Guest blog: Sharan Aggarwal
Dare2Know is delighted to invite Sharan Aggarwal, a fellow LSE Generate Mentor, to contribute a guest blog, sharing his expertise on the role of grant funding in startup finance. Thank you Sharan!
Grant funding and its role in the startup ecosystem
Startups today have several means of funding. These range from a plain vanilla issue of common equity to complicated forms of structured finance. Within this vast expanse of funding options lies the keenly sought offer form of a grant. This paper aims to explain what a grant is, the various types, and take a look at its advantages and disadvantages.
What is a grant?
Simply put, a grant is a sum of money given to an individual, corporate, or some other organization that does not need to be repaid within a set of requirements that need to be met. The protocol is to prevent moral hazard, so if the conditions agreed upon beforehand are not met, then the amount might need to be repaid.
When an investor sees that a startup has received a grant, it builds confidence as a grant helps to gain credibility, as the startup usually has to be thoroughly vetted to receive this money. It also means that the equity holders can see their business funded by favourable grants rather than debt. This feature of not having to be repaid differentiates a grant from a loan and makes it so desirable.
Refer to Figure 1, which illustrates the pecking order theory of corporate finance.
The order in which funding takes place is from top to down, and so, as can be seen, in both scenarios, debt is always repaid before equity, and so having a debt-free capital structure is always appealing to investors.
Generally, the most common grants are given by government-backed corporations or agencies, but charitable foundations, trusts, and private corporations also often offer them.
Types of grants
There are 4 types of grants:
Competitive Funding – This is the most common type of funding for research grants. It is also known as discretionary funding, and here the candidates are thoroughly pitted against each other to determine who is the most deserving.
Formula Funding – This form of funding is the most common for businesses. Usually, governments fund these grants. A preset criterion has to be met, and the grant is awarded based on whether or not it is achieved.
Continuation Funding – This grant is generally issued to multi-year educational or research projects which require a renewal of their existing grants.
Pass-through Funding – This is a grant in which an intermediary allocates the funds to the recipient.
Hence, it is important to know what type of grant one is eligible for, and to apply for the same accordingly. For startups, formula grants are often the most suitable. Knowledge entrepreneurs typically do research that helps others start their own businesses. For such research, a competitive or continuation funding grant might be appropriate.
Trends in funding – India and the rest of the world
The Indian economy is at its prime for the startup ecosystem. The government has launched various programs  to ensure the success of domestic businesses. Nationalism is at its peak with the ‘Make in India’ movement. The government has established a $1.232bn Fund of Funds for Startups (FFS) to extend funding support for innovation-driven startups. The FFS is to be monitored by the Department for Promotion of Industry and Internal Trade (DPIIT) and operated by the Small Industrial Development Bank of India (SIDBI), which finally invests in DPIIT-recognized startups using Alternative Investment Funds (AIFs). So far, SIDBI has already deployed over 50% of these funds across more than 45,000 startups (data @31.03.21)
Under the Startup India scheme, the number of companies recognized as startups by DPIIT have grown from 24,927 in November 2019 to 39,114 in November 2020. In last year’s vision document, the DPIIT stated that by 2024, its aim is to generate the following:
- 50,000 new startups
- 2 million jobs
- 500 new incubators and accelerators
- 100 innovation zones in urban local bodies, and
- Seven research parks to help startups.
India has also come into the limelight on the global stage by ranking 63rd in the World Bank’s 2020 report for ease of doing business. It has improved its position by 79 rankings in just 5 years (2014-2019). Source: The World Bank
Ranking On Doing Business In India
Source: The World Bank : https://archive.doingbusiness.org/en/data/exploreeconomies/india
According to the Federation of Indian Chambers of Commerce and Industry (FICCI), India has emerged as one of the top 3 countries globally regarding the number of startups funded. Incubation facilities for startups in India have played a pivotal role, with about 56% of the incubators located in universities. More than 50% of these incubators have been set up in just the last five years. While incubators are present across the country, most accelerator programs are concentrated in urban areas.
Angel investing has become an asset class in itself. Angel funding has shown an average annual growth rate of 124% in India between 2008 and 2015, with a significant increase in the number of first-time angels, reinvestments in deals, and younger investors. Angel networks have also increased 20 times between 2008 and 2015.
Last but not least, there is venture funding, which is mainly concentrated in Tier 1 cities. Being incubated or accelerated increases the chances of getting funded by a VC. Still, each VC’s investment philosophy differs from the other, so what might be an outstanding deal for one might not fit the bill for the other.
The government is encouraging entrepreneurship with a massive monetary stimulus and a rapid increase in angels and VCs. The country has also been ranked 63rd in terms of ease of doing business. So naturally, looking at government grants as a means of funding in India is a good idea!
Risks & downsides of grants
Although grants are an ideal, low-risk form, they have some risks and downsides.
One of the most significant risks is failing to meet the conditions upon which the grant depends. The grant can be redacted and the money claimed back in such a case. In the case of small businesses that are running low on cash, this can lead to a liquidity crisis and potentially even bankruptcy. So, achieving the milestones after the startup receives a grant is essential.
The other issue is that a grant is hit-and-miss, unlike a typical funding scenario based on give-and-take negotiation. There is no scope for negotiating valuations, the ask, clarifying doubts, and so on. It is a pass or fail, so if the grant is not awarded, there is no appeal process except in extreme circumstances. Moreover, it is incredibly time-consuming to fill out forms and tenders to apply for the grant. It involves much research as applying for the grant that will best suit one’s particular venture is very important. Since the proposal is the most important for receiving the grant, it can be tough to get it if it is not creative enough.
There is, therefore, an issue of confidentiality and the release of IP, work methods or future intentions that might be on show or inadvertently revealed during the bid process.
On average, around 2700  grant proposals are submitted each day, but less than 200 are awarded. To put that in perspective, only around 7.5% of applications are approved. So, it takes a lot of sweat to get a grant. For stretch founders burning cash, there is a significant opportunity cost to consider. Time is money!
Grants are free money, and so that is always a huge pro. However, one must bear in mind the cons of grants as well. It might be best to look at other sources of funding unless;
- the business idea has a strong foundation,
- the entrepreneur is sure that they are willing to invest time in the application, and
- that they can submit a lucrative and creative proposal,
That being said, should one wish to apply for a grant, the Indian startup ecosystem is growing rapidly and receiving a massive government stimulus, so conditions are favourable.
- Aggarwal,S., (2016), ‘Are Private Investments in Public Equities an Alternative Source of Both Funding and Investing?’.