What should be the structure of subsidiaries and holding companies when scaling up? How does sound financial and cash flow management help in longer runways? How to value the business? Guest experts Siddharth Kohli, CEO, Indigenesis Consulting; Zena Hamdan, Co-founder & Managing Partner, Fitlov, shared their views in a panel discussion organized by the Entrepreneurs Committee and moderated by Deepak Ahuja, Angel Investor & Managing Partner, Venture Catalyst.
DA: How does one decide on the right place for a holding company?
SK: You should set up your holding company in the market that you want to target, but it’s also important that your operating entity should always be separate from your holding entity.
ZH: We went struggled in figuring out the right place to open our company and found that investors have more of a say in this than we thought. We first opened our holding company in Delaware, USA, but it was exceedingly difficult to do anything there, including opening bank accounts for three years. And we also realized, that as an entrepreneur, we did not have anyone to advise us. We then moved to TECOM, but recently an angel investor forced us to move to DMCC, though we definitely wanted to go to ADGM. The learning is that when you at seed stage, you have to go where the investor wants you to go.
DA: How do you guide entrepreneurs in regard to fundraising?
SK: You need to first pause and analyze the stage of your business and if it really needs funds to scale. You might find that you valued your business too highly at the start, and this is a pain point that many realize only later. In the initial stages of your business, it is better to raise capital as low as you can, evaluate your model and check your revenue status. There was a time when the seed capital was restricted to about half a million to a million dollars, but these days, seed capital has dramatically increased to US$10 to US$15million. So carefully consider what valuation you’re raising funds at, and then where is the money actually going to go into.
DA: How do you value your company? What are the guidelines and different models available?
SK: There is a clear demarcation between a pre-revenue company and a post-revenue company. For a pre-revenue stage (i.e., idea-stage), you need to know what is the number of customers that you have been able to gather even though there is no revenue? How much marketing effort has already culminated into a customer base that might pay off at a later stage? What is attraction in the market? How many people are talking about it? For a post-revenue company at an early stage, typically, you would value the company at a minimum of US$4 million initially. Dilute a little bit based on what you want to raise, and then go ahead and raise more funds.
ZH: We were able to find the right investor who also added value with his experience and wisdom, and the company valuation was simpler to gauge since the investors had used our service. The strategy we’ve incorporated is to review active customers, compare with the market and then value the company. Going ahead, it’s going to be a preferred rate, like a convertible.
SK: Valuation is a little like a rubber band. On one side is the startup founder and on the other side, the investor. You can stretch it only so much and make sure it does not break.
DA: How important is corporate governance and financial structure?
SK: From an investor’s perspective, he will want to know how the company’s doing, what are the key metrics tracked, what is the growth in numbers and in revenue, is there an event that can raise the market value. Once you have investors on board, corporate governance is extremely important. You need quarterly board meetings with performance reports, present monthly updates, etc. Those with a good management team and sound corporate government processes will find it easier to access funding.
ZH: This is important, and we failed to get it right at the beginning. We just used an Excel spreadsheet, like everybody else who is starting out. But eventually you need to keep your books in order. We looked for accounting companies as advisors to help us. The moment an investor comes in, he’s going to ask to see clean accounting books.
DA: ESOPs (employee stock ownership plan) is a widespread practice in large corporate banks, but how do startups use these?
SK: One of the biggest challenges for any business owner these days is in hiring and retaining talent. But you also have to manage cashflow and don’t have sufficient funds to invest in employees. This is why the popularity of ESOPs has emerged as a way to ‘pay’ an employee with stock options, so that they stay with you long-term.
I know clients whose employees have only stayed on due to ESOPs, because even if salaries were not high, they knew that the company would be acquired or listed. They were able to increase their earnings dramatically compared to what they were earning only from salaries. Another trend is MSOP (management stock ownership plan) which is carved out separately.
DA: There are so many mentors and advisors that startups need onboard. How does a founder decide on whether to give sweat equity or discounted equity?
ZH: We are actually looking into this at present. Due to the advice of an angel investor, we have carved out a specific ESOP strategy and it has helped us with the people we hire as well. It makes them feel closer to the business strategy and they work as if the business is theirs.
SK: In one example of a unicorn in India, they are investing into shares on daily basis (not quarterly). This means that at the end of each day, the employee has earned one share!
DA: As a founder you have multiple options for fundraising, what has been your strategy?
ZH: For now, since we are in the starting phase, we’ve just gone with the flow. We gave equity to the first investor, and the new investor decided that he’s going to look for more preferred rates. At this point, we don’t really have the power to say what we want. After series B, the game might change, but we are not there yet.
SK: My advice would be that if you are sure about your business and believe it is going to go public, then better to take debt. But if there is any doubt, then we advise everybody, to take equity. Because debt comes with strings attached. If you are sure that you’ll be able to pay back debt, the interest part, service the finance cost, and then make money on top of it, then go ahead and take debt. But if you have even the slightest doubt then go ahead for an equity dilution.
Audience Question: How important is it to start everything in house versus outsourcing?
ZH: We outsourced in the beginning, and it was difficult and messy, and we got many things, such as our website and app wrong. When we got an angel investor on board, his first advice was, “I will invest if you get your own tech team.” And that was the best advice, and we now have a full in-house tech team.
DA: In this region people are familiar with different share classes. What are your learnings from other jurisdictions?
SK: Investors want a differential voting class with veto rights. A lot depends on the kind of relationship that you have with the investor. We advise our clients to find investors not only with a financial motivation but those that also bring aligned strategic value.
Audience Question: There seems to be a lot of VC funds available for startups, and over-the-top valuations are being presented. How long can this ecosystem be sustained?
SK: We thought it was a bubble, but actually I think it is here to stay. Many problems of the world are being solved by technology and scaling up also needs technology. Money is going to continue to flow into startups, with increasing high valuations being prediction. From an earlier US$250 million to US$500 million valuations, we are seeing startups that were valued at US$4 billion about three months ago, now being valued at US$8 billion.
Audience Question: As founder, what is the most effective way to find people who will invest and partner with you on your journey?
ZH: For us, our first investor was a client. The second investor came from a competition we won. Then there are useful platforms like MAGniTT, where you can post that you’re looking to raise a new series.
SK: The entire journey gets much easier if you can get a good investment banker with connections, because that way you can reach many more people. However, make sure you let the investment banker know what kind of investor you want, and clarify there is no upfront fee.
Audience Question: What are your thoughts about SPAC versus an IPO?
SK: I’ve been a founder myself, and if you have a strong business model, I will say go for SPAC. These are people who have a lot of money and could try to buy you out themselves but resist the temptation to sell. Emotionally, of course, seeing your company on the stock market gives you great satisfaction.