Let's say you are trying to raise your seed round. After reaching out to dozens of investors, one investor agrees to invest Rs 5 Cr at a Rs 40 Cr pre-money valuation in your startup. Is this the value of idea, product, expertise, revenue or something else?
The answer is all of them.
Rs 40 Cr is the current value of your business in the eyes of this investor. This value includes everything you've achieved, including the money you've invested in the business. It's a critical concept that many first-time tech founders are ignorant about. They mistakenly believe Rs 40 Cr is just the value of their idea.
Founders become directors when they register a private limited company in India. They invest some nominal money called paid-up capital into the company and get shares (common stock). As long as they are bootstrapping, they put more money into the company for expenses (salaries, rent, marketing, etc.). It's a common practice in India to show this additional capital as a director loan. Indian CAs advise it for tax reasons.
Let's assume you and your co-founder invest Rs 2 Cr into the business in the first year. On the company's Balance Sheet, this Rs 2 Cr sits as a loan. When the investor agrees to invest Rs 5 Cr into the business at Rs 40 Cr pre-money valuation, the company issues new shares (preferred stock) to him. Both you and your co-founder would get diluted.
I have met founders who thought they could use Rs 2 Cr from this Rs 5 Cr (investor money) to repay their director loan. Their rationale was the company could use the equity money to repay its loan.
While this may be correct in theory, it doesn't happen in real life.
The investor pre-money valuation of Rs 40 Cr includes the Rs 2 Cr you have invested in the business. Even though it sits on the Balance Sheet as debt, the investor considers this equity. This Rs 40 Cr valuation is the combined value of your idea, product, current stage, and the capital invested in the business.
This Rs 5 Cr of fresh capital is meant for growing the business. It's not for paying back the founders. All investors (VCs, Angels, etc.) ask the founders to convert any Director Loan into equity before investing. For many founders, this comes as a rude shock when they realise they won't get their loan back.
As a founder, you must understand that the valuation reflects everything you have put into the business. This means both your time and money. It's the value of your business in its current stage, not merely the value of your idea or product.
When you raise capital, you sell part ownership of your company to a new person or fund. You no longer own 100% of it. Hence, you must take money from the people you are comfortable with. They will become your partners. In all successful startups, founders and investors share a good rapport. Founder-investor conflict is one of the biggest reasons for startup failures.
Think carefully before you accept someone's cheque. You are selling a part-ownership of your startup. Now, both of you are joint owners of the company. All shareholders own a company. The day you raise capital from investors, your startup ceases to be exclusively yours. One big reason behind the conflict between founders and investors is that founders continue to believe they are 100% owners of startups. And they use the capital for personal vanity projects.
It’s a wrong attitude and often leads to disaster. When you take someone’s money, you also take responsibility for using that money wisely to grow the business. The money belongs to the company, not you. And the company belongs to both you and the investors.
A large share of startup horror stories where founders have burnt millions in vanity projects stems from this dishonest attitude.
If you are not prepared to consider investors your partners, refuse their money. Bootstrap your way.
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