Companies

Why start-up promoters are ceding control early on

Meera Siva BL Research Bureau | Updated on January 23, 2018

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The need for quick funding is forcing them to dilute their stakes to venture capitalists

The recent fracas involving Housing.com highlights the whittling down of promoter holdings in Indian start-ups. Rahul Yadav, CEO of Housing.com, held a mere 4.5 per cent stake in the company, which he gave out to employees. The Bansals’ stake in Flipkart is reported to be just around 15 per cent.

Venture money pouring into start-ups appears to be coming with a big catch — a smaller stake for promoters. Data from Venture Intelligence on stakes given up to raise early institutional funding (Series A round) show that companies such as Furlenco, which raised ₹38 crore recently, gave up 47 per cent to investors.

This is much higher than the 30 per cent typically taken by venture capitalists at this stage.

In many cases, raising funds from other sources, such as angel and seed funds, has led to stake reduction even before serious capital raising.

Early dilution

For instance, TalentSprint, which raised over ₹20 crore from Nexus Ventures, was left with just 34.6 per cent promoter holding after the Series A funding, even with the investor taking only a 26.5 per cent stake.

This could be because incubators and accelerators, which help start-ups with infrastructure, network and marketing, typically take stakes up to 10 per cent.

But why are passionate entrepreneurs selling their stakes so quickly?

There is a rush to maturity by accelerating growth, especially in consumer facing segments such as e-commerce.

“They raise more money on average and this comes with a significant stake dilution,” says Chinnu Senthilkumar, Partner and CTO, Exfinity, a technology focused fund.

Need for speed

This is because their window of opportunity to gain traction with customer acquisition is short. Data from Venture Intelligence on early-stage funding rounds show that $527 million was raised in 2014-15, up from $369 million in 2013-14.

“Founders see funding as a binary decision — do well with the money raised early or lose it all,” observes Vishesh Rajaram, Principal at Ventureast, a venture capital firm that also invests in early-stage start-ups.

Funding is also being used to quickly re-align companies as competition intensifies and the market shifts, says Radha Kizhanattam, Principal, Unitus Seed Fund.

“Start-ups look for smart capital from venture funds to provide support, guidance and network, beyond money,” she says.

Data also show that start-up valuations are soaring. Compared with a median valuation of ₹27.4 crore for a start-up last year, it has increased to ₹47.3 crore, according to Venture Intelligence.

Catching ’em young

While this may seem like a good thing for promoters — a higher valuation means giving up a smaller stake to raise the same amount of funding — there are two issues.

One, with only a few winners likely to emerge in e-commerce categories, venture capitalists are eager to catch start-ups young. “Even larger venture capital firms have started to fund at the seed level in the last two years,” says Senthilkumar.

Unlike angels, these funds typically prefer handing out larger cheques to fewer firms for ease of management. This could lead to founders losing their stake early. Two, there may be more dangers than losing stake, cautions Peesh Chopra, Managing Partner, Peesh Venture Capital. “With inflated valuations, VCs, derided as vulture capital, may include tougher clauses such as liquidation preference and multiples. These can lead to promoters not making any money in case of a takeover,” he notes.

More capital

But, on the other side, more controls for investors may help bring in more funds for start-ups.

“The Indian VC and PE market has given the lowest return in the last decade.

And investors who have burned their fingers are looking for more of a say in the business to increase their confidence,” says Thillai Rajan, Associate Professor at IIT-Madras. This may already be happening. Data from VCEdge show that there have been 61 deals in early-stage funding since January, compared with 115 for the whole of 2014.

Published on May 17, 2015

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