Written by Kayle Paustian
Startup founders wear many hats, with one of the most important ones being raising startup capital. A common assumption is that after you’ve tapped out on personal savings, friends and family, and angel funding, venture capital is your only option for getting financing. However, the truth is that only 0.05% of startups raise venture capital, with the remaining choosing from other options that are better aligned to the company and its long-term plans.
In this article, we walk you through the pros and cons of the following financing options:
- Venture debt
- Traditional debt
- Revenue-based lending (RBL)
Let’s dive in.
With equity financing, you are exchanging ownership of a piece of your company for capital.
This exchange can be in several forms:
1. Preferred Shares (aka Preferred Stock)
With preferred shares, the shareholder has a fixed dividend, and receives preferential payment over common-stock shares. Preferred shareholders do not have voting rights.
2. Common Shares (aka Common Stock)
Common shares represent a claim on company profits in the form of dividends. Common shareholders do have voting rights.
3. Simple Agreement for Future Equity (SAFE Agreement)
A SAFE agreement is an agreement between a company and an investor that gives the investor rights to future equity. It does not determine a price per share at the time of the initial investment.
Warrants give the holder the right (but not the obligation) to purchase company stock at a specified price (also known as the strike price or exercise price) within a specific period of time.
The pros of equity financing are:
- No Interest Payments – With equity financing, no interest or principal payments are required on a monthly basis. This frees up cash to be invested back into the growth of the business.
- Experience and Contacts – Your investors want your business to succeed and can bring valuable experience, managerial or technical skills along with their contacts and networks that you can tap into. Your initial investors can also help you raise funds in your next round of financing.
- Follow-on Funding – If you are able to prove yourself and your business is successful your initial investors will likely want to continue to invest in you as you raise additional funds.
The cons of equity financing are:
- Control – When you choose the equity funding route you relinquish some control of your company. Your investors will want to have a say in how you run your company. They will want regular updates and input on key decisions you are making. If Investors gain enough control and lose confidence in your ability to execute you could be forced out.
- Time – As a founder going through the process of raising equity financing can be a significant drain on your very limited time. It can take months of emails, phone calls and meetings before a deal is done and this is all on top of continuing to run your company. It is a drain on resources.
- Expensive – Raising equity is an expensive endeavor for a startup. And I am not just talking about lawyer fees or time. When you give up equity you reduce the value of your shares if you are successful in your exit strategy. Although equity does not have an upfront cost you will end up giving up a significant amount of your possible future return.
Want to learn more about equity financing? We’ve got you covered.
Venture debt, also known as venture lending, is funding provided by technology banks and dedicated venture debt funds. Venture dept typically has a three to four-year term loan or equipment lease.
Venture debt lenders will often also take stock warrants in either common or preferred stock to help reduce the risk and charge a lower interest rate. Venture debt financing isn’t right for every company, but it can be a smart strategy in some instances.
The pros of venture debt financing are:
- Easy Add On – Venture debt is easier to secure after going through an equity financing round and can significantly extend your runway without sacrificing immediate control.
- Inexpensive (Cash-wise) – Debt is cheaper than equity over the life of a startup especially venture debt. Venture debt is able to leverage the equity in order to take on debt at preferential rates in comparison to traditional lenders.
- Control – Unlike equity financing, venture debt lenders do not take board seats and in comparison to equity financing, there is less dilution of ownership shares.
The cons of venture debt financing are:
- Covenants – When accepting debt financing you are required to agree to certain debt covenants in your loan agreement. If you are unable to meet certain conditions as laid out in your loan document you may default on your loan. When you default the lender has the ability to demand the full payment of the loan (including interest) immediately. This can result in a significant cash squeeze for a startup or even lead to it failing.
- Warrants – Although the cash cost of venture backed debt is lower than traditional debt the long term costs to founders is higher due to having to provide warrants as collateral to reduce the interest rate.
Traditional debt is financed by banks and other traditional lenders in the form of bonds, bills, notes. The amount of the investment loan – also known as the principal – must be paid back on a set future date and incurs interest.
The pros of traditional debt financing are:
- Control – With traditional debt financing you are not giving up any controlling interest in your business. You continue to retain control and can guide your business largely as you see fit.
- Clean Slate – Once you have paid down your debt the liability ceases to be an issue on your balance sheet. You will not have to pay any additional interest or penalties once the debt has been paid down.
- Tax – The last significant benefit of debt (both VC and traditional) is that the interest is typically tax-deductible. For early stage and quickly growing companies without taxable income, this is less of a benefit.
The cons of traditional debt financing are:
- Repayment – Repayment of the loan is required regardless of how your company is performing. If you are burning through significant amounts of cash the loan repayments can end up breaking your company.
- Negative Valuation – Debt can reduce profitability and the multiple that your company is looking for on its next raise. In addition to a lower multiple, the terms of the equity agreement may be worse or the debt may prevent you from raising in the future.
- Covenants – When accepting debt financing, you are required to agree to certain debt covenants in your loan agreement. If you are unable to meet certain conditions as laid out in your loan document you may default on your loan. When you default the lender has the ability to demand the full payment of the loan (including interest) immediately. This can result in a significant cash squeeze for a startup or even lead to it failing.
Want a deeper dive on debt financing? Head on over here.
In general, grants represent money that you do not have to pay back. Grant recipients apply for the funds and are selected based on specific criteria for the grant. Typically, these grants are funded by the federal government, your state government, or a private or nonprofit organization. They are most commonly tied to the growth and support of the economy.
The pros of grants are:
- Control – With grant funding you are typically not giving up any equity in your company so you retain full control over the direction of your startup.
- Repayment – For most grants, you do not need to pay back the money you receive. This is great as it enables your startup to have a longer runway allowing you to bootstrap your company for a longer period of time potentially increasing the valuation you receive when you exit.
The cons of grants are:
- Strings – Even if you do not have to repay the money received, there may be other strings that come with government funding. Some grants and incentives limit what the funds can be used for which can make it difficult to grow your business.
- Narrow Focus – Grants often have a narrow focus. For example, grants may target women, veterans, people of color, specific regions or states. As well, they may be only offered at a certain time of year and may have fluctuating criteria and funding amounts.
- Time – Finding the right grant opportunities for your startup and applying for them can be a time consuming process. It can take as long if not longer to be successful in receipt of grant funds than going the VC route with significantly more upfront paperwork and interviews required.
Revenue-Based Lending (RBL)
Revenue-based lending is a relatively recent funding model targeted specifically towards startups and SaaS business models. The idea is for a company to share a percentage of future revenues – usually from 2% to 8% – in exchange for capital which can be up to one third of your annualized revenue run rate.
The pros of revenue-based loans are:
- Control – When you choose a revenue-based loan, you are not giving up any equity in your startup, nor are you likely to be bound by debt covenants.
- Time – As revenue-based lending does not require companies to achieve hyper-growth or large equity exits, lenders can provide funding in as little as four weeks. As well, you typically have a longer time to pay back your loan
The cons of revenue-based loans are:
- Requires Revenue – because this form of financing is revenue-based, pre-revenue startups are generally not a good fit.
- Smaller Amounts – As investors will not provide capital greater than 3 to 4 months of your company’s monthly recurring revenue (MMR). (However, as the company grows, this number grows, too.)
- Monthly payments – Unlike equity financing, RBLs require a monthly repayment. If you’re tight on cash, you’ll still need to pay.
So there you have – four more options to fund your startup beyond venture capital.
Want to learn more? Read our article regarding company stage and financing options here. And if you want to talk more specifically about your startup’s needs, book a complementary call with us – we’d be happy to help.
Author Note: Kayle serves as a Financial Advisory Manager at airCFO. He has a background as a fractional CFO working with multiple startups prior to joining our team. He brings a wealth of knowledge ranging from financial modeling to M&A.