Key Takeaways For SMEs To Understand Funding Options Relative To Their Stage Of Growth
Today's growth stage organizations have a variety of capital-raising choices, including equity financing, venture debt and alternative finance. Each capital choice has its own set of advantages and disadvantages. Your business decision on which financing option to choose is based on the end use of the capital as well as to consider a balanced capital stack. Let’s take a closer look at which funding option is the best to choose for a company and why.
Equity capital is crucial pre-product market fit or for funding uncertain expenditures
For founders, equity funding will always be a vital and popular financing option. Venture capitalists invest funds into a company in exchange for a majority or minority shareholding. Equity can be advantageous to founders, particularly pre-product market fit, when businesses are seeking to develop “something from nothing”. Even though it is a risky investment for venture capitalists, it has a potentially huge upside that is appealing.
As an organization grows, more financing options open up but equity financing continues to remain a useful instrument especially for funding research and development costs, starting a new product line, or any other end purpose for growth where the break-even time is longer than 24 months or is extremely difficult to anticipate.
While business leaders and entrepreneurs have traditionally relied on venture capital funding, it has its own set of drawbacks. It's time-consuming as well as difficult just to go through the process. It takes at least 6 months to cash in the bank and includes preparing a pitch deck, reaching out to potential investors, attending investor meetings, negotiating deals, executing final documents before funding. Not to talk about the fact that diluting your firm would eventually make you lose control of your organisation as well. Important to have the timing right and dilute in a calibrated way at the right time.
Debt financing is available for growth stage venture funded organizations
The traditional solution to the problem of dilution has been debt. Debt financing, rather than equity financing, allows a company to keep its ownership while simultaneously being less expensive and providing tax benefits. For growth stage asset light companies, access to debt financing has been limited as they don’t have greater than three year track record, or collaterals to pledge and are cash burning. Even if some companies get access, they realise that debt comes with a lot of restrictions in terms of fixed obligations, restrictive financial and operational covenants and personal guarantees that could be quite stringent. Venture debt has been an option for mid to growth stage startups which instead of requiring collateral, take a fixed coupon plus issue warrants (which are an option with the investor that can be converted into equity shares), resulting in partial dilution and a higher effective cost of financing. Venture debt is also limited to marquee VC backed startups (limiting access to not more than nearly 2 per cent of the startups).
Your recurring revenues can be your biggest asset to raise growth capital
Alternative financing has a significant advantage over other conventional means of financing since entrepreneurs don't have to dilute their ownership and the process is tech-driven and instant. Subscription-based financing (SBF) has recently gained popularity and caters to companies with recurring revenue streams.
Subscription based financing gives companies access to growth capital by pulling forward their own existing recurring revenue streams. This helps to bridge the time arbitrage between spending customer acquisition cost and earning revenues from those customers. It is one of the most founder friendly ways of raising capital.
Subscriptions that are paid on a monthly or a quarterly basis can be traded for cash upfront. Companies repay their investors as their end customers pay, giving them flexibility. This, along with the fact that there is no equity dilution, no restrictive covenants, no personal guarantees and flexibility with the founders to fund their growth, is a novel and innovative way for recurring revenue companies to obtain growth capital.
This is a fantastic fundraising method for businesses once they have established recurring revenue. It works best to fund your predictable recurring expenses like customer acquisition, retention, technology and product cost and acquisition financing (which have a payback period of <12 months). It can work with companies of any size from bootstrapped companies to publicly listed organizations.
Subscription based financing also complements venture capital by closely working together and empowering founders with best capital choices.
The bottom line
It's critical to comprehend the differences between all financing options in order to make an informed funding selection in terms of end use and cost of capital. It's fascinating to observe how alternative finance platforms such as Subscription-based Financing are rapidly expanding and gaining market dominance. It's an exciting moment to be a founder, but it's also critical to understand how to construct an efficient capital stack that works best for you and your company.
This article was first published by Abhinav Sherwal on Entrepreneur Magazine.