Data Focus

How the legal form of start-up impacts funding

Thillai Rajan A | Updated on July 19, 2021

The first step in setting up a start-up is incorporation. There are different categories in which a start-up can be incorporated, and it is very important to choose the category that aligns with the vision and ambition of the founders.

Our analysis show that the Private Limited Company is the most preferred format, with more than 82 per cent of the start-ups choosing this category for incorporation. The private limited company format is best suited for getting external funding and achieve non-linear growth. Limited Liability Partnership (LLP) and One Person Company (OPC) are the two other formats with significant percentage share.

While these two forms provide flexibility and ease of compliance, they are not the most suited for growth or for external funding. Though very small, an interesting observation is the percentage of start-ups incorporated as non-profit companies. An indication that companies with social motives have started adopting the start-up style of functioning to be more effective.

Small and big cities

As we all know, Tier-1 cities account for a majority of the start-ups. The top 8 cities in India account for close to two-thirds of the start-ups, whereas the rest of India accounts for only one-third. Variations could be seen for different incorporation formats between Tier-1 and smaller cities indicating that awareness could play a role in choice of incorporation format. For example, the percentage of start-ups that are private limited companies are lower in Tier -2 and -3 cities as compared to the percentage of OPCs. The first three stages in a start-up lifecycle from the perspective of external funding are incubation, angel funding and venture funding. Both incubators and investors prefer to support start-ups incorporated as a private limited company. For example, while the percentage share of LLPs and OPCs that have been incubated are 2.1 per cent and 1.8 per cent respectively, the share of private limited company is 5.7 per cent.

On a separate note, two observations that catch the eye is the high percentage share of start-ups that are subsidiaries of foreign company and non-profit companies in the incubated start-ups. Start-ups that are subsidiaries of foreign companies are attractive to incubators and as we see later, this trend persists among angel and VC investors as well. The role of incubators in supporting start-ups that are set as non-profit companies should deserve applause, more so when most of them would find it difficult to get investment from angels and VCs.

Private limited companies

Angel and venture funding trends also show that the private limited company format is the most preferred. For example, the percentage of private limited companies that have received VC funding is about 14 times higher than the percentage of LLPs. On a different note, investors seem to have an eye for start-ups that are subsidiaries of foreign companies. The percentage of foreign subsidiary start-ups that have received angel funding is more than three times higher than the percentage of private limited companies.

The implication of the results to start-up founders is clear. The choice of incorporation type is not an innocuous decision but one that should be chosen carefully given the importance attached to it by investors.

Choosing a structure other than the private limited company can significantly affect the chances of getting angel or venture funding subsequently. However, incorporating as a private limited company does not automatically get access to funding. Getting angel and venture funding in India is still a difficult proposition as the sample numbers indicate: Out of 47,820 start-ups, only 2,520 are incubated, 1,318 get angel funded and only 589 get VC funding. Entrepreneurs, who have mountains to climb, should not be felled down by small hurdles right at the beginning of their journey.

 

 

(The writer is Professor, Centre for Research on Start-ups and Risk Financing, IIT Madras; Associate, Harvard Kennedy School, Harvard University)

Published on July 19, 2021

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