3 of the Best Ways to Finance your Business without Diluting your Equity
How and when you raise capital for your business differs for every start-up. You might seek funding to develop your product, support operations or to expand into new markets.
Traditionally, equity investment has been the primary source of funding for the start-up and scale-up ecosystem in Australia and all around the world. The use of alternative funding options is continuing to grow, particularly during more difficult market conditions and where it is not the best outcome for founders to give away equity to grow their business.
Sleek recently sat down with Ethan Singer, Co-Founder of Fundabl. Fundabl are specialist capital providers to Australian start-ups, scale-ups and high-growth businesses. They have provided over 100+ loans and supported clients such as Lyka, T-Shirt Ventures and Search io.
Fundabl is a driving force in transforming the funding ecosystem, creating a dynamic environment where founders can get certainty as to the capital that is available to them, very quickly and without compromising ownership.
Ethan shared some insights into alternate funding options, the pros and main considerations of each, and things that founders should consider when exploring the options available to them.
Outline
- Why equity deals more popular than other types of funding
- Common things founders don’t realise or fully understand when accepting an equity deal
- The pros and cons of the alternate types of funding
- The one thing that start-ups can do to increase their chances of getting funding
- Where to learn more about capital raising
Q. Why are equity deals more popular than other types of funding?
In my opinion, this is primarily due to two factors:
- Firstly, there is an educational piece around funding options outside of traditional equity for founders. The Australian alternative funding landscape is underpenetrated and is lagging compared to more mature markets such as the US and UK.
- Secondly, historically, there has been this perceptive, or misconception, that the best companies raise equity and those that can’t look for debt.
That said, we’re finding that these perceptions and the awareness of alternative options available to founders is rapidly increasing. VC’s recognise that debt providers,
like Fundabl, offer runway extensions for their companies and can demonstrate additional traction without needing additional equity to set the business up for success. In the latest Cut Through Ventures publication, it was noted that VC’s recommended alternative funding options to at least 1 in 4 of their portfolio companies.
Q. In your experience, what are some common things founders don’t realise or fully understand when accepting an equity deal?
Depending on your stage of business, there can be a lot of benefits to raising equity. For example, depending on the prestige of your investor, this can add social proof or market validation and sometimes open doors to other investors or clients.
Some of the main considerations would be:
- There is equity dilution – giving away a portion of your business which will hopefully, be very valuable. There is a transfer of wealth, so is the most expensive form of funding for any growing business.
- Timing to receive funds (and certainty) – raising equity can take quite a long time and relies on a lot of management focus.
- Fees and costs – there are legal fees and other associated costs with the documentation.
- Potential negative controls – the requirement to provide Board seats or have negative controls which can impact the decision-making process and direction of your company.
- Ongoing reporting requirements – as a shareholder and business partner, equity investors will want regular reporting on the status and direction of the business.
- Return expectations of investors – Perhaps not as often considered, is to understand the expectations of your investors. VC’s have a very high return expectation for each investment that they make. You will often hear that each investment needs to have the potential to “return the fund” – this means your investors are expecting you to go on a high-growth, fast-moving trajectory which can put you under pressure to hit very high growth targets and take risk for this. This may not be for all businesses or all founders.
Q. Can you share the pros and cons of the alternate types of funding?
Convertible notes and SAFE notes
A convertible note is a hybrid security – it combines elements of debt and equity. An investor provides funding in the form of a loan, with a predetermined interest rate and a maturity date (like a regular loan) and on maturity, the investor has the option to get paid back in cash or convert this outstanding balance into equity.
A SAFE (Simple Agreement for Future Equity) has very similar characteristics to a convertible note, though does not always carry any interest costs or maturity date. An investor agrees to make an investment into the business in exchange for the right to convert this amount into shares at a qualified event, typically a priced funding round or acquisition.
Main Benefits:
- The process is quicker and simpler than raising a priced equity round – don’t need to agree on a valuation at this point which is often the most contentious and negotiated element of any fundraising event.
- No immediate dilution – companies can raise funds without needing to determine a valuation or give away equity straight away.
Things to consider:
- Future Dilution – while there might not be any immediate dilution, there’s likely dilution in future funding rounds.
- Conversion discounts – allow investors to convert the debt into equity at a lower price than subsequent investors.
- Interest cost – Convertible notes also have an interest cost associated.
- Costs – considerable legal and administrative costs to facilitate an agreement.
SAFE’s and convertible notes are typically used for internal bridging rounds where generally, founders will gauge initial interest with existing investors before going to other external investors. It’s important to note that raising from internal stakeholders does not necessarily make it easier. This still requires lots of time and management focus and is not guaranteed.
Revenue-based finance
Revenue-based finance is a credit product that has an interest rate and is required to be paid back within a certain time. There are different ways in which this is manifested.
- Revenue-based model – where you pay back a portion of your monthly revenue or;
- Fixed payments – paying fixed monthly payments over a period of time
As the name suggests, with RBF, lenders are looking at your revenues as the primary factor on which they are prepared to lend.
Main Benefits:
- No equity dilution
- Time to receive funds – As an example, Fundabl can make capital available within a week
- In some scenarios, as repayments are tied to a percentage of revenues, it can work well for businesses during period of lower revenues as the repayment amount decreases which reduces burn and strain on the business
Things to consider:
- For fast-growing businesses, a revenue-based financing arrangement can mean that businesses repay their loans quicker than planned
- In most scenarios, you will be required to take all the capital upfront, which means you’re paying interest on the total amount from the start.
- Revenue-based finance can have a long repayment period, which could limit a founder’s financial flexibility
Key takeaway for business owners considering revenue-based finance
Revenue-based finance can be a good option for founders who want to raise capital quickly to execute and do not want to give up any equity. Fundabl’s revenue-based finance product is very flexible and efficient, in particular, we believe that founders should be able to access capital and pay for the funding when they need it. This means that they do not incur all the funding costs and interest costs associated with drawing down the money in one go. Our funding is also dynamic, and so we can increase our lending as the business grows.
Venture debt
Venture debt financing is a type of financing often accessed by start-ups further along in their journey.
The main feature differences of venture debt to revenue-based finance are potential warrants/equity-kickers and the monthly repayments. The monthly repayments are usually agreed upfront.
Venture debt is often used in lieu of equity rounds, where founders need a larger amount of capital, but where they are more sensitive to dilution given the value of their business is more proven and growing.
Main Benefits:
- Larger quantum finance – typically, makes available more capital than other forms of debt products
- Less dilution – significantly less dilution than equity
Things to Consider:
- Timing – the timing to receive capital (or certainty) is similar to equity
- Still dilutive
- Negative controls – much like equity investment, there may be a board seat or negative controls associated with the capital borrowed
- Covenants – certain covenants that you need to adhere to to keep the debt in good standing
The key takeaway for business owners considering venture debt financing
Venture debt can be a great option for founders looking to raise a larger amount of capital than typical revenue-based financing products, but where they are more sensitive to dilution given the value of their business is more proven and valuable. Obtaining venture debt requires your business to be more mature and the establishment of a track record is higher than RBF. Fundabl’s venture debt product focuses on drastically reducing the time it takes to give you approval and dilution.
Q. What’s one thing that start-ups can do to increase their chances of getting funding?
Metrics aside, one piece of advice would be to understand the expected timing and certainty of each option.
For any process that you decide to go with, understand how long it could take if things don’t go to plan and at which point of the process, you are likely to have certainty of the outcome.
If you find this out too late, you can get yourself into lots of trouble – either taking significant dilution, accepting unfavourable terms, not enough runway for debt providers etc.
When I thought about setting up Fundabl, for me it was really about, is there a way to give founders certainty as to what they can access and the time frame that they will have an answer.
We are proud that we can offer this very quickly and provide founders with certainty as to the deal that is available on the table so that they can focus on growing their business.
Alternative funding options can also ‘buy time’ for founders so that they can negotiate and grow with confidence, knowing that they have the capital reserves behind them to make the best decisions and to set the business for success.
Want to learn more about capital raising?
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