Indian startup founders are giving up ownership too early – and that's a bad idea

• Startups in India raise multiple rounds of funding even before reaching series A stage, diluting their equity in the process.
  
• However, they have learnt a lesson and are now holding on to equity.
  
• Investors too believe startups should not give away large equities early on.

Indian startups aren't afraid of not finding funding anymore – but in return they might be giving up stakes in their own companies a lot sooner than they should.

A growing worry in the Indian startup community is that many early stage startups are increasingly giving up equity – or ownership in companies – too quickly. That often leads to the founder-entrepreneurs eventually having little or no say in those startup in the later stages.

The issue of dilution of equity is especially significant now as more and more startups are seeing multiple rounds of funding even before they reach the ‘series-A stage,’ leading to the crowding out of investors.

“So very often the founding team is 25% or lesser by series A. This is something that affects entrepreneurs and investors alike. If the founders have given up 70-80% of the company at Series A, it’s still a journey of 8-10 years after that to get to being a sizeable company. Founders need to have that incentive to continue for long,” said Alok Mittal, a prominent angel investor and co-founder of Indifi technologies.

Driven by the mushrooming of startups in India, and partly the success of few Indian unicorns, several investors including venture capital firms are increasingly chasing promising companies with potential for innovation or success at the early stages. A total of 386 companies got seed funding in 2018 for a total amount of $303.72 million.

Only few years ago VCs had restricted themselves to late-stage startups and tighter due diligence that included investing in companies with large revenue base and market share. And now VCs are investing both directly or through accelerator programs. Recently, Sequoia India launched Surge, an accelerator program for early-stage startups – showing its clear interest in creating a roadmap for Indian startup founders in the early stages.

Startups, for their part, don’t seem to mind giving up equity just to have a bigger VC in their kitty, say experts.

One of the consequences of giving up too much equity quickly is losing control of the company.
A recent conversation on Twitter included the top VCs discussing the dilution of equity of startups in the early stage. Shailendra Singh of Sequoia tweeted, “Met a promising company yesterday that diluted 35% in seed round for ~$1M... this was ok 5 years ago, but hope this changes now” (sic), to which Siddharth Pai of 3one4 capital replied that startups “Must not dilute more than 8-10% on seed round as it will no longer be aligned with founders vision.”

Another reason why entrepreneurs seem to give up equity sooner is underestimating how the company might fare in the future – in the early stage, startups are still looking at finding their way through the business, for instance.

“But in the beginning, we take equity dilution etc casually, only understanding about it later, in hindsight. At that point of time, when the business picks up, how your cap table looks becomes as important to the investor as everything else,” said Akshay Chaturvedi, co-founder of edutech startup Leverage Edu.

In Leverage Edu’s case, even though the startup did not raise capital on ‘day zero’ however, after a certain while, as the company started to pick scale, it decided to pick money mostly from ‘angels who they knew’ instead of venture, since it did not wanted to dilute as would happen in a proper round, wanted more time to build around the fundamentals etc.

“With a lot of things in place, and when ready to scale, Leverage Edu raised a VC round that was led by DSG Consumer Partners and Blume Ventures. I had worked in startups before, so that definitely helped,” he said.

However, most early stage investors will not worry about early stage dilution as long as the valuation is on an uptick, said Mittal adding that the issue is when the overall level of dilution is high.

As funding availability has grown in the country, at least startups have learnt the lesson the hard way – to not head for funding when there is no revenue, product road map or validation.

“We raised seed funding without these and so we didn't have much leverage to negotiate on the valuation and ended up diluting quite a bit. Back then, we thought 50L was a big amount but in reality it was not. Within a year we were again desperate for next round of funding. So when someone is raising money they need to raise an amount which would at least give 2-3 years runway,” said Naren Krishna Madhurakavi, founder of Stockroom.io.

There’s also an argument presented by investors. With more and more successes being witnessed in India, startup founders believe that smaller equity could be lucrative as well.

“Interestingly enough when startups see examples of successful companies say when a Flipkart is acquired by Walmart, it encourages them to scale up faster and dilute as well because then even a small percentage of equity can be cashed out for a large sum,” said Mittal.