders of XYZ Labs holding 100% of the company, and having a first angel round of 20% for $N valuation.

Angel Round

Let’s say the angel round is followed up by a Series-A round of 25% and $M valuation.

Series A

So, as mentioned above, at each stage of investment, the equity of the earlier investors or founders (equity holders) will get diluted. But, with higher valuations in every round, the diluted equity will have more value than in the previous round. Also, typically in Series-A there will be an additional 12.5% of Employee Stock Option Pool (ESOP) that is to be allocated. I haven’t considered ESOP in the above example to keep things simple.

The typical equity dilution at various rounds of investment looks as follows.

Equity Dilution

So, how does it happen in practice?

In practice, your earlier investors won’t like their equity to be diluted too much in the further round of investment.So, they would like to put some cap on the dilution.

The other important thing to notice is – the type of equity that the investors and founders hold is different. Lets understand that with an example. Let’s say the company XYZ Labs is being acquired by some other major company ABC Labs. So, will all the equity holders of XYZ Labs be paid at once? The answer is No. Typically, the order of payouts is as follows:

1. You first clear out any debts that XYZ Labs owes to any banks or other investors.

2. You then start paying out the equity holders in the following order:

a. Preferred Stock

b. Common Stock

The stock that the founders hold is called Common Stock. This has the least priority during payouts in case of bankruptcy, mergers & acquisitions, etc. As the investor would want to have an early and safe exit, the investors’ stock comes with certain preferences over the commonly held stock, and it is called Preferred Stock. Preferred Stock could have preferences such as conditions on future dilution, priority during payouts, option of investing in future rounds, etc. Additionally, preferred stock can also be converted into common stock to maximize investors’ returns. Also, since debt is payed before equity during payout, some investors will give you money in the form of debt (debt note) and not in the form of equity. Because investors know that debt has the highest priority during the time of payout, and hence they can have the earliest exit .

Now, you see that not all of us in the company are equal, and not all money is equal. But, remember that investors are putting their money on you at early stages and are taking high risk. So, it is justifiable for them to look for a safe and early exit with maximum return. As an entrepreneur, you will hear many terms such as convertible debt, participating preferred stock, etc. These are various payment preferences for the investors to have maximum return, and a safe and early exit under various situations of bankruptcy, mergers and acquisitions, or dividend payouts.

If you’re interested to know more about the start-up terms, please refer to the below link to a Forbes post.

http://www.forbes.com/sites/jjcolao/2013/10/14/10-terms-you-must-know-before-raising-startup-capital/

Hope you found this post useful. Thank you.

B-plan to pitch to the VCs

Though I have no experience in pitching to the VCs, I have written this based on my theoretical knowledge, and based on the inputs given by some of my acquaintances. My experience always taught me that people always want things very plain and simple. Though there are a hundred things to take care of in a business, a VC is looking forward to check some simple points in a firm under consideration.

Any VC will look forward for the following simple points:

  • Who are you? What did you do till now? What do you intend to do?
  • What is your future and why should I partner with you in your future?
  • What is in it for me in the future and in how many years?
  • Does it suit my investment portfolio and strategy?

The Team

Most VCs look for a very strong team that have the relevant domain and management expertise. In fact, this is the only factor that can offset any weaknesses in the business, because a strong team gains the trust of the investor that they know where they are going.

  • Who are the Key Founders?
  • Who are the Key Advisors?
  • Who are the board members, if applicable?

A Quick View or an Elevator Pitch

What does the company do?

What problems do you address or how do you add value to the customer?

What is the target market size?

Why will the customer use it?

Mission Statement

Why do you want to do what you want to do? It is about ‘Why?’.

Vision Statement

What do you want to achieve in this endeavor? It is about ‘What?’

It is important to see that the Vision and Mission statement realistic, and doesn’t include everything under the sun.

Market and Industry Environment

  • Industry or Area you operate in
  • Different market segments
  • Target segments, Size and Growth rate of the Target segments
  • Critical factors in this market, and the target segment
  • Situational Analysis of various stakeholders – customers and other participants, competition, suppliers, and distributors, etc.

Value Proposition

  • Who is your customer? (This is probably the first and the most important question that one has to answer.)
  • Why will the customer use your solution?
  • Why will the customer pay you?
  • What are the alternatives available to the customer?
  • Road-map of the evolution of the suite of products and services
  • Assumptions made

Competitive Scenario

  • Existing Competition
  • Future Competition
  • What sustainable competitive advantage you have?

Revenue Model

  • Important revenue and cost drivers of the business
  • Pricing and Different customer offerings
  • Key partnerships and alliances

Financial till date (if applicable)

  • All the audited financial statements – PNL statement, Balance Sheet, Cash Flow, etc.
  • Break even path
  • Assumptions made

Until here, the document explained all the details about the business background, achievements till date, and the possible market strategies with some assumptions.  Now, the document has to convince the investor by showing why this is a good business to invest. One can do that by:

  • Showing the competitive advantage that the investor will gain
  • Which are the possible companies that might acquire you and the reasons?
  • What are the valuations of similar companies in the past after a particular duration?

Capital Required and the Return on the Investment (ROI)

Most VC firms have a strategic advisory panel that will help on the capital required and how to manage the funds. But, an entrepreneur who is paving the future is also expected to know how much money does he need and the reasons. If the business model is decently good, the best way to convince the VC is always to talk about money – Return on Investment.

  • Amount of capital needed and the rationale behind it
  • Rationale for the allocation of the funds
  • Return on the Investment at different time period
  • Exit Strategy for the VC

Risks, Gaps, and Assumptions

Self-Explanatory

It is always important to do a detailed study of the best probable investors for your start-up based on the domain and other factors such as the size and stage of the start-up. Following is the list of some top VC firms in India based on the number of investments made till now, it is not based on the value of the investments. Most of these VC firms invest in a diverse portfolio of companies across different verticals like consumer, technology, healthcare, finance, energy, etc and some of the VC firms are interested in only some verticals.

  • Sequoia Capital India
  • Ventureast
  • Intel Capital
  • Helion Venture Partners
  • DFJ India
  • Norwest Venture Partners
  • Nexus India Capital
  • NEA IndoUS Ventures
  • Canan Partners
  • Kleiner Perkins
Thank you.