FedEx Corporation, one of the most successful American multinational delivery services today, was in dire straits back in the day in the 1970s, when they were just starting off and were perhaps just a small business. Their revenue was barely able to cover their costs. The owner, Frederick W. Smith, bet the last $5000 he had on a game of blackjack, won the gamble and made $27,000 of the initial money that he bid on the gamble. With this money, he could pay wages and bills, which had earlier posed a threat of bringing the company to a halt. That’s one success story of how from this point, FedEx grew and expanded.
While this was also an unusual story, many startup founders and newly emerging companies can relate to this situation of a money crunch. They face a dire need for funds to run their businesses, grow, expand and, ultimately, emerge as big shots, with their names on the biggest magazine covers, business websites and billboards across the world.
The need for funding is universal among all businesses and startups and while there are several ways to acquire funding like bootstrapping, personal investments, crowdfunding, accelerators or incubators, we’re focusing on investor funding in this article. Therefore, investor-based fundraising is just one option among many others.
Securing business funding is a major first step for companies just starting out. Investor funding can be broadly classified into three types: (1.) Debt/Loans (2.) Equity (3.) Convertible Debt.
Equity financing and debt financing are the two major types of funding that are available to startups and emerging companies. Convertible debt is a solid mix of both of these aforementioned funding types.
In this article, we’ll be exploring the three types of investor funding that an entrepreneur could choose from, a basic understanding of each method and the factors to keep in mind, while choosing one of the given methods to acquire funding from investors. In order to secure the best type of funding, it is required to be aware of and distinguish between the major types of funding (here, investor funding). Let’s dive into the three methods of investor funding and understand the pros and cons of each method.
Along with being the most traditional way of obtaining financing, debt is also the easiest and the most common method of acquiring funds. It is borrowing money that you’ll return later, with an interest that is pre-established. Numerous companies have and continue to benefit from debt providers to execute their business ideas and to expand/grow. Therefore, debt funding is basically a loan taken from a lender and paying them back with interest, in monthly installments. An important aspect of debt financing and loans is collateral, which is anything sellable that your lender can take from you in case your business doesn’t go as planned and you’re unable to repay the loans you took.
Things to keep in mind while opting for this method of fundraising:
- Debt funding is a good option when you need a small amount of money (say, up to $50,000) and aren’t looking for huge sums of money. For relatively small amounts, debt is a better option than giving up equity. Another related perk is that it lowers the risk of both, the entrepreneur and the investor.
- Debt is also a feasible option when you’re in need of capital urgently or when you come across a time-sensitive market opportunity for your business for which you need to raise funds quickly.
- One of the most important perks of debt raises is that the borrower or the entrepreneur won’t have to give up control over their company and can, thus, retain ownership of their company while getting the funds they need from lenders, with a promise of repaying the entire amount with interest within a stipulated amount of time. Therefore, if you’re not willing to offer equity, a debt-raise is a suitable option for you to help you retain control over your company.
- The downside of debt raises is that once you’ve taken a loan and cannot repay it because your business doesn’t work out the way you planned for it to, the assets of your business pledged as security will be seized by the lender.
- Getting a loan isn’t always easy, the investor needs to have faith in your financial capability to repay the loan, which will be formed, depending on your financials and credit score.
- Another obvious disadvantage of getting a loan is that you’ll be paying more than you initially get, which could pose a problem if you’re going through a financial crunch and have to continue making monthly payments for the loans you take.
Equity funding is when you get funding for your business in return for equity of your company. Subscribing to an equity fundraise means that investors will receive a stake in your company (ownership stake and/or control in your company) in exchange for the money they invest in your company. It is one of the most sought-after forms of capital for entrepreneurs and is a very attractive option for companies, as you’re associated with high powered investor partners, who bring to the table a wide array of experience and knowledge of the market. Equity funding for companies often involves angel investors and venture capitalists (VCs).
Factors to keep in mind while opting for this option:
- Equity investments are favourable in the case of companies that will need money in the long run, the ones that need a considerable amount and an infusion of operating cash to sustain their business before it starts making profits.
- Another case, when equity funding is a seemingly lucrative option, is when you have zero or no collateral to offer as security to obtain loans. In such a case, finding an equity investor who believes in your business idea, sees potential in it and is, thus, willing to invest in your business is the best possible option. This is because you have nothing to lose as you have nothing to “sell” if your business goes south. This is a high risk and, thus, a high reward option for investors.
- Not all businesses can sustain or even start off with methods such as using your own savings or bootstrapping. Some startups need massive amounts of money/capital to get off the ground (example, a private airline company). In such cases, going for equity financing is the most favourable option.
- The major perk of this type of funding is that, while investing, the investors have a holistic, realistic and long-term approach to the investment and are usually understanding of the fact that a business needs time to grow, therefore, there is no pressure for immediate or fast-paced results.
- Along with the funding, it is also a suitable option for those seeking some advice and expertise in that respective field or industry. Most equity investors come with a lot of experience and knowledge about the functioning and mechanisms of the market.
- First and foremost, by obtaining equity funding, you are letting go of a part of your company’s ownership by giving a percentage of your company to the investor. This also means that you may need to treat them as partners when you take major decisions regarding the company, which would affect the business.
- The demand for equity investments is much larger than the ones being offered, that is, there are more people seeking equity investments than there are investors who are willing to invest. This makes it harder for those who need funding to get equity fundraising for their respective companies. Only the best of the lot, the most ambitious companies with the most promising ideas are able to win over equity investors.
- It’s a one-way street and an almost irreversible decision once you’ve opted for this method of fundraising. This is because once you give an investor a share in your company, you’re not likely to get it back. It’s a rare phenomenon to buy back the equity you’ve given away in the initial phase. Once you’ve sold a certain percentage to an investor, they become a part of your business in the long term. It’s not a temporary business deal you struck. Therefore, it is indeed imperative to look for investors who you think will be perfect for your business to flourish in the years to come.
Convertible debt is essentially a mix of both types of financing, debt and equity financing. Money is borrowed from investors with the understanding that it’ll either be repaid or turned into a share in the company at a later point in time, once the business reaches a certain valuation.
The details of how the debt will be converted into equity are pre-established. This involves incentives for investors such as warrants and discounts, in the next round of fundraising. The “valuation cap” for convertible debt fundraises is the point of maximum company valuation at which investors can convert their debt to equity, after which the investors lose their chance to do so and will have their debt repaid to them without a share in the company.
Factors to keep in mind while opting for this method of fundraising:
- This is a suitable option for those companies or startups that don’t have a specified valuation to their company yet, maybe because they think it’s too soon to determine one or because they think it can be much higher at a later stage. Convertible debt is a safe option thus, as it gets you the funds you need as well as allows you to secure the value of your equity later.
- It is a very suitable option for investors as they can observe the performance of your business before jumping onto the equity train. They have an exit strategy by opting for the debt structure and the security that is pledged with it. They also have the incentives of warrants and discounts on your equity if they choose to convert. Thus, it offers them the best of both worlds and is an attractive option for investors.
- Many investors do not look at it as a favorable option as they like to know the percentage of shares they’ll be holding from the very beginning before they invest in your company. They don’t prefer to take equity-sized risks only to get debt-sized returns and the only way to make this attractive to investors is by offering them higher discounts.
- It’s not always an entrepreneur’s best friend although it may look like it, because it is acquired fast and keeps transaction costs low, but it’s important to be doubly sure before opting for this fundraising method.
This was an overview of the three types of investor-based fundraising mechanisms. There is no universally perfect method to raise funds, it’s always subjective. What suits your company better can be very different from what suits someone else’s company. It’s better to be well aware of your options and everything it entails before going right into it and accepting an offer because of the need for capital at the moment.
A very well articulated and concise insight presented into startup fundings. A useful seven minute opener for the young and old entrepreneurs alike. Thank you