Foundation — How a company raises money, and the eleven Category I and II strategies

11.1 What Category I and II AIFs invest in

Category I AIFs and Category II AIFs are primarily investing in unlisted and high-growth companies, which include early-stage start-ups, small and medium enterprises, infrastructure companies or companies planning to issue shares through an Initial Public Offering.

To understand what strategies they use, you first have to understand when a company needs money and who is willing to give it.

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11.1.1 The five stages of fund-raising

1. Pre-seed Capital

Pre-seed capital is provided to entrepreneurs or start-up founders to help them develop an idea. At this stage, the entrepreneurs identify a problem statement and develop an innovative solution to solve the problem. To ensure that the idea is validated, the entrepreneurs also seek support from start-up incubators which provide them the required mentorships and connect with early-stage investors. The capital raised at this stage is invested to validate the idea and ensure that the idea is sustainable, scalable and saleable.

Since the entrepreneurs only have an idea and not ongoing revenue, it becomes difficult to raise the initial investment from banks and investors. Investors at this stage are Family and Friends.

Three words to remember for what pre-seed money must prove: sustainable, scalable and saleable.

2. Seed Capital

Seed capital is the capital provided to help the entrepreneur develop their idea into an early-stage product. This is the stage at which the idea is validated, and the entrepreneur is willing to develop the innovative product/service offering, for selling it to potential customers. To ensure that customers like the product, the entrepreneur will be required to do necessary research and development (R&D) to identify the right product segment, market segments, customer profiles.

And the definition the exam loves:

If a customer liked the product/service offerings, paid for the same and is willing to pay for it once again, then the entrepreneur has said to achieve "Product Market Fit".

Three tests in that sentence: liked it, paid for it, willing to pay again. Not two, three.

At this stage, high net-worth individuals called "Angel Investors" would be willing to take the risk and invest in such product offerings in anticipation of growth. Generally, investors prefer investing through hybrid securities such as Convertible Debentures or Convertible Preference Shares, as it gives a fixed income flow for the initial years, especially in the first 3 to 5 years of the company; and also provides the benefit of equity-shareholding in the long term. Investors at this stage are High Networth Individuals (HNIs), Angel Investors or Angel Funds.

3. Early-stage Capital

Early-stage capital is the capital provided to set up initial operation and basic production, as the company can get customers for their offering to help generate revenue. Early-stage capital supports product development, digital marketing, commercial manufacturing and initial customer outreach.

As the company starts generating revenues, it can raise funds from Venture Capital investors by issuing equity shares in a Pre-Series A, Series A or Series B round, and it may also raise debt-funding from Venture Debt funds.

At this stage, investors such as friends, family and early-stage angel investors, who invested in Stage 1 and Stage 2 funding, exit the company. This helps them to realize their profits by selling their holdings to new investors in the "Secondaries" market.

The workbook adds a caution about labels: the terms Pre-seed funding, Seed Funding Round, Series A, B, C.... are not standardised for all investee companies. These are determined based on the stage of growth of the company and the specific milestones and requirements in each case. However, generally speaking, the pre-seed stage is when the founders establish the company and work on the concept. At Seed round, the first bit of external capital is raised typically from non-institutional sources or formal angel funds to develop the product and establish the proof-of-concept. At series A, which is considered the first round of venture capital, the investors look for companies to prove the business model with revenues and potential for scaling.

Series A is considered the FIRST round of venture capital. That is a clean exam fact.

Some companies may require short-term financing to fund their working capital requirements between two rounds of funding. This is known as a "Bridge Round". Banks, Debt Funds or even Venture Capital Funds provide such working capital funds. Investors at this stage are Venture Capital Funds, Debt Funds, Venture Debt Funds etc.

4. Later-stage Capital

Later-stage capital is the capital provided in order to scale the business and expand in different markets, geographies, develop new product segments or acquire companies in order to increase their product offerings.

This stage starts from raising Series C funds, in order to invest in product improvement, large-scale marketing campaigns, new acquisitions and launching new products. A company can raise funds through Series D, E, F and further rounds, till it announces its IPO and gets listed on a stock exchange. If the company does not wish to get listed, it may continue to raise funds from the private markets and also reach out to institutional investors, such as banks, insurance companies and mutual funds. At this junction, the initial angel investors and venture capital funds exit the company to realize their profits. Investors at this stage are Private Equity Funds, Institutional Investors etc.

5. Mezzanine Round

Mezzanine Round is required when the company wants to get listed on the stock exchange and requires funds to complete the listing formalities, such as appointing merchant bankers, legal counsels, auditors, registrar and transfer agents, among others. Investors include anchor investors who are allotted shares at a reasonable discount to the Issue Price of shares in the IPO. This Pre-IPO round of investment also provides an opportunity for employees having Employee Stock Option Plans (ESOPs) to exercise their option and sell shares to new investors in the company. Investors at this stage are Anchor Investors, Institutional Investors, Retail Investors.

The stages at which a company raises funds may differ from industry to industry, based on the industry dynamics and execution plan of the management team.

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11.1.2 The eleven investment strategies

1. Angel Investments

Angel Investments are made at the initial stages, generally Stage 1 and Stage 2 of a company's life cycle. Essentially angel investors are high net worth individuals (HNIs) who invest in their individual capacity or through their family offices with own funds. In most situations, start-up ventures find it difficult to establish the required confidence for Venture Capital funds to invest or banks to lend to them. Therefore, angels take the high risk and address the critical financing gap in the initial formative phase of a start-up business venture.

Angel investors primarily look at the potential growth of the start-up's business idea, along with the team who will execute the business idea. When investing in nascent stages, the investors may not know whether the idea will sustain and scale-up. At this stage, they are simply seeing the team's capabilities and experience.

Angel investors will look at the Customer Acquisition Cost (CAC) and the Customer Lifetime Value (CLV) of the start-up. This measures that how much is the start-up spending per customer, to get its revenue from that person. If the CAC is very high, there are high chances that the start-up would not be able to make profits from its operations.

And the numbers that explain everything about angel portfolio construction:

In India, the failure rate of start-ups is 90%, while 80% of start-ups fail in the first five years. On account of such high risk, angel investors prefer to have a portfolio of minimum 10 companies, out of which they expect 1 or 2 companies to give exponential growth and Net Return on Investments, after averaging the losses in other companies.

90 per cent failure rate. 80 per cent fail within five years. Minimum 10 companies in a portfolio. 1 or 2 expected to carry the rest.

2. Venture Capital Investments

Venture capital can be termed as the first stage of institutional financing in an early-stage company or start-up, generally after the angel funds are successfully raised. Venture Capitalists are always on investing in asset-light businesses that are intensive in technology, intellectual property or digital media applications.

The SEBI (Alternative Investment Funds) Regulations state that VC investments should be made in companies offering new products, new services, technology or intellectual property-based activities or a new business model. These nascent ventures show high potential to grow into large businesses or start to demonstrate growth at a very high growth rate year on year. Venture capital investments are therefore considered highly risky and rank as such among alternative investments.

The clean distinction from angels:

Venture Capital investors invest in revenue-generating companies, as compared to Angel investors who invest their money on the Founding Team at the idea stage. Venture capital investors look at metrics like Monthly Run Rate (MRR) or Annual Run Rate (ARR), to gauge the consistency and sustainability of revenue generated by the investee companies.

Angel invests in the TEAM at the idea stage. VC invests in REVENUE.

The three market-size metrics

Presence of competition is a good sign for investors as it proves as a validation of a high Total Addressable Market (TAM) for the investor. If the market size is big and demand for the company's offerings is growing, the investors will always show keen interest and focus their research on the ability of the founding team to execute the business model.

This is captured by a metric called as Serviceable Available Market (SAM), which measures how much TAM can be realistically achieved by the investee company, based on its business model and revenue targets. The investors then actively look at the Serviceable Obtainable Market (SOM), which is percentage of the SAM that can be captured in the long run, with a sustainable marketing approach. Valuation of an investee company at this stage depends on high value of the SOM for the company.

TAM → SAM → SOM, each narrower than the last. TAM is the whole market. SAM is what this business model can realistically address. SOM is what it can actually capture — and valuation depends on a high SOM.

Note the counter-intuitive point: presence of competition is a GOOD sign for investors because it validates that a real market exists.

3. Private Equity Investments

PE Fund means "an AIF which invests primarily in equity or equity linked instruments or partnership interests of investee companies according to the stated objective of the fund". The footnote defines the phrase: equity linked instruments include instruments convertible into equity shares or share warrants, preference shares, debentures compulsorily or optionally convertible into equity.

Private equity fund is primarily an equity-based investor but unlike venture capital funds which are focussed on early-stage investments, private equity funds are mostly involved in later stage financing in business entities that have established a business model and need to be scaled up for further growth.

The term 'private equity' (PE) has wider import and is a generic term used for direct investments in companies that are not listed on a stock exchange. Typically, PE investments are made into mature businesses in traditional industries in exchange for equity, or ownership stake. Growth investing is a common PE strategy, wherein an investor will acquire a minority stake, looking to further grow the company. These investments typically take place at the intersection of VC and PE, where companies are still growing but may have already shown some profitability. Generally, Private Equity Funds prefer to have a board seat on the investee companies and not dilute their shareholding on account of further fund-raising.

4. Syndication

Syndicates enable many small investors to pool their funds in a "Special Purpose Vehicle" and participate in an investment with other reputable and big ticket-size investors. The Special Purpose Vehicle makes a single investment in the target company, by subscribing to the equity shares, although the money is pooled from various investors.

To initiate the process of syndication, there is a "Lead Investor" who gets high-risk, high return deal to invest in a potential start-up. Before syndication of funds happen, such Lead Investor ensures that thorough due diligence is done on the company, including Financial Due Diligence, Business Due Diligence, Operation Due Diligence and Technological Due Diligence. Once the Lead Investor is convinced that the start-up has growth potential, such investor will create a Syndicate and commit capital, to ensure skin-in-the-game.

Two regulatory and commercial points:

As per SEBI (Alternative Investment Funds) Regulations, only Accredited Investors are permitted to invest in the syndicate deals.

The Lead Investors generally charges a fee from syndicate investors, to compensate for their efforts of due diligence and deal scouting. Some Lead Investors may charge a one-time fee, while others may take a share in the profits earned by the Syndicate, like Carried Interest.

The worked illustration: Mr. A is a lead investor who wants to raise INR 25 crore for a Pre-series A round for Company XYZ. He created a Syndicate called ABC LLP and committed INR 5 crore himself and has approached other accredited investors who are willing to commit the balance INR 20 crore, with a Carry of 15%. If ABC LLP exits the start-up by selling its stake at INR 75 crore after 3 years, then the Syndicate investors (including Mr. A) will pay 15% of the profit of INR 50 crore to Mr. A and the balance will be distributed to investors on a pro-rata basis.

15 per cent of INR 50 crore = INR 7.5 crore carry to the lead investor, and note that the lead pays carry on his own INR 5 crore too, since he is himself a syndicate investor.

5. Securitized Debt Instruments (SDIs)

Securitized debt instruments are financial securities that are created by securitizing loans (debt) given to companies, listed or to-be-listed debentures and other forms of structured financing such as sub-ordinate debt, working capital loans and mezzanine financing. Securitization is the process in which certain types of assets are pooled so that they can be repackaged into investable securities with a pre-determined periodic income.

Securitized Debt Instruments can be traded on the stock exchange in India. An SDI is almost similar to a Special Purpose Vehicle (SPV), which is created with the sole intention of pooling funds and investing in assets that can be further leased on to a target company, with an intent to receive periodic lease as well as the scrap value on sale of such assets, after the targeted tenure. The target company, especially those which are capital-intensive (such as manufacturers of Drones, Electronic Vehicles, Charging Stations, Robots, etc.) can avoid paying interest on loans and directly lease the required assets from the SPV.

The originator, or sponsor, of the SDI is responsible to do due diligence on the target company which takes the assets on lease, to avoid default risk. The Sponsor should do its reference checks on the management team of the target company and identify potential red flags in the company's financial statements, key contracts taken, existing lenders, default history, compliance issues, pending litigations, among others. SDIs issued by such sponsor are also rated by credit rating agencies.

SDI was introduced by SEBI in 2008 under the SEBI (Issue and Listing of Securitised Debt Instruments and Security Receipts) Regulations.

6. Leveraged Buy-out

An LBO is a buyout where an acquiring company borrows funds to buy the target company, taking on significant debt, which is secured against the target company's assets. LBOs are an attractive option for acquiring companies promising a high return on investment, with a smaller upfront investment. In such transactions, investors typically look to acquire controlling interests of either 51% or more of the share capital or voting rights of a target company.

Leveraged Buyouts are typically done when there is large forecast of cash flows contingent on the unlocking of value from a new project, business plan or corporate restructuring. Through the LBO deal, an investor can take a public company, private. Alternatively, a target company can spin-off an existing business vertical and sell it in the LBO deal.

Management Buyouts (MBOs) are a common form of Leveraged Buyouts, wherein a group led by people in the current management of a company buy out majority of the shares from existing shareholders and take control of the company. For example, company ABC is a listed entity where the management has a 25 per cent holding while the remaining portion is held by public shareholders. In the case of an MBO, the current management will purchase enough shares from the public so that it can end up holding at least 51 per cent of the stock.

7. Performing Credit / Credit Opportunities

The market sizing first, because these figures get tested:

Globally, the private credit market consisting of loans and subscription to privately placed debt securities by alternative funds and other institutions was estimated as a USD 2 trillion market in 2024. The Indian private credit market was assessed at USD 25 billion at that time. According to EY, domestic players constituted merely 50% of the private credit providers in India in 2024. And: in developed markets such as UK and USA, private credit has shown returns between 200 to 600 basis points above conventional debt.

Loans are typically structured as senior / sub-ordinate debt / mezzanine debt with ring-fenced asset collaterals and/or other credit enhancement where available. These enhancements could be shares or escrow accounts or debt service reserves as found feasible. Since most Indian companies have banks as senior lenders, private credit lenders have to provide sub-ordinate debt or look for structured financing with a ring-fencing or SPV structure.

Mezzanine debt could have co-investment rights in some cases to the extent permissible under the SEBI (AIF) Regulations. Mezzanine debt with conversion rights may also be provided for companies preparing for IPO such that the mezzanine lender may be able to hold equity that is eligible for an offer for sale in the IPO. Most sub-ordinated debt structures have equity kickers in the form of equity warrants or preference shares or equity at pre-determined valuation.

Term sheets in private credit tend to be flexible with a minimum interest rate payable quarterly (in many cases) and structured repayment of the principal amounts pegged to cash flow or future financings.

The four growth opportunities the workbook identifies: new age businesses that may not qualify for traditional loans; high capital requirements of start-ups where sub-ordinated structured debt fills the gap with equity kickers; promoter stake retention — founders usually want to stay above 20% of the paid-up capital to retain management control and promoter status at listing, and private credit lets them shore up stakes; and M&A financing, since acquisitions are still predominantly equity funded and there is scope for private credit to step in and fill the gaps in M&A financing which conventional bank financing cannot.

Note the 20 per cent figure — the level below which founders do not want their stake to fall.

8. Real Estate Debt

Real estate debt forms a sizeable chunk of the private debt market due to the fact that purchase of land cannot be financed by banks under their construction finance schemes or working capital schemes for large developers. Land acquisition financing provides an opportunity for debt AIFs to step in. In recent years, land costs in India skyrocketed in metro cities and often constituted more than 50% of the project cost of a development. Collapse of some established real estate financing NBFCs opened the door for private credit funds to enter real estate financing. Private credit AIFs in real estate usually fund established developers with subordinate or structured debt using promoter shares as collaterals. If these shares are listed, they not only provide collateral value but can also be liquidated without much difficulty.

Banks cannot finance land purchase. Land is often more than 50 per cent of project cost. That gap is the opportunity.

9. Venture Debt

Typical template for Venture debt is to provide high growth start-ups with debt capital as a good mix with equity capital. Since equity involves dilution for founders and existing investors, venture debt can bridge the problem of high dilution when the company is yet to reach its optimum valuation.

The benefits to venture debt providers are: (a) it has a contractual maturity date with shorter duration such as 2-3 years as compared to venture capital, (b) it often has shares or other collateral, (c) it is senior to the equity in the capital structure.

Venture debt does come in at a higher risk level than normal bank debt and even private credit in established companies. The risk is mainly in terms of the insufficiency or negative cash flow of the debtor companies at that stage. Should the company's fortunes turn for the worse, the lending AIF would be left with some founder shares in the distressed company which are available as collateral. Since such shares are not traded, the loans can become sticky.

However, if things go well, venture debt gets paid in 2-3 years out of the subsequent rounds of financings. They also usually carry an equity kicker for the venture debt provider to get shares in the company by converting a part of the loan at an agreed valuation. If the company manages to increase its valuation progressively, the conversion clause provides an in-the-money option to the lender. Venture debt structures can potentially yield high IRRs of over 25-30% to lending funds though the private credit market got moderated down considerably in 2024-25 with more funds coming in.

2 to 3 year duration. IRRs of over 25 to 30 per cent. Three benefits: contractual maturity, collateral, seniority to equity.

10. Special Situations Debt

Under the AIF Regulations, special situations fund is a sub-category under Category I AIF and has to be registered as such. Special Situation Fund means a Category I AIF that invests in special situation assets in accordance with its investment objectives and may act as a resolution applicant under the Insolvency and Bankruptcy Code (IBC), 2016.

Note the precise categorisation: a sub-category under Category I AIF, and it may act as a resolution applicant under the IBC, 2016.

11. Distressed Debt Opportunities

Distressed debt opportunities for Category I and II AIFs typically deal with financing companies stretched for cash and are finding it difficult to meet their liabilities while being going concerns. Distressed investors target companies or assets where the company is at a high risk of entering bankruptcy or restructuring for its existing debt obligations. The distress capital financing is essentially a debt refinancing that will help to clear up the accumulated dues, reduce leverage and provide relief to the company from either a restructuring or a bankruptcy. Usually, such financing are provided as senior loans with adequate collaterals and at a higher cost than what a performing company may get.

The essential characteristic in distress financing should be to identify companies that are in operation but require debt relief.

The second form of distress financing would be indirect financing by participation in security receipt (SR) issuances by Asset Reconstruction Companies (ARCs) registered with the RBI under the SARFAESI Act. Category II AIFs can invest in SRs issued by ARCs as they are specifically categorised as 'Qualified Institutional Buyers' under the SARFAESI Act for this purpose.

Two restrictions to memorise: (a) an AIF cannot invest in SRs issued by an ARC which is its portfolio investee company and (b) an AIF cannot invest in SRs that become related party transactions (backed by the underlying loans of its associate or group companies) due to potential conflict of interest.

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11.1.3 An idea versus an opportunity

There is a big difference between an idea and an opportunity in business. An idea is a concept that could be used to make money; however, an opportunity has proven commercial value. Knowing the difference between an idea and an opportunity is crucial to avoid wasting significant time and money of the investors, as well as the founders.

An idea has the potential to become 'an opportunity' and a viable enterprise, if it has the potential to break even, generally within 36 months from ideation, has a passionate and dedicated team developing the idea, faces manageable risks and can forecast high gross margins.

Four tests, one of them a number: break even within 36 months; a passionate and dedicated team; manageable risks; high forecast gross margins.

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11.1.3.1 Deal sourcing for private equity firms

Deal sourcing refers to the process of finding new companies to invest in. Private equity firms invest in private companies that aren't part of the public stock exchange list. Therefore, it's harder to find new opportunities. In private equity deal sourcing, a firm typically analyses at least 40 to 50 investee companies, before making 1 investment.

40 to 50 companies analysed per investment made. That ratio tells you how much of a fund manager's work never produces a deal.

Growth monitoring can be done through software subscriptions providing data on business model, founding team, current investors, revenue model, Annual Run Rate (ARR), Cash Burn, Product Segments, Market Segments. The common indicators: growth in team size, social media presence, revenue growth, market share and key competitors, experienced management team, potential to become a leader of the market, unit economics.

Liquidity indicators signal why a company needs PE money: C-level employees nearing retirement or wanting an Exit, after achieving targeted growth; expansion plans in multiple geographies and appointing a team of distributors; rise of competition and a chance to acquire new players in the market; to allow existing Venture Capital or Angel investors to exit.

Brand presence: building a solid brand presence is one of the most important aspects for Private Equity firms... One of the main reasons behind this increase in brand-building rises from competition for the best deals. And it runs both ways — start-ups and investee companies may select a PE firm with a stronger brand presence. Early-stage start-ups also prefer to get investors who have the ability and willingness to help the business grow, by giving them the right market access at the right time.

Two definitions from the footnotes: ARR is the yearly equivalent of MRR and represents the predictable revenue generated annually. Cash Burn is the rate at which a start-up spends its cash flows for business purpose.

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11.1.3.2 The private equity deal pipeline

The deal pipeline in private equity consists of the following steps:

1. Deal sourcing — dedicated professionals help a PE Fund to streamline the process and building lists of potential start-ups from research, emails, calls, and other sources. The start-ups so approached provide investor pitch to the PE Fund.
2. Signing an NDA — after gaining interest in a start-up, a Private Equity firm will move on to signing a Non-Disclosure Agreement (NDA), so that their team can assess and examine the start-up's records before proceeding.
3. Initial due diligence — helps to gain a deeper understanding on how the start-up and its management is executing the plan that was pitched to the investor.
4. Investment proposal and non-binding Letter of Intent (LOI) — the Private Equity Fund will provide a non-binding LOI with their proposed investment amount, start-up valuation and the stake in the company. The amount is usually defined in a range, not a specific value.
5. Term Sheet negotiations — if the start-up has accepted the letter of intent, they sign on the Term Sheet and a Summary of Principle Terms (SOPT), which lays down the binding and non-binding clauses on both parties. At this stage, the investment has not been made yet in the start-up.
6. Final due diligence — the Private Equity investor will get access to confidential information about their business and conduct their final due diligence. This includes financial due diligence, business due diligence, technological due diligence, and operational due diligence.
7. Final Investment Memorandum — once the investment committee of the PE Fund gives its final approval, they create a Final Investment Memorandum, and the deal team proposes a specific amount of valuation for the acquisition of the company. The start-up can negotiate on the final valuation, before signing the final agreements.
8. Signing the Shareholder Agreement and Share Subscription Agreement — the Private Equity firm will hand over the cheque... the investor will be allotted the shares and receive the share certificates. The name of the investor will also appear on the Capitalization Table of the start-up.

Two features of the pipeline that catch candidates: the LOI amount is a range, not a specific value, and the specific valuation only appears at step 7, in the Final Investment Memorandum. And there are two due diligence rounds — an initial one before the LOI and a final one after the term sheet.