Is it just me, or has people’s penchant for worshipping startups led to some strange business practices? For example, think of the great lengths we go to congratulate companies on raising outside capital, when in fact the real work doesn’t actually begin until after that “necessary evil” is done. This shocks me. Perhaps it’s my Wall Street background or just a healthy dose of cynicism, but I don’t see why everyone gets excited about raising capital. Sure, it provides outside validation of an idea or some work that’s been done, but is a pat on the back really necessary, especially if it comes with such an incredibly high price tag?
My background is in financial services and, as you might expect, I view the startup ecosystem through that lens. With that in mind, I look at how larger companies fund their operations and what that could suggest for smaller businesses.
For many, the first choice is to tap into the company’s cash flow. Why? Because it’s exceedingly cheap, doesn’t dilute ownership, and the only real cost is the lost opportunity to use that cash somewhere else. If your business is growing fast and you’re confident it will succeed, why wouldn’t you want to invest your cash flow back into it? Plus, if everything goes well, you get to keep all of the upside for yourself. It’s high reward, but also high risk.
Next comes debt in all of its many forms. With debt, a company is able to get the additional capital it needs to grow, but it has to pay it all back with interest. This approach is definitely more expensive than utilizing internal cash flow because of the ongoing cost of interest payments. However, that cost never changes regardless of how the business performs. So, even if things go well, and the investment generates huge value for the company, the lender sees no change in his return — just steady interest payments. On the other hand, should things go poorly, at least you haven’t put any more of your own money at risk. That’s why debt can be a good option for getting a pretty high reward with lower risk.
The last option is typically equity, which allows companies to get the additional capital they need without incurring any ongoing income statement costs. However, equity is actually much more expensive than other financing alternatives when you factor in the ownership that you’ll have to give up to the new investors. Unlike startups, when larger businesses look for equity, it’s probably as a last resort when other options are no longer available. That’s because no matter what happens in the future of the business, you will own less of it. While you may have lowered your overall risk, it comes with a much lower reward.
As a venture investor, I think about this range of alternatives whenever I meet a small company. While the analog isn’t perfect, I’m not sure rushing directly to raising equity makes sense for every startup because of the dilution in ownership they suffer. If a company is so willing to give up its reward when other options are available, I become a bit confused.
So what are some of the smaller company options that avoid further dilution? Start by looking for alternative sources of financing for as long as possible. That way when you do have to raise, it can be at a much higher valuation driven by fundamental performance. Those alternative sources might be your personal savings or a home equity loan. They can definitely be hard to swallow but on the upside they create a real incentive to examine every dollar being spent. Do you really want to hire that sales rep if you’re not sure he has enough opportunities to chase? Should you truly be worried about marketing if you don’t know if you have the right product / market fit yet? After all, necessity is the father of invention, and risking personal capital creates a lot of necessity.
After maxing out those methods, which many entrepreneurs do, there are a slew of other debt and equity-like alternatives to consider. They come in a variety of flavors, but below are three that are fairly similar to how larger companies fund their operations, allowing you to grow your business while hoarding more of the upside for yourself.
— Venture debt is a form of debt available to early stage companies after they’ve already had at least one institutional equity round. While technically a secured term loan, the terms of the security are usually flexible and look very similar to an interest-only home loan but with additional upside to the lender. That upside comes through rights to buy common shares or warrants at a predetermined price, which can be worth a lot if the company continues to grow. Venture debt can be an interesting option to extend the time until the next round of financing, i.e., letting your business get past a new milestone which may make the overall business much more valuable and be a more appropriate time to raise a larger round that only venture capital can provide.
A somewhat overlooked form of financing is revenue sharing, i.e., using your future revenue streams. If you have a partner or vendor who needs you to pay for their services, one way of structuring the arrangement could be to offer up a revenue share for the future. This arrangement also has the added benefit of incentivizing the other party to make you successful. The downside, of course, is that it can be a very expensive option if the company becomes successful. Considering a cap or phase out can work to mitigate that risk.
Asset Backed Facilities (Working Capital Lines) are another, more traditional source of financing that entails using the hard assets or accounts receivable already on your balance sheet to accelerate cash collection. To the extent you have hard assets, equipment leases either through your vendor or a bank can help free up cash. However, the interest rate isn’t always the most attractive at an early stage. If you happen to have large accounts receivable or contracted revenue balances instead, those too may be lendable. With these you might be able to take a large portion of the total value as cash today in exchange for giving up the full value over time.
Don’t get me wrong, raising equity capital definitely has a place and is incredibly important in the life cycle of your company. After all, if I didn’t believe in it, I’d be out of a job. However, I’m a bit worried that companies rely on it too early and for the wrong reasons. From my point of view, I’d like to see a company try to make it work in every other possible way before seeking venture capital. That conveys the appropriate signal to me that management is hungry, efficient, and dedicated to making the business a success.
Jonathan Kimmel is an associate at OpenView Venture Partners, a Boston-based venture capital firm focused on investing in expansion-stage SaaS companies.