There are more options than ever for businesses seeking a cash infusion. Companies can go straight to the masses with crowdfunding. They can find a government incubator or nonprofit to provide cash on cheap terms. There are banks, of course, for loans. And there’s angel investors looking for the Next Big Thing. Finding money often isn’t as crucial as deciding how to go about it.
Whether an organization is looking for money to reinvest in the business or it needs working capital to feed growth, there are a diverse set of options available — but there are also key questions to answer: How much control do you want to retain in your company? What is the company’s cash flow? What short-term challenges does your company need to address?
Of course, all fundraising opportunities have their individual risks and rewards, which is why it’s important to understand how each of these options operate before commiting to a strategy. Let’s explore what’s trending in fundraising.
Show me the money
In the bootstrapping days, before an employee is hired, there aren’t many institutional ways to fund a startup. Founders turn to family and friends, cash out their savings, or run up a credit card tab to get a business started. This is by far the reality of most businesses; according to Forbes, less than 1% of companies get investment capital. For the fortunate few, when a company is ready to build out, there are options not limited by your American Express credit limit. There are three common paths to fundraising for business ventures: an organization can sell shares of their company, an organization can take out a loan, or a blend of both points.
For those less familiar with the fundraising landscape, selling shares of a company to raise money and further invest in the business is more commonly known as venture capital funding. According to a 2011 study by William Kerr and Josh Lerner of Harvard, and Antoinette Schoar of MIT, angel investors provide a significant bump in success for companies. In the study, they found that companies receiving funding were 20 to 25% more likely to survive after four years and 16 to 19% more likely to have at least 75 employees.
How much can a company expect to get? It depends how far along the business is, but capital investments generally fall into two camps: pre-seed and seed round funding.
Dubbed the “friends and family” round by many entrepreneurs, the pre-seed funding round includes the first amount of money you scrape together from any source — often this comes in the form of a loan that converts into equity, or a convertible note, as the company grows. A 2017 study by The American Angel found the average check at this stage was around $36,000 and the median check was for $25,000.
You’ll know it’s time to seek pre-seed funding when:
- You’ve identified a clear market opportunity
- You’ve got something to show, even if it’s not quite a minimally viable product (MVP)
- You’re getting ready to hire
- You’re expenses are piling up
Worth noting: The study also found that about 11% of investments actually made money for investors. And it’s possible you’ll get more than just money out of the relationship. 55% of angels were entrepreneurs themselves, with a variety of experiences that can lend wisdom to a startup.
Once you’ve got a MVP that’s worth courting angel investors and a productive team to showcase, you’re likely ready for seed round funding. An investment from a venture capital firm can provide financial support for a company from the very early stages, all the way to IPO. If companies choose to find venture capital, they face less downside risk should their business not be profitable as they have no debts to repay. But the thrill of rapid growth could be tempered by the need to distribute profits to new investors.
Of course, there are other ways for companies to get cash.
Debt financing, obviously, involves taking out a loan. The downside is the startup must repay the loan, regardless of whether the company is profitable. A key upside for debt financing is that business owners retain control of their company without diluting themselves (as compared to venture capital funding), thus reaping all the capital gains. Such a strategy can help a company more rapidly reach the metrics required for better terms, once it comes time to raise more equity to further the growth of an organization. Of course, the downside is that the company is still tied to making principal and interest payments on time, even if the company is not immediately profitable.
Normally, this is a fairly staid part of the business world. But in 2021, as the coronavirus pandemic still prevailed, money has been cheap. Interest rates are low and show little signs of making major jumps in the near future. As a result, corporate borrowing skyrocketed, resulting in more than $11 trillion in corporate debt. Why not? Interest rates this spring dropped to about 4.4%, the lowest since 2004. While some companies are borrowing money to pay down higher-interest debts, there’s still a wide array of funding available for companies looking to grow and expand business.
The risk and reward of venture capital
In most cases, venture capital funding is dedicated to building the infrastructure needed to grow a business. This funding is used to provide fixed assets and working capital, as well as expense investments related to marketing, sales, and manufacturing.
Venture capital investors are looking to invest in high-risk, high-reward companies. Essentially, a good venture capital partner is buying a stake in an organization’s idea. This capital is invested on a five-to-seven-year horizon to nurture an entrepreneur’s initiative until the company appreciates in size, so that it can be sold to a corporation or IPO. Venture capital firms also tend to be larger in scale than non-venture businesses, though this tends to be a loose guideline and not a hard and fast rule.
Naturally, venture capital investments carry their own risk, but a large gain in one endeavor can erase 10 busted investments for the firm. Here are some of the common questions and risks familiar to VC investors:
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Venture capital risks
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- Technology risk: Will the product/service work?
- Management risk: Can the team scale and run the business?
- Market risk: Is the market big and addressable?
- Financing risk: Will the company be able to obtain capital to address the market?
The search for a VC investor begins with targeting firms that identify as viable fits for an endeavor. A fundraising timeline of approximately six months can take an organization from the initial introductions, through pitch meetings, all the way to having the investment wired.
As a company grows, various funding rounds will follow:
- Pre-seed funding comes from the founders of the company themselves, or friends and family, who are willing to foot the bill to start a company.
- Institutional seed rounds of $1-3m are common. We are seeing bigger and bigger seeds and seed extension (e.g. pre-product market fit)
- Series A is a big cutoff between companies that make it and don’t. We’re seeing larger amounts raised at larger valuations here, too.
- Series B is a tougher, in-betweener round that functions as a mix of traditional early-stage venture and growth focused funds.
- Series C is for businesses that have established repeatable GTM and are in scaling mode.
It goes without saying that VC investment is a risky venture. Firms are often on the lookout for organizations that can project a potential of returning 10 times their investment. If a company is unable to forecast a sizable return, another funding avenue may be a more realistic approach.
Non-venture capital funding
Non-venture scale businesses are typically on a path to a valuation under $10 million. This is where small companies or lifestyle businesses turn to KickStarter or similar crowdfunding sources in search of a cash infusion.
Many non-venture capital investors tend to prefer investments in low-risk companies — low technology risk, low management risk, and low market risk.
But certain types of investors and some VC funds do focus on non-venture scale businesses (such as the fund that invested in Pavilion).
Finding the right debt funding
Whether it’s home-equity loans, car loans, or mortgages, we’ve likely all used someone else’s equity to buy something at one point or another. Traditionally a business would go straight to a commercial bank to get a loan, but with the debt world currently seeing unprecedented levels of borrowing, that mode of business has given way to various alternative debt financing options.
Who uses debt funding? Almost everybody and almost every company, at some point. Managing corporate debt is similar to personal debt: doing it helps build the business’ credit rating, unless the company borrows money and doesn’t pay it back on time. A strong credit rating can help companies find investors in the future. And establishing credit lines can go a long way to getting more credit in the future, to say nothing of what a company does with the money to grow a business.
Though a bank loan is still a viable option, it is only one of several debt financing paths available to business owners:
Bank debt: It’s a borrower’s world right now as the U.S. government is charging historically low interest rates to banks. The banks, in turn, are offering low rates and good deals to borrowers with good credit scores in order to attract competitive business. Loans can run L+50 bps with no covenants.
Venture debt: Amid the uncertainty of COVID-19, venture debt has become a more viable option for business leaders looking to access capital. Venture debt requires less equity dilution and can be used to support businesses at an early stage facing short-term challenges. SVB is making a ton of money off these given their ‘portfolio’ of warrants from venture deals.
Mezzanine: Loans featuring mid-teen interest rates and warrants to get 30%+ IRR. This is a very competitive environment, but a great place to get a deal done. The rates can feel expensive, but in the long run are often still cheaper than preferred equity.
Alternative: In our current market, alternative financing is all the rage. Think: Pipe, Capchase, Shopify, Stripe, Brex etc. There are a bunch of folks popping up to provide cash now for SaaS contracts. There are also a number of companies out there providing cheap working capital to e-commerce companies. SaaS and e-commerce companies (two prominent business models in tech) will find a lot of success with these options.
Which funding choice is right?
Finding the right avenue for a company’s cash infusion doesn’t have to be hard. And thanks to current borrowing rates and advances in alternative fundraising, there have never been more options available to aggressive and innovative entrepreneurs. There is no simple answer. At some point, almost every company needs a cash infusion in order to grow and be even more profitable in the future. The answer often lies in relationships. If companies find an angel investor with experience and wisdom to offer, they often will choose that route. If a company finds a silent partner who just wants to reap expected profits, that will often be attractive. And if a company has a solid balance sheet and expects to make money on a regular basis, the founders might choose to retain full control and simply take out a loan. Whatever the choice, the funding markets are open for business.
If you want to connect with a community of finance leaders and dive into even more discussions on fundraising, join our Finance community in Pavilion.
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