There are many Types of Funding for Business. If you want to Raise Capital, read this article from a respected writer Elizabeth Yin on the types of funding for businesses. You can Follow Elizabeth here.
One of the things that I’m noticing is that the early stage financing scene is changing quite rapidly. It may not feel like it — it’s still hard to raise money of any form, but there are a lot more options now than say even 5 years ago.
Traditionally, you have a lot of tech startups
flocking to venture capital firms to raise money, because VCs have done a great
job, as an industry, in marketing themselves. But the vast majority of startups
who seek VC funding are not the right profile for that type of funding. As an
entrepreneur, this is something I didn’t understand — what types of funders are
out there and who is a good fit for what?
For example, angels and VCs are often lumped
together in the same category. Afterall, they both invest in early stage startups
on an equity-basis (this includes investing in convertible notes and
convertible securities as well) But they could not be more different.
(See my post on closing angel investors)
In this post, I want to talk about different
categories of funding beyond equity-based financing. These are categories I’d
not even thought about as a founder. Here are the rough categories of financing
options for early stage founders:
1) Equity financing (priced / notes / convertible
2) Revenue based financing
3) Debt financing
…and some permutation of the above!
1) Equity financing
This is the one that everyone knows about or at
least has heard about. In its simplest form, with equity financing, you as the
founder sell shares in your company for cash.
Variations on this include using convertible notes
and convertible securities (SAFEs / KISS doc). (see here for details on the differences)
What most people don’t realize is that this is the
most expensive form of financing if you are successful. Why? Because your
payback amount is delayed significantly and the amount you end up paying back
is a LOT if you are successful.
Let’s say you sell 5% of your company for $100k.
You think “whee! I have $100k to work with.” In 10 years, if you do incredibly
well, and now your company is worth $100m and you sell your startup for an
all-cash deal, you pay your investor $5m (assuming no dilution in this
example). That is a 50x return for your investor.
Now let’s suppose you had a crystal ball and you
knew this outcome would definitely happen. Knowing that, would you
take this deal? Of course not. $5m is a ridiculous amount to give up for a
$100k investment. If you knew for certain that this outcome would happen, you
would likely try to fund your business with other money so that you could
retain the extra $5m for yourself. Right?
Now of course, the reason entrepreneurs take this
deal is that you don’t know ahead of time if you will be successful in 10
years! And most founders don’t get to this outcome. A common phenomenon that I
see successful founders face is that they are at first incredibly excited to
raise their first couple of rounds of equity but then later, they become a bit
frustrated that they have taken too much dilution.
Guess what — equity investors need to take a lot of
your company in order to justify the risk they take so early on in your
business. The heavy amount of equity you sell in your business needs to offset
all the losers in a given investor’s portfolio (plus more).
People don’t realize that equity financing is one
of the most expensive forms of financing — because you don’t feel it
until years later.
The flip side is if you raise equity financing and
your company does go belly up, you don’t owe anyone anything. The investor is
taking all the risk here as well.
2) Revenue based financing
Revenue based financing is a bit akin of
income-shared agreements (ISAs) for individuals. With revenue based financing
models, an investor invests money not for shares in your company but for a
repayment percentage until you hit a certain cap.
In this model, say we invest $100k and the deal is
to pay 10% of your revenue every week until you hit 1.2x or $120k in total
repayments. Let’s say that next week, you generate $10k in revenue, so in this
model, you pay back $1000 that week. And the week after that, let’s say it’s a
great week, and you generate $20k in revenue, so you pay back $2000 that week.
Now let’s say that the following week, you have a bad week, and you make $0.
You pay back $0. In this model, the investor is with you through the highs and
the lows — always taking 10% no matter what. If it takes you 6 months to hit
$120k in repayments, that’s a great fast return for the investor, and if it
takes you 3 years to repay back $120k, that’s probably a lot slower than the
investor would have liked with a much lower IRR. He/she is with you through the
ups and the downs — that is the risk that he/she takes.
Investors in this model make money by essentially
picking companies that are generating fairly consistent revenue that have low
default risk, and they are trying to target quick payback periods so that their
IRR is high.
Now, let’s compare this form of investing vs equity
investing. Suppose again we are pretty certain we can sell our company for
$100m in 10 years, I would rather take $100k in revenue-based financing.
Afterall, I would only have to pay back $120k instead of $5m.
But, let’s say we are at the very very beginning of
our startup, and we don’t have many customers and not a lot of revenue. Equity
financing allows us to keep all of the cash we make to pour back into the
business. We don’t have to pay anyone out each week, and that extra cash can
help us get to the $100m outcome faster on an equity investing model. Moreover,
we probably wouldn’t qualify for revenue-based financing at that stage.
3) Debt financing
The last form of common early stage financing is
debt financing. Unlike revenue-based financing, this is time based. This is
also the cheapest form of capital but also the riskiest to the entrepreneur. In
debt financing, if an investor puts $100k into your company, he/she is looking
to be repaid back with interest by a certain date. So, say we do a debt
investment of $100k into a company, we might ask for $120k back after 1 year
(the principle plus 20% annual interest).
In addition, often, you have to personally
guarantee a loan if your company cannot pay it back. Sometimes, debt
financing come with warrants as well — if an entrepreneur cannot pay back the
debt within a certain time period, the entrepreneur must give up other things
including equity in the business.
So even though this is the cheapest form of
financing, it’s also the highest risk for the entrepreneur.
Tying this all together…
Let’s analyze all of these forms of financing.
First off, usually debt is the cheapest form of capital and equity is the most
expensive. Now you might think, “Wait, a minute! 20% annual interest in this
last example feels really expensive!” But when you compare the interest to the
revenue based financing model and the equity model, it’s not.
To compare all 3 of these financing options, we
need to look at the returns on the same time scale.
- An equity investment of $100k that turns into
$5m 10 years later has an average annual IRR of 48% per year.
- A revenue-based financing investment of $100k
that turns into $120k in 6 months has an average annual IRR of 44%
- And of course, a debt investment of $100k with
20% interest after 1 year has an average annual IRR of 20% per
Of course, if the time scale for the revenue based
financing model changes, that will impact the IRR. And if the company that
raised money on an equity basis exits earlier or later, that will also change
the IRR for the equity-based investment.
Now of course, we are just looking strictly at what
capital each scenario can provide. However, it’s possible that with a value-add
investor, he/she can change the trajectory of your company. In the equity
example, what if it were your $100k investor who introduced you to your
would-be acquirer? Then the $5m repayment seems totally worth it. Or what if
he/she introduced you to your key hire that led to the acquisition? Totally
Wrapping this up…
Even though it’s a much cheaper form of financing,
founders are typically averse to debt. It’s a natural reaction, because in our
personal lives, we go around saying, “Oooooh, debt is bad.” In our personal
lives, debt is often bad, because your own cashflows are generally not growing
faster than your interest rate. You typically are not getting 20%+ year over
year raises each year.
In a startup, if your revenues are growing 20% MoM
and your interest rate is only 20% year over year, you are growing your
business significantly faster than your debt. And so not only will you have the
cash flows to cover this 1.2x multiple of investment, but cash that you can put
to use today will make your company worth (1.2^12) 9x more valuable a year from
now, while you are only required to pay back 1.2x of the cash you took in.
In the early days when you have no revenue (and
maybe you cannot get other forms of financing), equity financing is the least
risky for you as the entrepreneur, because not only are you NOT on the hook for
losses, but you can pour all revenue back into your business. But once you
start to get some certainty around your revenues and some predictability around
your cash flows, it may make sense to look at a blend of different forms of
For example, let’s say we’ve started a business,
and we are doing $12k per month in revenue and growing on average 20% MoM. What
if we did $90k in equity financing and 10% in revenue based financing? If our
revenue and cash flows are growing at more than 20% year over year, then this
could makes total sense.
On the surface, it may seem insignificant to only
raise $10k in revenue based financing, but when you think about what that
could potentially become in 10 years, using the example above, it would
be $500k in liquidity in 10 years on a $100m company exit, which is pretty
I think that once you have some level of understanding
of your cash flows, it makes sense to look at your composition of financing and
try to figure out what proportions of various forms of financing make sense
based on your risk tolerance and predictability of your cash flows. I don’t
think we do this enough as business owners.
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