A Brief Guide to Stock Appreciation Rights (SARs)
In this blog we will try to cover what SARs are and what are its pros and cons over ESOPs.
While 2021 saw record capital flows into Indian startups, thanks to the macro-economic and geo-political factors, we are now seeing investors and founders exercising caution as can be seen in the reduced funding numbers over the last quarter.
As profitability and unit economics are back onto the discussion table, these are also times for founders to fundamentally look at their growth plans and cost structures and explore optimal ways to finance their business plans.
First let’s understand the various funding choices that founders have to grow their businesses.
Startups at an early stage do not have the luxury of sustaining through customer revenue (also commonly called internal cash accruals). Infact, many startups, as we know them, are even negative contribution margin in their quest to acquire customers faster. In this context, an equity investor becomes both — the funder of first and last resort! Equity capital can primarily use to hire the core team, build the product, capital expenditure and in some cases also spend on marketing and initial customer acquisition to demonstrate initial traction. Many a times, startups don’t have the luxury of other forms of capital and hence, are forced to spend equity capital to fund all kinds of expenses.
Founders must also realize that equity is the most expensive form of capital as founders are giving their valuable shareholding to an equity investor every-time they raise funds. Abusing this source is counterproductive for everyone in the long run as founders gradually lose skin-in-the-game and along with it, the incentive to grow the venture.
Use equity capital for the highest leverage items — spends that give them maximum ROI for the longest period of time.
Hence product, leadership team, fixed assets etc. are direct candidates, while other recurring/operating costs should ideally be avoided over a period of time.
Raising debt capital for an early-stage startup is like chasing a mirage in the desert. Only a few lucky ones end up finding this metaphorical oasis. By nature of the instrument, most early-stage startups don’t qualify for debt — lenders typically require a certain period of track-record as well as a particular threshold of balance sheet strength. Also, unlike equity, debt comes with a legal compulsion to payback the principal along with the accrued interest in the stipulated time, failing which, the startup is pushed into default and liquidation.
Thus, debt while desired, is a double-edged sword — one should sport it only if one can wield it!
Hence, while it is a challenging source for an early-stage startup, given the uncertainty of revenue, it can turn out to be a cost-effective source for certain turnover-based business models with constant flow of money. Further startups should look for possibilities of soft-loans, credit enhancements, credit guarantee schemes (like CGTMSE or Mudra) and interest subvention possibilities to make this source attractive for early stages as well.
Also, some amount of debt also helps drive discipline in startups in terms of monitoring cashflows and making regular repayments as the cost of default is quite high. This invariably leads to incorporation of processes and systems to manage the start-up’s finances better and setting them up for scale.
Venture Debt: Of-late, there are specialized funders called Venture-Debt Funds who are willing to fund growth stage startups at a slightly earlier stage than the typical banks and other financial institutions. They evaluate companies similar to a VC fund and take a call on investing an appropriate sum based on several factors such as: amount of equity funding raised, annual revenue, growth rate, unit economics, predictability of cashflow etc. Several startups have leveraged venture debt to wade through the funding winter and get some bridge capital to extend their runways before they raise their next equity round. However, note that founders need to part with periodic interest payment as well as some portion of small equity either as upfront equity or in the form of warrants which gives the lender an optionality to unlock value in case the company does well in the future.
Raise debt only for items that have a predictable cashflow to repay it back along with interest.
Grants are a great way to fuel your initial journey. Grants as the word indicates is an equity-free, one-way grant of money, and in many cases — with no-strings-attached. Basically, it’s free money, a windfall you never expected. While one can’t predict grants in a business plan, once you get it, you can definitely use it to take you to the next logical orbital.
I have commonly seen how grants have helped startups:
Whenever you get such grants, treat it as an investment into a set of many mini projects in your wish-list. Hence it is important that you create a business plan for each opportunity and select the most attractive one that directly or indirectly maximizes your north star metric.
Forget the thumb, just grab it with both hands! :)
Most grant programs are selection based on applications. So, keep those standard answers about your startup ready and get interns to continuously apply to these programs.
The tip here is to attempt every delivery, persevere and stay long enough. And you are sure to get your share of low full-tosses to capitalize.
Sources: Govt. schemes (BIRAC, DST, MEITY, State Govt Programs, Patent Reimbursements), CSR and Corporate Grants as part of accelerator and social impact programs, Awards and Competitions etc.
Before we conclude, let’s explore another form of non-dilutive financing which can prove to be an optimal form of funding for growth stage startups, especially given the funding winter seen in equity-based funds.
By definition, a revenue-based financing (RBF) or Subscription based financing is ability to convert company’s future projected revenue into upfront funding.
Funders basically look at the booked revenue or recurring revenue (typically in SaaS) and get a certain percentage of the recurring revenue as upfront financing which needs to be repaid in instalments linked to the revenue of the company until a certain return amount or percentage is achieved for the investor.
The advantage of RBF is that it is a hybrid instrument. It is not equity on one side, and it is also not purely debt on the other and it straddles beautifully in between. So, you don’t need to dilute equity while you might not be forced to pay in case you are not making a revenue as the instalments are revenue linked. For this flexibility, startups need to typically shell out a larger return than debt, however it is not expensive as equity. This flexibility can be quite handy for companies looking to get some upfront cash to manage and grow their operations.