Stories of entrepreneurs setting new standards of wealth building are common these days. We have been hearing quotes like “success is a long journey” or “success takes time”, but in case of startups it is a matter of only a few years and we see promoters building wealth to the tune of millions and billions.
The traditionally rich people have been in business for decades. So how do these startups build such huge wealth in matter of few years. Is it some secret formula they have?
Yes, there is a secret formula and you should be really happy to know that the formula is not very tough to learn. If you understand this success formula and get your basics right, you are almost there in the future list of entrepreneurs who would create wealth in matter of few years.
So, let us start.
It all starts with an idea. It is likely that the primary idea will transform and evolve by the time you reach the advance rounds of business cycle. However, the primary idea is extremely important. More powerful the idea, easier it will be to promote it and gather support.
When someone has a business idea, they usually share it with a close relative or friend. Such people may be one, two or a dozen and are called the primary supporters. These people offer initial support that includes initial monetary contribution and/or skills and other professional services.
In order to maintain professional standards and outlook, the promoters prefer incorporation of their business at this stage. In India, incorporated companies have names ending with ‘private limited’ or ‘limited’. In United States, such companies have names ending with Inc. which means incorporated. There are other companies which are proprietary concerns or partnership firms, but companies registered as private, public or inc.(United States) have broader scope of growth and only such companies can issue shares. Various laws govern such companies and they are subject to more compliance than normal proprietary or partnerships companies. Robust compliance make such companies run professionally and are sound for investors.
While incorporating the company, promoters can decide the initial shareholding pattern. For easier understanding, if ABC Alphabets Private Limited has two promoters and one investor, the company will have three shareholders. The investor brings in Rs 1 million and the promoters decide to keep 60% shares (30% each) and give investor the rest 40% shares for his investment. This brings the virtual valuation of the company to Rs 2.5 million making the value of the shares of promoters valued at Rs 1.5 million.
At this stage, the promoters have invested minor amount in incorporation and other initial cost. But the virtual value of their holding is already Rs 1.5 million while they are yet to do any business. The funding offered by the investors can be called seed funding and the round will be called seed round funding.
The seed funding is used over a short developmental period. In this period, the entrepreneurs develop their products and services as well as do the initial PR for their organisation. The developmental period is also used to evaluate and establish further business prospect. Once the initial developmental period is over and the product or the service is defined to a saleable stage, it is time to launch it with a bigger prospect. Here comes fresh round of funding.
The next round for funding is to hire team and resources to support increased business operations. Here the needs are bigger and investors with bigger strength come in action. They are the venture capital firms or the angel investors. Venture capital firms popularly known as VCs are companies that build capital from a group of investors and invest in new businesses while the angel investors are people who invest their own money in projects.
Angel investors are usually people who have worked in large corporations in similar industries or people who have successfully launched their own startups in the past. While offering initial support and personal relations were important till now, higher business potential is the decisive factor in this round. Capabilities of the team will also be crucial in this round of funding. This round is known as Series A round.
While the sharing against investment in the seed round is usually decided by the promoters in the series A round, it is decided based on the pre and post money valuation. Pre money valuation is the valuation of the company before receiving fresh funding and the post money is after the latest round of funding. Promoters usually try higher pre money valuation and investors look for higher post money valuation. At this stage, if the pre money valuation of the company ABC alphabets is considered at Rs 10 million, 40% stake in the company will come at an investment of Rs 4 million. This is four times of the seed round.
This way valuation of the share of promoters reaches Rs 6 million (Rs 3 million each) while they have not invested a single rupee in latest round of funding. The series A round will also increase the value of the investor who invested in seed round and their investment will be valued at Rs 4 million. The company will now have Rs 4 million fresh funds for business expansion which is raised against fresh issue of shares and not by selling the shares that existing investors held. A company can increase their share capital anytime to accommodate new investors however, there applies some laws and compliance which differ from country to country. The period from seed round to series A actually depends on your product or service but is usually 6 months to 2 years.
After series A, the company can reach new heights of business and come up with similar rounds of funding which will be called series B, series C, series D and so on. With every fresh round, the valuation of the company and eventually the shares held by the promoters will increase. After running business for several years and taking to a stable position, the promoters have option to exit by selling their shares. However, investors will always want promoters to stay as their involvement means a lot to business of the company.
Promoters can sell their shares to other big companies or offer an initial public offering (IPO) in the stock market. The selling of shares to other individual or company will be done in same way the series A funding was done, however, if it is done by selling the shares held by the promoters, the company will not receive the money but the promoter will. Hence, it will not be a fresh round of funding.
To sell the shares by means of an IPO will be a capital increase and will be done through the stock exchanges. The company will offer an IPO and will then list their shares on a stock exchange so that they can be traded by investors very easily. This step involves many more processes than the earlier rounds but will create a public value of share of a company. The shares held by promoters and other investors will not have a fluctuating value that is indicated by stock exchanges. The value of shares of a listed company depends on the demand and availability of its shares in the market. The demand and availability depends on the financial performance of a company. The investors always want to invest in the shares of a company which is doing well financially.
The value of the shares held by promoters is in manifolds by the time their company is listed while they have not invested a single rupee in the business since the seed round.