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Pricing & Funding Lesson

Price is the amount that a buyer charges for a product or a service. It is all around us. The school charges a price in the form of a fee. Railways charge a price in the form of fare, and consumer products charge a price in the form of an MRP, etc. 

The price depends on factors such as fixed and variable costs, cost of production, company objectives, competition, target market, willingness to pay and to purchase power of customers, producer’s control on demand and supply etc. For an enterprise, the goal in terms of price is to reduce costs by improving efficiency. 

For making price decisions, the following questions must be considered:

  • What is the value of the product or service for the consumer or buyer?

  • How does the price compare with competitors?

  • Does the pricing meet our margins requirements?

  • Are there established price points for the product or service?

  • How price sensitive is the customer?

  • Can price increase lead to increased market share?

  • Can different prices be charged to different customer segments?

  • What discounts can be offered to customers?

Some pricing strategies using to make pricing decisions are as follows:

  1. A) Penetration pricing

In penetration pricing, the price of a product or a service is set low initially. Usually, the objective of setting the price low in the beginning is attracting new customers, increasing sales, and capturing more market share. Once the market is created, or market share growth is achieved, the price is increased. Penetration pricing works best for a new product that does not have much differentiation from competitor products in the market. 

  1. B) Cost-Based Pricing

In cost-plus pricing, the price is set in a manner to cover the cost of making, providing and distributing a product or a service, and accommodating for an additional profit. A reasonable markup or margin is added to come up with the final price. For example, it may cost INR 100 to produce an item, and if the firm adds 20% as a profit margin, the selling price would be INR 120.

  1. C) Skimming Pricing

Skimming, also referred to as creaming, is a strategy where the prices are initially set high and slowly lowered to make the product or service available to a wider market. Price skimming aims to reach a segment that is price-insensitive or has a relatively low price-sensitivity. These could be the ‘early adopters’ of a product or service that was launched with price skimming. This product is adopted in the market when targeting consumers that have higher disposable income or those willing to pay a premium price. For this, the price and quality relationships must be viewed favorably by quality conscious customers. For example, Apple uses price skimming as the pricing strategy for its smartphones

  1. D) Variable Pricing

Different prices are charged to different customers for the same products or services in variable or dynamic pricing. Pricing varies depending on anticipated business from different customer groups. Other factors that influence price include order size, levels of supply and demand, bargaining power, and purchasing power of customers.For example, with street vendors or small shops, a standard price is posted on each item, but it is negotiated to sell items to customers who are not willing to pay the standard price. Auctioning or Bidding also works on variable pricing as the price of an item being sold through auction changes depending on the demand, as evidenced by bid prices. Two markets that use the principle of variable pricing are the stock market and the real estate marke

Different Pricing Strategies

Competition Pricing: In this, the price is compared with competitor pricing, where the price is set lower, the same or higher than competitor products or services.

Product Line Pricing: Within the same product range, different products are set at different prices. For example, HD and non-HD are charged differently by Direct to Home (DTH) channel operators.

Bundle Pricing: This strategy is used to bundle a group of products at a lowered price. For example, ‘buy one and get one free’ promotions, especially popular with supermarkets, is an example of bundle pricing.

Psychological Pricing: The most commonly found pricing strategy, in this the psychology and positioning of the price are considered, where INR 99 is charged instead of INR 100 or INR 199 is charged instead of INR 200.

Premium Pricing: As the name suggests, a high price is set to reflect the product’s exclusiveness. This can be charged for services or products that are unique or are customized for the customer. For example, first-class airline tickets or designer wear clothes or vintage cars.

Optional Pricing: Some additional products or services are made optional to the customer, and a price is charged for it. For example, in the automobile industry, especially for cars, additional optional services and features are made optional.

Funding

You have already understood the sources of funds in the financial literacy module. Let’s apply those concepts in the start-up world and understand Equity and Debt in detail.

Equity Financing

Equity financing or equity funding is the method of raising capital by selling company stock to investors.

Features of Equity Financing:

  • Equity finance is more of a permanent source of raising finance

  • Ownership rights have to be shared with investors

  • There is no charge that is implied over assets

  • There is no obligation for fixed dividend payment

  • Controlling rights can used by the entrepreneur through voting power

Methods of Equity Financing:

Reinvesting Profits: Retained profits are usually held back for some years and utilized again and again for the development and growth of the business. New entrepreneurs cannot use this method as they do not have any profits.

Equity Shares: Any business that releases equity shares is under no obligation to pay the shareholders any fixed dividend or principal amount. 

Preference Shares: The shares which are entitled to the payment of a fixed dividend before the payment of dividend on equity shares are called preference shares. These shares can be of different types such as cumulative or non-cumulative, convertible or non-convertible or participating or non-participating

Stages of Equity Financing for Startups

  1. a) Early-Stage Financing:

Seed Capital Financing (Seed Round): Seed capital is the initial capital, given in relatively small amounts, which can be used to start a business at a stage when it is still an idea or a concept. Some areas where this capital is used include market research, initial operating expenses, product research and development and advancing to the next stage of operations.

Series A Financing (Start-up Round): This funding happens for early stage startups once it is launched. The capital sourced this round is used for continuing with further product development, covering manufacturing or operational costs, facilitating initial marketing and making early sales. At this stage, the startup might have some paying customers and a ready-to-go product. The funding is used to expand sales and customer base. For this round, angel investors and venture capitalists get involved.

  1. b) Stages of Expansion or Development Financing:

Series B Financing (Second Round): This round of funding might happen when there is no clear profitability or cash flow yet for the startup. This funding is used in expanding market reach, assisting in continued development, hiring employees, increasing sales and marketing. By this time, the startup would already have a strong customer base, but would be looking to grow by expanding to a bigger market. It is mainly sourced from venture capital firms that invest in the later stage

Series C Financing (Third Round): By this round, the company is looking for major expansion, with perfecting the business model, scaling and even acquisition of other companies. With rapid sales growth, high market share and positive profit levels, different investors such as hedge funds, private equity firms, investment banks etc. start to fund these startups.

Series D Financing (Fourth Round): This round, followed by a fifth round sometimes, helps to bridge the financing gap for an initial public offering (IPO). Sometimes, this round is also used by the startup to position itself for a private acquisition.

  1. c) Acquisitions and Leveraged Buyout Financing (Diversification, Research   Development):

Exit (IPO): With the exit, either the company goes for a merger, an acquisition or an IPO. If the startup has been successful, this stage can provide a vast amount of return for founders and investors, and serve as a significant incentive for their initial investment.

Leveraged Buyouts (LBOs): In this, the management of a company might choose to completely acquire the company control by buying the stake owned by other present owners.

Going Private or Go Global: An option where some owners of the company might choose to completely go private and buy back all of the outstanding stock. With this, the company might also think of global expansion through mergers, foreign collaborations, acquisitions, joint ventures or franchising.

Key sources of Equity Financing

Under equity financing, these three stages are most of the times funded by two key sources of investors referred to as venture capitalists and angel investors. Let us look at each of those in brief.

  1. a) Angel Investors

Angel Investors, also called Business Angels, are wealthy individuals or virtually invisible groups of wealthy investors who are interested in investment opportunities by providing equity financing to all types of startup or business ventures.

Angel investors usually exist in the informal risk capital market. They provide capital to big and small entrepreneurial ventures, needed at all stages of financing, especially the early stages. Since the first stage is the most difficult to obtain for a new entrepreneur, angels invest during the Seed Round or the Startup or Series A round. Angel investors are relatively active in financing the seed round and startup round of funding, but are not restricted to financing other rounds as well.

  1. b) Venture Capitalists

Financing through venture capitalists has gained popularity over the years. Equity financing is difficult to secure for small businesses, new startups and private middle market companies.

Venture capitalists are investment companies or individual investors who specialize in financing new startups or business ventures that are high potential, and sometimes technology oriented.

How does valuation work?

The three vital factors for any business are "Financing", "Production" and "Marketing", The first rated as the most important of the three factors is "Financing" because without money one can do nothing. Thus for success in business "Finance" is the most vital element. An entrepreneur before acting upon his vision/idea should be able to answer the following three questions very clearly:

  1. What is the quantum of money required?

  1. What are the available sources to generate such monies?

  1. What is the timeline in which such money needs to be made available?

An exhaustive statement of various assets that an enterprise will require will be a good estimation of the money needed. Let us understand how equity and valuation play a key role in financing for startups.

Example:

Stage 1:

Think that your “to be business” is a pie. You got a business idea and did some research on it and strongly felt that it could be a great business opportunity. Right now, you own the whole business

Stage 2:

You thought you would want to start building upon your idea or form a prototype, but you do not have all the knowledge and expertise to give a practical shape to your business idea. You know a friend whom you trust and who could possibly help. First, you think of hiring him but then you realize you do not have the money to give him a salary. You think maybe you can tell him that he can own some part of the business when it starts. You do not know how much to offer him. Do you think it is maybe 15%? This would mean that whatever profits your business would make, your friend would get 15% of it. Your friend thinks that it is too less because he is taking a risk. He is choosing to not make any money right now and work using his knowledge and skills. He is also choosing to devote all his time and wait until he can make some money. He offers to be a co-founder or partner in your company by owning half the business. You first think that is too much because the idea was yours originally. But then you realize it is of no commercial value right now and you might not be able to move forward without someone else’s skills, knowledge, and expertise. So, you choose to split the business and give him 50%

Stage 3:

You and your co-founder start creating value by giving your idea a more realistic and concrete form and by doing one or two market tests. Now, you have some evidence to prove that there is a market out there for your solution. You feel you need some cash to make your final product. You also feel you might want to get some advice and support from industry advisors who could help you push your business forward. You come across an “incubator and accelerator center” in your city. Incubators are centers or companies that help start-up companies to develop their business by providing office space, training, mentoring, advisory services, technical support and facilitating finances. You contact the center and pitch your startup idea to them. You look at your financial projections and see how much your company is going to make. You look at your start-up costs and see how much you need. They think your startup is worth Rs.1000. They offer you Rs.50 and office space in their center as well as connect you to some industry experts.

However, in turn, they want to own a part of your company. Now, it is time for you to make a decision. By offering the center some part of the business, you will lose more control as you did when you partnered with your friend. But you need the money and maybe it is wise to lose some control to get that money because you still would earn a lot of money later. So, after discussing it with your co-founder, you decide to take the money and give some part. But, how do you know how much to give to the center? One way to determine it would be to:

Look at how much they are offering: Rs.50

Figure out what the value of your business would be after you get the money: Rs.1050

Divide the offer by the value to determine the stake: 50/1050 = 4.76%

You close the deal with the incubator by giving them a stake of 4.76%. Let us see how your pie looks now.

Stage 4:

You and your team have successfully created the final product and taken some pre- orders as well. Maybe it is time to get your business off the ground. However, you know you are going to need more money to fulfill those pre-orders. You meet an affluent individual called an angel investor who started and is successfully running his own company now. He thinks that your business can be valued at Rs.2000 and offers to give you Rs.250 as seed funding. But in exchange, he wants to own a part of your company. Seed funding is an initial form of funding a business needs, usually after a product launch.

Look at how much they are offering: Rs.250

Figure out what the value of your business would be after you get the money: Rs.2250

Divide the offer by the value to determine the stake: 250/2250 = 11.12% 

Stage 5:

You have made a decent number of sales, built a small team, and are looking at growing your business now. To scale up your business, you need more money because that would mean more assets and more people. This is where the so-called “Venture Capital Firms” come in. These firms do the work for you. These firms usually provide funding after they see that your start-up has made sales and has the scope to grow. Start-ups have multiple rounds of funding from Venture Capital firms with the first round referred to as the Series A round. So, you finally are looking at scale now and you get in touch with a Venture Capital firm. They think your start-up can be valued at Rs.4000 and offer to give you Rs.1000. Now it is the bigger decision. If you take the money you are going to lose some stake in your company. With any kind of investor comes control. They are going to be owners too and will have equal say in what the business does as you would. This is when you have to understand that you take the money only if the investment is necessary. You might lose some control, but with every investment, your business becomes bigger. 

Look at how much they are offering: Rs.1000

Figure out what the value of your business would be after you get the money: Rs.5000

Divide the offer by the value to determine the stake: 1000/5000 = 20%

Debt Financing

Debt Financing refers to borrowing money or taking a loan which has to be paid back at a point in time in future along with interest. Typically, debt financing requires some asset e.g. piece of land, house, equipment, car, etc. be used as a collateral, against the release of loans and is also referred to as asset-based financing.

Debt-financing is a financing method involving an interest-bearing instrument, usually a loan, the payment of which is only indirectly related to the sales and profits of the venture.

Sources of Debt Financing

  1. Public Deposits: Raising funds through public deposits is a way of financing where the general public deposits its savings with a company, for a period not exceeding 3 years (36 months) at the expected interest rate that is usually higher than the rate of return on bank deposits. These depositors play the role of creditors, with no say or rights in the management of the company

  1. Debentures: A debenture is a written document or instrument that acknowledges a debt, mentioning provisions about the repayment of principal amount and the payment of interest at a fixed rate. In other words, it is like a certificate issued by the company with a sign and seal, acknowledging the loan, its repayment and its expiry. Debentures help to secure financing for the long term.

  1. Loan from Bank: Commercial banks, give out short term, medium term and long-term loans to businesses of all sizes. Some of the ways it does this, is by:

  1. Loans and Advances: A loan is advance money or capital given to a business, against a collateral, for a specified period of time. The borrower is usually given the entire amount, either in lump sum or in installments, in cash or by bank transfer, where a fixed interest rate is charged on the loan.

  1. Demand Loans: Demand loans are the loans provided by banks against the security of Life Insurance Policies, Fixed Deposits Receipts (FDR), Government Securities etc. The bank can demand these loans back at any time by releasing a notice to the borrower.

  1. Term Loan: Term loans are one of the most common types of loans given by banks. They are given for a predefined fixed period of time, where the borrower can repay them in quarterly, monthly, half-yearly and annual installments. These loans help companies to purchase assets, machineries, equipment, trucks etc.

  1. Overdraft: Under overdraft, an arrangement is made where the bank gives permission to the borrower to overdraw money from his or her account upto a certain limit for a predefined or agreed period of time, where an interest is charged on the overdrawn amount. For this, the borrower must have a current account with the bank. Overdraft is allowed either on the borrower’s personal security or on security of assets.

  1. Discounting of Bills: Discounting of bills is an arrangement where the bank encashes the bills of the borrower before they become due for payment. For discounting of bills, a nominal amount called discounting charges is charged by the bank. In this, the bank can also recover the amount from the borrower in case the bill is dishonored.

  1. Factoring: Similar to discounting of bills, factoring is a financial service which is rendered by the specialized person known as a ‘factor’. This person has experience dealing with realizing the bills receivables, book debts managing sundry debtors and sales registers of the commercial and trading companies. The factor acts as an agent for a commission called commercial charges or discount. Factoring is basically the sale of accounts receivables to a bank or financial company or anyone else.

  1. Cash Credit: Cash credit is similar to overdraft, where the bank allows borrowing upto a certain limit, where the borrower can withdraw the money credited as and when required.

  1. Loans from Financial Institutions: Financial institutions provide finance for setting up of industries in backward areas, develop investment markets and for facilitating technical assistance to industrial units.

  2. Loans from Specialized Financial Institutions: There are some specialized financial institutions that mainly provide long term financial assistance, technical help, guidance & knowledge to entrepreneurs

Quiz:

  1. Which of the following factors does the “price” depend on?

  1. Fixed & Variable Cost

  2. Cost of Production

  3. Competition

  4. All of the above

  1. Name the Pricing Strategy where Rs. 999 is charged instead of Rs. 1000

  1. Psychological Pricing

  2. Product Line Pricing

  3. Bundle Pricing

  4. Optional Pricing

  1. Name the pricing strategy where initially the prices are kept high and then lowered to grab a wide market?

  1. Cost Based Pricing

  2. Penetration Pricing

  3. Variable Pricing

  4. Skimming Pricing

  1. Which among the following is a source of Debt Financing?

  1. Loan

  2. Debenture

  3. Factoring

  4. All of these

  1. Who are Angel Investors?

  1. Group of Wealthy Investors

  2. Venture Capitalist

  3. People who manage the startup

D. None of the above