Costs and Benefits of Start-up FundingBy
There is always a point in time when a start-up’s founders, senior management team, and top finance executives evaluate strategies for how to scale the company to the next level and catalog what’s required to do that successfully. Securing financing at an early stage can speed up growth and lead to measurable and attainable success. Eventually, finance managers and the strategic planning team have to decide on the right funding source to help the company reach its goals.
It can be challenging to choose the financing model that best aligns with the strategic targets that management sets for the organization. Weighing the risks and competitive threats in a balanced and intelligent way is crucial as it can decide the future of your company. The implications of selling equity, managing inconsistent cash flow, interest rate movements, and the need to make timely payments to lenders are among the factors to consider, just to name a few.
That said, with the rise of new and more sophisticated funding options that put the business interests of start-ups and midsize companies first, there’s typically a way to figure out a solution that’s a good fit. It’s important to investigate the different funding options that are available to a company’s founders, management accountants, and finance officers and what considerations they need to make for both the short and long term.
TRADITIONAL FUNDING SOURCES
Today, there are many funding options that company owners and financial managers can choose from. The following are some of the traditional sources of funding, which include savings, credit cards, venture equity, corporate venture capital, venture debt, and angel investors.
Savings and credit cards: Your initial capital will often come from founders’ bank vaults, especially if you’re just starting out. In fact, using your own savings and personal credit lines is probably the most effective way to test your business before approaching banks or investors. Many companies prefer to kick-start the business in the initial phase using their savings account to fund an idea or a credit card to pay for the equipment, software, or rent.
In this funding option, it’s crucial to maintain expense records early on because unequal financial contributions or sweat equity among the partners may cause disputes over how the ownership shares are divvied up. You’ll want to document everything to avoid future conflicts.
Venture equity and corporate venture capital: Global venture capital (VC) funding in the first half of 2021 surged 61% compared to the prior peak of $179 billion in the second half of 2020, according to Crunchbase. Although this is the most common type of start-up funding, it’s also the most difficult to come by and the most expensive because you have to let go of a portion of your share of equity in the company in exchange for capital.
Getting a meeting with a VC investor can be hard, and even if you win their trust, you must give away approximately 10% to 20% of your allotment of stock each round. On average, a VC-backed founding team will control less than 15% of its company’s shares by the time it achieves an exit, typically seven to 10 years later.
Start-ups and companies looking to raise funds can opt for a deal with corporate VC firms, which often provide industry expertise, executive support, and access to a network and customer base, unlike typical VC companies. Small businesses interested in partnering with corporate VCs should search for firms that will allow them to tap into their enormous customer base instantly and act as a support system that helps start-ups to nourish early relationships.
Venture debt: If you want to avoid dilution, then venture debt can be an option to consider, but it comes at a cost as well. The interest rates vary but are typically somewhere in the 6% to 12% range.
In addition, warrants and transaction fees add up quickly. The all-in costs over the length of the loan will end up adding anywhere from 25% to 50% of the amount drawn. Expect your lender to place a variety of covenants and operating restrictions on your company, and in the event of liquidation, your venture debt will have to be paid first, possibly leaving the company’s founders with nothing.
To get an idea of this type of funding’s scale, €8.3 billion ($9.74 billion) have been raised through debt financing by European start-ups from January 1 through September 7, 2021. These stats indicate that many are no longer considering debt as a secondary option. It’s very much in demand.
This trend is mainly due to two critical factors: The VC market has matured, while companies with recurring revenue and predictable business models prefer debt instead of diluting their equity. It’s a convenient option because founders get cash without compromising their independence or giving up equity, but the overall status of the company’s progress in achieving profitability plays a crucial role in deciding whether it’s eligible to get funds through debt financing.
Angel investors: Angel investors can be a good source of funding for early-stage start-ups. As experienced investors, they can guide your company in its nascent stage and help you when you decide to scale.
But angel investing isn’t any different from other funding options that entail selling shares to new investors, ultimately limiting entrepreneurs’ and finance executives’ ability to make choices independently. It may potentially put a ceiling on valuations and limit alternatives for the next round of funding because privately owned shares have generally been difficult to sell to others.
Sources: “Glossary of Funding Types,” Crunchbase; Emily Heaslip, “Financing Strategies for Every Stage of Your Business,” U.S. Chamber of Commerce. Click to enlarge.
FUNDING OPTIONS FOR EACH STAGE OF GROWTH
Different funding options may be appropriate depending on which stage of growth your company is in. Diving into all these options puts the CFO and founders in a position to evaluate the best alternative for their company’s growth stage and the requirements of the business. It’s important for finance professionals to understand how funding options match the organization’s requirements.
Start-up phase: An aspiring start-up’s leaders may decide to bootstrap their way to the next stage of growth. Bootstrapping entails starting a business with nothing except founders’ own money and, presumably, the proceeds from the start-up’s early sales and revenue. In this pre-seed stage, the available options are personal savings and lines of credit, loans from friends and family, and crowdfunding, which is funding raised through donations or investments of small amounts of money from many different people via the internet or social media.
Taking out a loan probably isn’t a good idea until you validate that your target customers will pay for your products and services. That said, every situation is different; interest rates may vary widely; and those with an excellent credit score, good unit economics, or valuable sources of collateral may be able to negotiate favorable terms.
Survival mode: Once you’ve gotten the company up and running, you’re likely already eligible for a seed phase of venture funding to get your business off the ground. Proceed carefully, as this next step is crucial and potentially fraught with peril. This is the stage at which the asymmetry of information between investors and founder is greatest. Try to get as many proof points about the potential of the business as possible and make sure you get many eyes on the company and multiple viewpoints on its potential valuation. You also need to know how much money you’ll need to get to the next stage of development—and eventually profitability—and formulate a plan for how you’re going to use it.
Before you seek a VC investment, however, there are several other options to consider: angel investors; equity crowdfunding; and grants from federal and state authorities, private businesses, or nonprofit organizations. In addition, you can seek help from microlenders, which usually offer modest loans of less than $50,000.
Initial success: During this stage when a start-up finds initial success in gaining brand recognition and accumulating customers, many entrepreneurs seek financing to drive further growth. This could mean funding a budget to launch a new product line or e-commerce site or application, open a new location, or expand sales and marketing efforts to reach out to potential consumers, all with the goal of increasing revenues. The record, metrics, and growth trajectory of your company will hopefully pique the curiosity of investors at this stage.
Some of the most popular financing options at this stage of the growth curve include:
- Series A funding: A start-up with potential but a shortage of working capital might use Series A financing to grow its operations by recruiting talent, acquiring inventory and equipment, investing in technology, and seeking ways to achieve other long-term ambitions.
- Short-term business loans: If you only need a little more cash for significant equipment purchases, then consider a short-term small company loan to boost your working capital.
Takeoff phase: After you’ve decided to expand, the takeoff phase begins, during which entrepreneurs and senior finance executives must decide whether to grow their company further or sell it and potentially start a new venture. Working with a venture capitalist is the preferred fundraising approach at this stage of your journey. Once the product market fit is clear and your go-to-market strategy is predictable, your organization will likely be eligible for Series B and C funding.
- Series B funding: This form of finance concentrates on growing your company and satisfying market demand for your product or service. More market research and company development will be requested by a venture capitalist. The money raised in a Series B round is usually between $7 million and $10 million.
- Series C funding: This round of financing is for companies with a lot of success that need additional money to keep growing. Some companies utilize their Series C investment to acquire or partner with another company.
Maturity stage: At a more mature stage of a company’s growth curve, some leadership teams seek to make an initial public offering (IPO) of equity shares to investors. Years of hard effort, a fantastic idea and business plan, and significant financial support are required to achieve the degree of success necessary to go public.
It’s widely believed that you must reach at least $100 million in revenue to be eligible for an IPO, but entrepreneurs and finance executives should understand that delaying your IPO can be as disastrous as doing it too early.
Financial leaders need to measure the return on investment (ROI) from each of their financial decisions and evaluate whether it makes sense based on the company’s strategic plan, objectives, resources, and capabilities. The traditional models of financing have many drawbacks, mainly related to removing your freedom to operate efficiently. When founders add new investors to the company, the effect is similar to getting new bosses, especially if they also sit on the board of directors. There’s an additional reporting effort; decisions are no longer made unilaterally, and investors’ motives may not necessarily align totally with the founder’s vision. While they can effectively meet some of the organization’s goals, it would behoove organizations, especially software-as-a-service (SaaS) companies, to explore other more innovative options as well.
One such funding option is programmatic financing, which doesn’t take equity or put companies in debt. Rather, it advances revenues that SaaS companies would get in the future from customers they’ve already signed. Customers can pay monthly, but the company gets cash instantly, which leaders can use to fuel growth initiatives.
The main benefits of programmatic financing include:
- Speed: Rapidly accessible growth capital is often available within days.
- Scalability: The borrower’s credit limit adjusts dynamically based on monthly growth.
- Flexibility: Borrowers can draw what funds they need when they need it; lenders place no restrictions on the use of capital.
- Affordability: Deployment is generally assisted by AI, leading cumulative fees to be somewhere between 1% and 10%.
- Transparency: Agreements carry a single transparent fee with no hidden costs in warrants, covenants, or security interest.
The revenue-finance option allows founders to have more independence over their decisions related to the company’s performance, and it doesn’t carry the risk of compromising board seats. Founders and senior finance executives would like to be aware of the avenues where they need to spend their money—and they should. With revenue financing, no one has control over your spending decisions.
Another possibility is to take advantage of the expense financing model to direct the funding more strategically by using it to cover important ongoing expenses or onetime expenditures that your company needs to make. Examples of this can include managing large bills without depleting cash, expanding your payments while getting up-front discounts from vendors, and ensuring that salespeople get their commissions as soon as they close deals, but the cash outflows are split over the following months.
When senior finance executives are working to arrive at a specific number for the company’s ROI that will eventually help the organization to secure funding, consider the following points:
- Your company’s valuation and what’s in it for the investor;
- How much money the investor is providing your company and how leadership is planning to use it; and
- The risks associated with investing in your business.
Talking in numbers, this is the difference between the main types of funding and their ROI. The traditional model of financing, or so-called static funding, yields an ROI of 1.5 to 3 times the implied cost of capital in most cases. In this model, the investor contributes a lot of cash up front, which the company doesn’t need instantly. As a result, the founders are selling big parts of the company at the present valuation in exchange for cash that they won’t use until several months into the future. For example, if you raise $1 million for 10% of the company and spend that amount while growing three times over a year, that same 10% would now be worth $3 million, so your investors would be getting a return of 200%.
According to the National Bureau of Economic Research, venture capitalists expect a 25% return on their investment on average. As a founder or senior finance executive, don’t let the cash influx distract you from this 25% number. It may haunt you in the future unless you opt for a more cost-effective option for fueling your business. Additionally, to achieve the 25% overall portfolio return that VCs expect, the most successful companies actually end up returning upward of 60% of the value to their investors. This means that if you were to use other sources of cash to fund the business, that’s the implied interest rate that you would be paying. It’s really expensive.
If the company opts for programmatic funding, then every dollar used is put to work immediately to generate returns, which gives the company the potential to achieve a much higher ROI, often ranging from eight to 11 times. With programmatic financing, you wouldn’t get money today to use over a year; instead, you would get the amount that you need to deploy over the following 30 to 60 days. This method also allows a recurring payment that’s tailor-made to suit your business needs. And with this option, founders don’t have to worry about equity dilution.
MAXIMIZING FUNDING TO FUEL GROWTH
Every start-up knows that it needs money to catapult its business to a new level, but the funding may come with a high price tag, especially in the case of VC or debt. While these traditional financing options will help your company in the initial phase with mentorship and support, financial managers should also know that they have other cost-effective financing models to choose from.
As a finance executive at a thriving start-up, your goal is to sustain your business without putting a dent in your daily operations, ownership, and sentiment. If you’re stuck paying high interest rates or end up giving up a portion of your equity, then imagine the long-term impact on your return on equity. It’s worthwhile to consider other forms of funding, such as alternative financing that blends different aspects of VC and venture debt to focus on the essential elements of your business.
Raising cash means that the company can afford more talented people and better tools, multiplying its efficiency and leveraging growth initiatives. Examples of this can include increasing brand awareness through advertising, upgrading technology, developing new products, hiring a marketing research firm to open new markets, or bringing on board high-performing candidates to boost productivity. All these activities will likely help you to outpace your competitors and create a strong position in the industry.
Your company will stay afloat in rough seas if you have a suitable business model and forward-thinking strategic plan in place. But the complicated task of finding the right funding source is probably the most critical step in your journey. Do it wisely. There’s a lot at stake.
Pitfalls to Avoid When Seeking Financing
Borrowing more than you can afford
Even if a lender offers more money than you anticipated, don’t go for it without proper due diligence. Conservative borrowing is preferable to accepting a big loan. That’s because you have to keep in mind interest payments as well. The more you borrow, the more interest you pay. If you don’t have a specific need for the extra funds, then there’s a threat that you could be overpaying for money you won’t utilize.
Not understanding the lender’s intention
Study the investor’s or the lender’s background before you start the process of raising funds. The reason: If you’re just beginning and approach a lender with a vast portfolio, chances are that you won’t get the desired investment and you’ll end up wasting time, which can ultimately lead to frustration.
The last thing you want to do is hesitate in front of potential investors when they ask about your goals or tactics for achieving ROI. Approach an investor only if you’re sure that your company’s strategic business plan and financial projections build trust and credibility and are worth investing in.
Failing to take care of debt-to-equity ratio
It’s an enticing thought to keep your business afloat by pumping in money. But you must keep in mind that investors will look for your company’s organic growth as well. Your debt-to-equity ratio will be a crucial element in gauging if your start-up is worth investing in.
Thinking it would be an easy ride
Securing investment is a lengthy process. Don’t forget this when you initiate it. Having off-base expectations can lead to frustration and distractions. Be patient and set realistic goals and timelines.
Underestimating the risk of failure
While failure is part of the process, underestimating its consequences can prove costly to you, your cofounders, and colleagues. A lot is at stake when you get a loan from a bank or funding from an investor. You have to worry about the interest payments and the collateral. So, you must identify the associated risks before applying for a loan or an investment.
Approaching just one source
If your research skills are reasonable, then you can find investors or lenders who provide competitive interest rates. Failing to do that can result in your company paying higher interest rates when there are other more affordable options in the market.
Source: Jared Hecht, “6 Business Financing Mistakes You Can’t Afford To Make,” Forbes; Dennis Beaver, “Pitfalls to Avoid When Financing Your Business,” NASDAQ.
Vetting Potential Investors
- What is your involvement?
Gauge the lender’s/investor’s seriousness. While financial capital is crucial in today’s economy, the lender’s/investor’s involvement and time spent with your start-up are equally important.
- What is your “primary” vs. “follow-on” investment plan?
Understand the investor’s stance after making the initial investment.This is important, as investors keep funds in reserve for future rounds, which are usually in a four-to-one ratio.
- What’s your follow-on investment status?
Check with your lenders/investors if they have undertaken follow-on investments or loans in the past. Some lender/investor firms don’t do it, which means you’ll have fewer funding reserves.
- How should we report to you?
Understand lenders’/investors’ expectations in terms of communication regarding annual or quarterly developments.
- Who will be our point of contact?
Stay in touch with your lenders/investors through their internal teams and advisors to guide you in your journey. Some lenders/investors prefer to not interfere once they feel that things are streamlined.
- How often will you lead rounds?
Check if the investors will lead your start-up for new rounds. Without their support, you will find it hard to get funds. So, ask them specifically if they will be leading rounds in the future.
- What do you fear most about this investment?
Helps with clearing their doubts and giving them assurance about your plans.
- Can we talk to other entrepreneurs from your portfolio of start-ups?
Show you’re serious about your start-up and the funding that you received. Also, you’ll get an idea of how the investor reacts if things go south.
- What are your expectations regarding the returns?
Gauge the investors’ stance on the timeline of ROI. If they’re under a lot of pressure and expect quick returns while you’re looking for an easygoing long-term investment, then it probably isn’t a good idea to go with those investors.
- How can we improve our pitch?
Reaffirm your seriousness about the funding round. It’ll show the lender/investor that you’re willing to learn and grow. For creating a winning deck, check out Peter Thiel’s pitch template.
Source: Micah Rosenbloom, “The 12 Questions All Founders Should Ask VCs,” Founder Collective; Alejandro Cremades, “20 Questions Entrepreneurs Should Ask Investors,” Forbes.