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 securities)
2) Revenue based financing
3) Debt financing
…and some permutation of the above!
Image credit: Giphy
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% per year.
- And of course, a debt investment of $100k with 20% interest after 1 year has an average annual IRR of 20% per year.
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 worth it.
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 financing.
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 significant.
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.
4 thoughts on “How to think about different types of funding for your early stage startup”
Great summary! 🙂
dear @dunkhippo33 – could you please dive in into your choice of funding early startups as a VC? Why have you chosen to start a VC model in particular as compared to any other possible alternative?
I’m interested in the internal motivation 🙂
Great article. I always thought debt equity was a bad thing.
these options aren’t bad or good; as any solution or tool it might be helpful or harmful depending on context and goals.