Is it Time to Consider Alternative Financing Strategies?
The economic turmoil of the past six months caused by everything from inflation to interest rate increases to supply chain disruption, not to mention large scale war in Europe, and then massive increases in the price of gas, have combined to trigger a bear market on Wall Street. A bear market on Wall Street is defined by a twenty percent decrease in valuations from the nadir of exuberance. We briefly saw the first post-GFC (global financial crisis) bear market in March of 2020 at the outset of the pandemic, before governments started printing money. The current bear market arrived in June 2022 in response to Federal Reserve interest rate hikes aimed at stemming inflation.
Not surprisingly, the bear market public valuations have started to trickle down to private markets. One need not look further than last week’s announcement by global fintech behemoth Stripe that it had dropped the internal value of its shares by 28%. Recently, Crunchbase released venture capital financing data for the second quarter of 2022, which found a 23% drop in venture capital funding to startups on a global level from the prior period, the second largest quarterly percentage drop as well as the largest quarterly percentage drop in deals in the past ten years. Digging deeper, however, reveals that venture capital funding for startups in the second quarter of 2022 was still the sixth highest total on record. Indeed, it was above the totals recorded in every period prior to the pandemic.
So, we start from the principal that there is plenty of venture funding still available for startups, just not at the record levels of the past year. That said, there are alternatives to venture capital financing available, and founders might want to take a closer look at these alternative methods to secure capital.
Alternative financing can offer benefits for founders, including allowing them to retain more control and avoid dilution. With venture funding becoming a bit harder to secure, these might be an increasingly attractive option for startups. Below, we take a closer look at some of the alternative financing options available.
When venture equity is expensive, or valuations low, startups should look to accelerating the receipt of cash by signing multi-year deals with channel partners for larger amounts that can finance the company in the outer periods. Accelerating revenue may come on the condition of discounted pricing, essentially the net present value of future payments, or more, but it allows you to take cash now.
Non-dilutive government incentives
Shortly after the pandemic, governments around the world scrambled to put cash into the hands of small and medium sized businesses to keep them afloat and workers on the payroll. In the US, the Small Business Administration was charged with implementing the Paycheck Protection Program and the Economic Injury Disaster Loan Program. These programs kept the economy afloat until the economy had a chance to rebound.
Governments of all types and sizes provide other stimulus and incentives for the creation of new business that will stimulate jobs and tax revenue. The R&D tax credit is for taxpayer sthat design, develop or improve products, processes, techniques, formulas or software, and is calculated on the basis of R&D expenditures and rewards companies that pursue innovation with increasing investment. It reduces federal and state taxable income, and allows some companies to receive a dollar-for-dolar tax credit and still get to deduct expenses related to R&D, which can total a 10-15% return on investment.
Government incentives usually come with strings attached, so it’s important to read the fine print and understand the conditions.
Loans, Venture Debt and Other Forms of IOU
When equity is hard to come by or expensive, one need look no further than debt, which can come in all forms, shapes and sizes. A traditional bank loan is likely reserved for profitable companies that generate enough cash flow to make a “Main Street” bank credit committee comfortable.
Existing investors may want to inject capital to send a signal to the market that your business can weather the storm and has backing. This can come in the form of a new convertible loan or “bridge” financing that converts into equity at the next financing, usually with some sort of discount and at some sort of capped valuation to give upside to the lenders.
Venture Debt is essentially a loan designed for early stage, high growth startups who have already secured venture financing. This is important to note, as venture debt is not necessarily a first step for a startup. It is really for startups in growth mode who need additional financing after they have their venture capital financing in place.
Venture debt loans can vary widely, with loans based on the equity already raised. Loans typically range between 25-50% of equity raised in the last round of financing. This means that loans to later stage companies who are looking at funding for expansion are often much larger than those to very early-stage companies.
The obvious benefit of taking on venture debt is it allows companies to focus on growth, while allowing founders to retain more control rather than taking on more venture capital financing and further diluting their ownership. But, as with any loan, venture debt must be repaid down the road, something that must be carefully considered when weighing this option.
Think of venture debt as extending the runway from your venture equity so that you can wait to go out for your next round with better numbers at a higher valuation.
Venture debt can take the form of term debt or revolving debt, and can be asset or receivables-based. Generally it requires over-collateralization and the cost is comparable although discounted to venture equity if all works out.
Shared Earning Agreements
A Shared Earning Agreement, or an SEA, is an agreement between investors and founders that entitles investors to future earnings of the company. The earnings include the founder’s salaries, dividends and retained earnings. Because an SEA includes the founders’ salaries in the earnings, these agreements typically include a salary cap for founders.
SEA’s can also include a Shared Earnings Cap, allowing the investor to be paid a predetermined amount of the earnings, with the founders then able to retain earnings after that cap is met.
So, when does an SEA make sense? The goal for companies utilizing an SEA is profit. This allows the investor to generate a return on their investment and then for the founder to retain future earnings. This means they work best for small to medium sized companies that are highly likely to generate a profit, but they are not well suited for high growth companies working toward an IPO. So, not a great alternative for venture-backed startups or startups seeking to raise significant capital.
One considerable upside to SEAs is that founders can retain future earnings once the Shared Earnings Cap is reached. However, reaching that cap is determined by the amount of profit generated by the company, and the company’s ability to generate a substantial profit should be a critical consideration in determining whether this type of financing is a fit.
Revenue-based financing allows startups to raise capital by pledging a percentage of future ongoing revenues to investors. A regular share of income is paid out to investors until a certain predetermined multiple of the original investment has been repaid. That multiple can range between three to five times the original investment.
Investors are paid based on the success of the company, and payments are not fixed. Payments to investors will increase or decrease monthly based on how well the company is doing.
One reason revenue-based financing can be beneficial to founders is that it allows them to retain a greater level of control. The investors do not actually have any direct ownership in the company, although they do have a great stake in the success of the company.
In today’s economic climate, we expect to see more startups looking outside venture capital to secure the financing they need. Each type of alternative financing comes with its own risks and rewards that must all be considered. There is no one size fits all solution, and founders should weigh all options to determines what works for them.