5 points founders must keep in mind before diluting equity

By Mahesh Krishnamurthy

I have been rushing through many requests for startup funding on a daily basis and see that most of the entrepreneurs have become good in presentation skills and would like to give a thumps-up sign to all of them.

However, a lot of stuff still needs to be done before most of the startups are ready to meet investors, that is where many consulting firms come in and play their part.

All entrepreneurs in this space are attempting to create a value, solve some problem that they consider an opportunity and make a difference. It is also very exciting to see young, middle-aged and even highly experienced professionals getting into entrepreneurship roles to prove a point – make money, earn fame or for what they consider a unique proposition they can bring to this world.

The Indian startup story is big, exciting, real and here to stay. What is more important for the founders is to assess when, why, how much and what-for they need funds.

Some of the important aspects that must be considered by the founders before diluting their equity are:

1. Understanding Debt versus Equity concept
Typically, debt is cheaper than equity. Today there are avenues where startups can get debt funding. The rate of interest for debt could vary and repayment terms can also be negotiated favorably. Equity is far more expensive hence the returns expected are much more.

2. What it takes to get an investor in
Getting an investor on board is an exercise which involves investing lot of time, process and effort on part of the founder. The founder must plan this well in advance so that he does not get stuck in between execution and funding. It calls for a lot of balancing as his entrepreneurship skills gets tested. Fund raising is one of the important strengths founder must possess.

3. Timing when the first investor needs to be brought in
An ideal stage for any founder to bring in an investor would be after some traction is seen in the business. Which means when the product has been developed, in at least stage one and rolled out after some feedback and testing. Some amount of financial planning and discipline is required to perfect the timing (Do read my previous articles on this subject.) There are exceptions where investment may happen in idea or initial phase of development. These are rare cases.

4. What percentage of holding needs to be diluted
Any founder’s case becomes stronger when traction happens and there is growth seen in revenue. Confidence of the founder also goes up at this juncture. Some of the assumptions he has made in the initial stages of his journey also get proven and many questions get answered. The ability to bargain with the investor becomes greater as there is more clarity in terms of the opportunity and targeted segment. The objective of the investor is to get returns and he walks in with this objective. Most of the startups will need multiple round of dilution for growth hence dilution of equity calls for prudence.

5. Clear exit strategy for investors
Proven assumptions, proven product (even in a small way), proven execution make founders’ planning and exit strategy for investors clearer. There is better chance of getting investors’ nod in such a situation and a founder’s case can become stronger.

Mahesh Krishnamurthy, Director at 1st Impact Solutions, Chennai, Tamil Nadu.
Mahesh Krishnamurthy, Director, 1st Impact Solutions, Chennai, Tamil Nadu.

Mahesh Krishnamurthy has over 25 years of work experience with various companies in finance and accounts, general management, funding, strategic planning and running SME businesses. His areas of expertise include management consultancy, mentoring, strategic business planning, business turnaround, Temp CFO services, turning family business to professional set up and exit strategy, due diligence, funding, debt restructuring & business process re-engineering. You can get in touch with him at mahesh@1stimpact.in.

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