There are a number of issues and options for business owners to consider when looking to raise capital in connection with start-up equity offerings and post-launch financing rounds as well as debt-financing and other arrangements. While there are many potential sources of financing, some are more appropriate than others depending on the particular circumstances and objectives of a given business. This article will discuss various sources of financing and provide a general introduction into the emergent field of crowdfunding, which will be covered in depth in future articles.
Traditional Debt Financing
When considering debt versus equity financing, business owners naturally are reluctant to part with equity. However, unless the business is able to show sustainable revenue or offer legitimate collateral, non-equity based financing may not be a realistic option. For those interested in debt financing and who have an appropriate basis to facilitate it, it is an attractive option because you do not need to give up equity, the cost is a fixed expense and the interest is deductible.
There are a variety of types of debt available, including without limitation, lines of credit and credit cards, traditional term loans, factoring, asset-based and cash-flow based loans, and so forth. Ultimately, lenders are looking at the borrower’s ability to service the debt, which is commonly demonstrated through a P&L statement and cap table, a fully funded business plan, existence of a part time or full time CFO, accurate financial projections, and other elements that are provided in a professional presentation.
Peer-to-peer (P2P) lending is an innovative form of debt financing that connects individual financing partners without the formalities of traditional institutions. The lending typically takes place on online platforms that create a network of borrowers and lenders. This process cuts out the banks or other formal financial institutions, allowing borrowers to obtain better interest rates and lenders to find a greater return on their investments. This option is especially attractive for small businesses, or for those who may not be able to qualify for traditional financing due to poor credit history.
Additionally, businesses that tend to require large amounts of cash on hand to expand or operate can benefit from the relatively expedited funding process, which can often occur within days. Although originally contemplated as a mechanism to acquire loans from small private investors, large financial institutions have become increasingly involved in P2P lending. While this may seem to take away from the original concept, the influx of institutional money has given the space a boost, driven competition and lowered interest rates, all to the benefit of borrowers.
Royalty based Financing
Another model that offers flexibility and allows business owners to retain equity is royalty based financing. With this method, a business is essentially taking a loan against its future revenues. By doing this, the business can protect itself from the possibility of default since repayment will inherently be a function of how much cash the business brings in. Further, whether the business structures its repayment as a simple percentage of the revenue stream or combines it with an interest component, typically there is a cap in place limiting the repayment amount should the business make it big.
Of course, a business must closely consider whether a royalty structure is appropriate since cash flow will be directly diverted from reinvestment into the business. Such financing option may not be readily available to companies in the early stages of concept development since angel investors or private equity– the common sources of royalty based financing – often require a developed product or service before taking a chance on future sales. Later posts will discuss key terms and issues to consider when negotiating royalty deals.
Equity based Financing
Another common financing option is to offer a portion of equity in the business or venture to interested investors, such as friends and family, angel investors and venture capital (VC) firms. There are many factors to consider when seeking equity financing, which will be covered in future posts. Overall, when contemplating equity investment, it’s important to think of the business in terms of what is important for investors and to understand what the viable options are. For instance, VC investment is not as abundant and accessible as business owners may think. In 2013, only 120 seed stage companies were backed by VCs, while over 32,000 deals were backed by angels. The majority of companies do not get VC money. Interestingly, only about 16% of the Fortune 500 companies have had VC financing. Also, VCs commonly look to own 25-40% of companies in return for their investment; whereas angels typically fall in the 5-20% range.
A new form of financing has emerged over the past 5 years that is projected to grow exponentially over the next decade. Crowdfunding is a form of raising money through general public solicitation for a specific purpose, such as creating a video game, making a movie, starting a business and so on. It can be applied to nearly any industry and any venture. By providing a new source of capital- money from the “crowd”- that is widely applicable and accessible, the potential social and economic implications crowdfunding will have are extraordinary. Later posts will discuss crowdfunding in detail.
In sum, there are many issues and options to consider when looking to raise money, and our team of experienced attorneys is happy to help navigate you through the process to identify and secure the best arrangement for your business.