Forms of Early Financing: Pros and Cons

So, you want to venture into the world of entrepreneurship, have a great idea and desire to work hard, but lack capital.

What can you do? Of course there are friends and family, and your own personal savings, but that will only get you as far as your next capital requirement.  At this point you need do decide which form of capital you will pursue.

There two primary forms of capital ― debt and equity ― with every sort of variation in between. If you thought that writing a business plan was tough, understanding the pros and cons around each form of capital available to you is even tougher and, considered by many, as a full-time job.

In its simplest form, debt is offered in return for a principle plus interest and equity is offered as a form of debt but with no financial near-term obligations. Instead, the investor gets paid when your company has an exit (e.g., gets bought out, offers an initial public offering (IPO), etc.).

Reading this, you may think that equity is the way to go since you don’t owe anything near-term, and all the risk is on the investor. While the notion is absolutely right, if you fail as a company, it is quite the opposite for a successful company, where equity financing based on your exit can be the most expensive form of capital, not to mention, leave you with very little in the end.

Let me explain; say you are valued at $2MM and you take equity financing for 500K and in return give your investor 25% of your company, eight years go by and you finally exit at 16MM (8X), this would mean your investor share now is worth $4MM (~30% annual cost of capital).  However this is just the beginning, leading up to your exit you will have to do multiple rounds of financing, which in the end will result in investors owning ~70-80% of your company, leaving you with ~10-30%.

There are exceptions, if you are the next Google, Facebook etc. the law of big numbers will apply, where even if you get diluted to ~10-30% ownership at exit, you will still walk away with a significant portion of money. In this scenario the bigger challenge will be how to deal with investors who have a controlling stake in the company and could force you to take decisions that are not aligned to your vision. A very public example in recent times of this has been Groupon.

Now consider taking debt for the same example above; you borrow $500K from a bank at 10% annual interest rate for 5 years and put down assets (mainly personal) as collateral. In this scenario not only have you signed up for a significant liability (fixed monthly payment) but have increased your personal risk and in event of default could end up losing not only your personal assets but also your business. However, the bright side if you make payments on time is that you don’t give up equity and/or control and upon exit walk away with lot more.

At this point most of you will look at these two options and say that they don’t align to your best interests. That would be a correct take-away, which gets me to the point of discussing the variation of these models that I mentioned earlier. The two that are quite interesting are convertible debt (a debt equity hybrid model) and revenue-based financing (share of revenues between investor and company).

Convertible debt has been around for a while and seems to be gaining popularity with early investors (angels). Using the example above; say you borrow $500K in debt at 10% interest with a promise to convert to equity at defined time frame (~3 years) and at a discounted valuation (~20%). In 3 years assuming you valuation is $4MM (2X) the investor will own 21%. Assuming an exit at $16MM the investor will get $3.3MM (~27% annual cost of capital). Here the model works great if you can covert the debt at a higher valuation (high-growth company) otherwise you risk giving away a large chunk of your equity at conversion and at exit having the same challenges you face with pure equity financing.

Finally, revenue-based financing, this is where instead of paying fixed monthly interests payments, as in the case of a bank-loan, you share a small percentage (~2%-10%) of monthly revenues with the investors (i.e., so in months the business does not make money the investor does not get paid) you also do not put down any form of personal assets as collateral. Payments in this model continue until a pre-defined total target cap is reached. Using the example above; say you take a 500K revenue loan to be paid in five years or until a 2.5X return for the investor is met, your cost of capital will be ~24%.  This is lower than equity financing, extremely aligned to your business growth, (i.e., monthly payments are not fixed but a function of your monthly revenue flow) and takes away any personal risk. However this model does have limitations. If you are a business that does not expect to grow by more than 3X in 5 years you should consider alternative models. ❒

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