Pakistan is experiencing a start-up boom. With our unique demographics of having a majority of our population below 25, and as associated shortage of lucrative jobs, the aspiration of our youth and young professionals is to become entrepreneurs as opposed to working for a salary. This momentum has been assisted by the creation of incubators and accelerators across the country which provide working space, mentorship and business skills to these start-ups. Budding entrepreneurs, however, easily get confused about the jargon used in this fledging industry. So let’s go through all the funding stages a start-up can possibly go through.
Let’s say you get an idea for an application (app) which you think can go viral. You start working on your application. You are alone at this stage and own 100 percent of your company. In theory, 100 percent sounds great. But 100 percent of zero equals zero. You need to create ‘value’ so your company can be worth something.
You soon realise that at some time soon you will need funds for equipment and research. At that stage you will have two options. You can raise funds from friends and family, or you can bootstrap, meaning you use your own savings. Just remember that every time you raise funds you give up part of your equity.
An industry veteran provides a walk-through on financing your dreams
Think of it as a pie. At the start, you own 100 percent of the pie. When you raise money from friends and family, your ownership reduces but the size of the pie has increased. By the time you exit, your ownership may be as low as 15 percent but the size of the pie may be worth hundreds of millions.
When I started Tameer Bank, the management owned 60 percent of the bank. The bank had been capitalised at 10 million dollars. Three years later, a telephone company purchased 51 percent of the bank. All shareholders including myself got diluted. The management now owned only 29 percent of the bank but the management’s 29 percent ownership was worth far more than the 60 percent it held initially. Reduction in ownership does not necessarily translate in lower wealth.
2. SHARING EQUITY WITH A PARTNER
At this stage you are humming along, you still have funds but you realise that you could use another person’s skill. Typically the second person is the chief technology officer, unless you are a coder yourself. So you now have a co-founder. She is brilliant, but is working on a salary which you cannot afford. So you decide to offer her equity instead of a salary. This is known as sweat equity.
You and your co-founder decide what percent of equity she should get. There is no set rule as to the equity that is provided to a co-founder. The idea is yours but you cannot execute it without her. Both are taking a risk, as the global average for start-up failure is 95 percent.
3. EQUITY FOR CASH
Now there are two of you and you start to make progress. But as you progress, the cash you had put in the business is burning fast. Neither of you are trust-fund kids, so you have to look elsewhere.
In most countries you cannot place an advertisement in the newspaper looking for funds as firstly you are yet to incorporate your company. But even if you had a private company, you cannot solicit public funds. Your friends tell you to try crowd-funding. This is where instead of one or more large investors, you simply post your idea on social media or on a site which provides crowd-funding services. Hundreds or thousands of small investors invest in your company. Unfortunately, crowd funding at the moment is a criminal activity in Pakistan, although the Securities and Exchange Commission of Pakistan (SECP) has started work on creating regulations for this medium of investment.
So you turn to friends and family. The bulk of start-ups use this medium. It’s less formal and does not require you to incorporate your business into a company. Again, you will be required to give up a piece of equity for the cash injection you have managed to raise. Friends and family are usually small and in Pakistan, they are bound to raise between five to 10 hundred thousand rupees.
4. ANGEL INVESTORS
You are now making serious progress on your application. But as you slowly move towards your end stage, you realise you need to hire a couple of programmers, you need data storage, you need hardware. You are now ready for the angel round.
As a prerequisite to the angel round, you must incorporate your company. Incorporation is relatively inexpensive as you can do it online on the SECP website. But you do require articles and memorandum of association.
So you end with an inexpensive lawyer or cut-and-paste existing documents of a company your friend has already incorporated. Next you need a bank account. Turns out opening a simple bank account with a cheque book and an ATM card is a nightmare as you are made to go from one desk to another at the bank branch you visited. You are forced to call in the heavy guns and an uncle or aunt makes a call to the bank and the account is opened. You are now ready for angel funding.
However, are you?
Raising funds from friend and family was easy. Just an informal pitch, no real numbers, no clear monetisation strategy. The angels you are after will take the bulk of the risk. To engage an angel in Pakistan, as there only a handful, you need access and a compelling pitch.
The other source of funding at this stage would have been an incubator or accelerator. Unfortunately, only two out of the 35 incubators or accelerators in Pakistan provide funding. The third source of funding globally would a seed fund. Again, unfortunately there are only two seed funds in all of Pakistan.
An angel will typically seek between 20 and 40 percent equity for the funds you seek. Unlike the previous round you are now looking for an amount that will last you till the venture capital round.
You hope your company is worth between 50 rupees and 100 million rupees. You raise 20 to 40 million rupees. You now focus all your energies into getting your product to the market. You are beyond the proof of concept, and looking for a commercial launch. You are extra diligent in ensuring that you are not missing your key performance indicators as the angel investor may have a provision which forces you to give up more equity if you do hit your agreed milestones.
Remember the angel valued your company based on the projections you swore you would achieve. Your company was pre-revenue at that stage, meaning your company was making a loss.
5. VENTURE CAPITAL
Finally you go to market and people start downloading your application and use it. Your app is user-friendly and you are ready to scale your business. However, to achieve scale, you need serious marketing money, you need to upgrade your data centre or your cloud storage. You need additional space, you may need seats at a call center. This is the point when you should consider yourself ready for the venture round. The first round is called Series A and the subsequent round is Series B and so on.
If you thought the angel round was tough, you are told that it was a tea party compared to what the venture capitalist is going to put you through. But you have the exuberance of youth, are confident and unlike an idea, now have data to back up what you have created. You are successful in raising in funds from your Series A round.
Series A typically starts around one million dollars. The funds are meant for growing the business to a commercial state. When you raise Series A onwards, you will be diluting existing shareholders but your company valuation has also increased
A company typically continues to fund its growth through these kinds of funding rounds. Investors typically get to cash out when a company goes public through an initial public offering, or through a trade sale, a private sale to another company or partial cash out during these rounds. Unfortunately this is a real challenge in Pakistan. There are only a handful of successful trade sales (Tameer Bank being the most successful), very limited initial public offerings for start-ups and a dearth of venture capital companies. However, the industry given our population, the digitalisation of Pakistan and the undervaluation compared to other emerging markets, both venture capital and private equity firms are taking notice of this high potential country.
The writer is the founder of Planet N Group of Companies. He tweets @nadeemplanetn
Published in Dawn, EOS, October 1st, 2017