External Financing Options for Early Stage Companies
Note: This article was originally written and published for DailyDAC as the third installment in a series of articles.
The majority of early stage companies fund their initial capital needs personally, but the capability to do this is limited, and without external funding, a business will be starved of the nutrient required to allow it to grow to its full potential. The amount of funding needs typically increase with each stage of the business, and the sources of capital will change according to the stage.
As an entrepreneur of an early stage company exhausts his/her personal capability or willingness to fund the business, he/she needs to look for “less friendly” sources of capital. External financing sources have a financial return as a much higher priority, and the entrepreneur must showcase the viability of the business.
As explained, in a prior installment, funding the business through internal means can include use of personal savings; taking out and using home equity loans or other personal debt obligations, proceeds from selling investment portfolio, withdrawals from retirement accounts, and even maxing out credit cards. In addition, the entrepreneur will leverage the family and friends network (F&F).
Early stage companies have no operating history, and as such, the risk of failure is high. And, as the adage goes, with risk, must come reward. Once family and friends are exhausted, funding from outsiders depends on being able to demonstrate a reasonable probability of a financial return commensurate with the risk of the opportunity.
As noted above, the amount of funding needs typically increase with each stage of the business, and the sources of capital will change according to the stage. As shown in Illustration 1, start-ups generally follow a similar path in terms of what funding source they seek out as they grow and as their business models are proven to higher degrees of certainty. And, as a company grows and seeks out greater amounts of capital, the deal with each successive provider of capital tends to be more complex than the last.
Source: VentureLab (www.theventurelab.com)
Through future installments, we will further discuss the activity of angels, angel groups, venture funds, and private equity with respect to investing in companies. The size of investments from each of these groups, and their level of activity is constantly changing with the market.
The investments referred to above are typically made as equity (both common and preferred), although convertible preferred notes are relatively common in early stage funding. These are promissory notes, typically with an annual interest rate attached, and have conditions upon which they convert into equity, usually at a future round when the valuation is established. The various investment structures will be discussed in future articles as well.
One other set of funding sources must be mentioned. You can think of them as non-dilutive sources, since they may provide dollars for the building a business without requiring equity in return. These include:
Business plan competitions typically offer prizes that are worth between $10K-$100K in cash and in-kind services. These competitions are also a means for a company to refine the pitch. Further, they also provide access to potential investors. With respect to government grant programs, there are no less than 11 federal agencies that collectively award billions of dollars annually to small business to support innovation-based R&D.
Raising capital from external sources is a full-time job and takes the management team away from product creation or revenue generation activities. The efficiency of the capital raise is, therefore, important. A company should map out its capital needs and have a strategic plan to fulfill them.
A proper strategy will break down the tranches of capital to be raised and the likely sources of such capital for each tranche. A goal should be to hit enough critical milestones so that the uptick in valuation resulting from each milestone is significant enough to counterweigh the dilutive effects of additional equity investments.
The value of the capital that each external funding source brings to the company varies, and this value may be a crucial factor in a deal being finalized with any source. Although the value rating that the investor and entrepreneur ascribe to each of these criteria may vastly differ, these are some key checkboxes than an entrepreneur will be looking for from an investor:
• Can investor provide necessary capital and/or help finding the additional capital
• Timing and effort required to complete funding
• Value-add of funding party to company business (experience, rolodex, etc.)
• Ability provide follow-on capital
• Shared business vision
- Corporate governance
Next installment: What is Angel & VC Investing?