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Nuts And Bolts Of A Start-up Machine A proper organizational structure with all its legalities in sync prevents a start-up from falling apart.

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A sailor, before the start of his long voyage, scrutinizes two things: (i) his crew, and (ii) his ship. In the absence of his crew, a sailor can still manage to navigate and steer forward. But what would a sailor do without a strong ship?

Why Structuring And Planning

Taking a cue from the above, an entrepreneur is the sailor and the form of entity through which he flourishes, is his ship. A proper organizational structure with all its legalities in sync prevents a start-up from falling apart. Not only does it help improve efficiency but it also helps the entrepreneur attract investors.

Structuring involves designing an entity that satisfies the entrepreneur's requirements, ensures that the concerns of all stakeholders are met and is legally compliant. Before opening their doors to business, a startup must have in place a suitable legal structure for its business entity. One must keep in mind the potential proliferation of his business while deciding the legal structure.

It is also critical and necessary for entrepreneurs to envisage a smooth exit for retirement or in case of other unfortunate event. Although an entrepreneur would not think of shutting his business down, effective planning to develop an exit mechanism can be of utmost benefit in times of consolidation or winding up. Just like the business, the entity also requires management and planning from the beginning.

Potential Challenges

Financial management (both attracting investments and sustaining the same) is the heart of any organization. The global finance market, today, has diversified in the field of investments and borrowings. Financing growth can be done through a variety of means but the most fundamental decision to make is whether to relinquish ownership in order to raise equity. It is important to know when to get debt or equity, and in what form, in order to build an ingenious business structure.

Another challenge that could arise is while bringing in an investor on board. Several start-ups initially borrow money from friends and relatives against equity shares, however, when the angel investment dries up and the entrepreneur envisages growth, he considers bringing on board an investor. An investor's interest lies in the acquiring a big chunk of the stake and would be quite apprehensive to invest in a company that has a number of shareholders holding miniscule amount of shares in the company. It then becomes a challenge for the entrepreneur to convince an investor for funding, in the event the company has too many shareholders holding small percentage of shares.

Assuming the entrepreneur decides to buy out the relatives and friends, they would want an exit with some returns adding to the pressures of the entrepreneur. He needs money from the investor, but he would have to shell out extra money to buy out the relatives. Had the entrepreneur structured his investments from the start, he would have been saved him from the hassles.

Potential Threats Of Overvaluing And Undervaluing The Business

One of the fundamental and critical aspects of raising funds is deriving a suitable valuation of the company especially for the purpose of investment. When one puts in years of hard work and sweat, it is natural for the entrepreneur to assume that the business would be worth a lot of money. It is challenging for an entrepreneur to be non-biased towards his venture, especially as it defines him.

The competitive market and need of funds may drive entrepreneur to overvalue the business of the company during investment process. Misvaluation of any entity leads to misallocation of resources. An overvalued entity would have better access to investments than the others for obvious reasons — higher the valuation more the returns expected, hence more money flows in. As a result over valued entities would undertake investments which may not be optimally utilized.

Inspite of money pumping in these overvalued entities, profitability may be a far-reality, which makes sustaining the market in the long run all the more challenging. Usually investments dry up because of burning of cash. This valuation bubble would burst when investments start to desiccate. Over valuing a business may fetch the necessary investment; however, in the long run, it not only harms the business but also the entire economic market.

An entrepreneur may be digging a grave not only for his own entity but also for the entire market by overvaluing the business. Entrepreneurs will agree that growth and valuation both involve risk and if not managed properly, the same has the ability to make the entrepreneur lose the principal amount as well.

Fear of the unknown (i.e. whether the entity is valued appropriately or whether the investor will be able to get his basic investment let alone with returns) may weaken the faith of the investors, who would try to exit the business. Premature exits of the investors could cause panic which may keep other investors at bay, stock prices could plummet, and there may be loss of confidence in the business. This, in turn, on a larger scale has the potential of harming the economy on the whole.

There is no straight jacket formula to determine the exact valuation of the business, unless there is a buyer willing to pay such a price. Nonetheless, one must make sure that the business of the company is neither overvalued nor undervalued. It is only practical to seek what is needed and utilize the same resourcefully (maybe avoid getting caught in the valuation bubble!).

Importance Of Having The Right Advisors Onboard

Some entrepreneurs may cringe at the idea of bringing a third party onboard. An entrepreneur may not be an expert on everything and may opt to deal with the necessary situation on trial and error basis or may be after some thought, to hire an expert. Both of which can turn out to be too expensive.

The success of a start-up rests on whether it is able to build itself into a highly functional organization with no legal loop holes. An expert can make accurate and informed decisions quicker than the promoters themselves, saving valuable time and energy. With the in-depth knowledge of the industry, the right advisor can become an invaluable asset to the company.

The right legal expert on board has become all the more important given the increase in regulatory compliances and governmental watchdogs. Not only does the legal advisor bring on board the right kind of expertise, it also reduces the burden on the entrepreneur to be legally compliant and avoid hefty legal notices. It gives the entrepreneur the much needed space to focus on the business rather than worry about plethora of legal compliances.

Structuring may not seem as important as paying attention to the business at the initial stage. However, bad structuring has the potential to kill many unsuspecting entrepreneurs. Having an agreement vetted by lawyers may seem like an added expense but it inexpensive as compared to expenses that may be incurred on subsequent legal bills.

Purvi Kapadia & Zil Shah

( Partner & Associate at Rajani Associates)

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