
What to watch out for when raising equity?
The very first and most important factor when a startup wants to raise equity funding is that it needs to be registered as a company. Only a company can issue equity. If it is any other form of business, such as a sole proprietorship, or partnership for instance, then unless the business is converted to a company structure, it cannot raise equity. Many businesses say they will open a new company in which they will carry out all future business activities because they are currently an LLP and they have all their business in this LLP, however the existence of significant GST credit in the LLP can become a deterrent for them to stop all activities in the LLP. Hence, this is definitely a key consideration.
Another important consideration when raising equity funding is the degree of control that the promoters are going to be losing as the equity holders will have a stake in the business and this will go from the promoters and existing investors’ stake, subject to the antidilution provisions.
The wrong investor can actually prove to be bad for the business. Some investors do not leave founders to run the business as they deem fit and nor do they add any value in terms of helping them scale. In such cases, the founders feel burdened and demotivated to work and many startups have even shut down due to the wrong investors. Hence, it is equally important for the startup to vet investors, as it is for investors to vet startups. It is a marriage of a sort and both parties must complement each other.
One major factor to look out for when raising equity is the amount of debt already on the balance sheet. If there is a significant amount of debt, it could lead to what is called a debt overhang situation. This means that in case the startup fails, the first people to get paid back will be the debtholders and equity holders will be paid last. Hence debt is a call option on equity. As a result of this, when raising funds, it may get harder to raise equity funding as any presence of debt may dissuade potential equity investors.