Welcome to a BetaKit weekly series designed to help startups and entrepreneurs. Each week, investors Roger Chabra and Katherine Hague tackle the tough questions facing founders today. Have a question you would like answered? Tweet them with the #askaninvestor hashtag, or email them here.
Throughout this series, we have often weighed the pros and cons of venture capital, never fully discussing other ways you might choose to capitalize your business. An informed decision on whether or not to seek venture capital must also involve weighing your alternatives.
This week’s post is adapted from my book Funded, and covers five non-dilutive alternatives to venture capital.
An average equity round of financing results in founders giving up 10 to 30 percent ownership of their company; non-dilutive forms of financing allow you to keep full ownership and still raise the money you require for growth.
If you decide not to raise venture capital, the alternatives covered here could become your primary sources of capital. If you do decide to raise venture capital, understanding the other sources of financing available to early stage companies will give you a sense of your BATNA (Best Alternative to a Negotiated Agreement) and an understanding of additional ways to capitalize your business.
Crowdfunding is the practice of funding a project or venture by raising monetary contributions from a large number of people. Reward-based crowdfunding is when contributors pay money to back a product or project and expect to receive a reward — oftentimes the product itself — if the crowdfunding campaign is successful.
Reward-based crowdfunding has grown dramatically in popularity over the past few years as a means of both proving demand for a product, and as a way of financing initial production, with the most popular crowdfunding platforms being Kickstarter and Indiegogo.
Crowdfunding has emerged outside of the traditional financial system. Reward-based crowdfunding allows entrepreneurs to maintain full ownership and control of their company, and does not have to be repaid.
For companies looking to produce a physical product, reward-based crowdfunding has proven to be an incredibly powerful financing platform with some products like the Pebble watch, or the Ouya gaming console raising over $10 million through crowdfunding.
Crowdfunding can be used as an alternative to venture capital, as a marketing tactic after venture capital is raised, or as a way to get the attention of venture capital investors. By proving the demand for your product on a crowdfunding platform you can prove to investors that there is a market need.
What is the downside?
While there are many upsides to reward-based crowdfunding, there are also some risks. First, reward-based crowdfunding hasn’t yet proven to be a reliable form of financing for software or service based companies, so it’s not right for every business.
Secondly, crowdfunding, like raising venture capital, is very time-consuming. Running a successful crowdfunding campaign requires intense planning and attention to detail.
Crowdfunding can be a full-time job leading up to and during a campaign, and can take you and your team away from building other parts of your business.
Finally, unlike venture capital funds, you need to provide something in exchange for the money. Delivering on your crowdfunding promises can be extremely costly and time-consuming, something most entrepreneurs greatly underestimate before they begin.
A commercial loan is a debt-based funding arrangement that a business can set up with a financial institution. Much like venture capital, commercial loans are often used by corporations to fund large capital expenditures that a business may otherwise be unable to afford.
Why commercial loans?
Commercial loans are a more traditional form of financing, often provided by banks, and they generally require that a company already have revenue in order to qualify, and they are sometimes secured against company assets. Commercial loans allow companies to avoid any loss of equity or control and can be faster to secure than venture capital. Financial institutions providing commercial loans are not buying into your business, so they will not actively interfere with your operations.
What is the downside?
Commercial loans are often not accessible nor particularly well-suited to early stage ventures. Pre-revenue companies without significant assets will find it very difficult to secure traditional commercial loans. When a young company does manage to secure a commercial loan, they are often required to provide personal guarantees, meaning if the company isn’t able to pay back the debt, the entrepreneur would be on the hook for the money personally.
Beyond just the personal financial risk they may impose, commercial loans may simply not be a practical way to finance a company that expects to be pre-revenue or cash flow negative for a long period of time. When a company is unable to pay off its debts, those debts will sit as a liability on the company’s books. A company with many liabilities is less attractive to acquirers, and will be forced to use future revenues to pay off those debts rather than invest in growth.
Venture debt is a compliment to equity financing. It provides flexibility and can be less costly when structured properly.
Regions that don’t typically attract startup activity tend to have more aggressive government incentive programs, an attempt to make up for other shortcomings.
Unlike a commercial loan, venture debt is specifically designed for startups and growth companies that do not have positive cash flows or significant assets to use as collateral. Venture debt, which can sometimes be secured against a company’s accounts receivable, can be used to make infrastructure purchases or may simply be used to finance growth in the place of an equity round. Financial institutions and individuals offering venture debt as a substitute for equity financing tend to follow a similar opportunity assessment process as they would if they were investing in an equity round.
Venture debt is typically structured as a loan or series of loans with warrants for company stock to compensate for the higher risk of the investment. Many venture debt shops will want warrant coverage in the amount five to 20 percent of the loan value.
A government grant is a financial award given by federal, regional, or local governments to eligible grantees. Government grants are not expected to be repaid by the recipient. Government grants for small businesses, especially those addressing social problems, developing new technologies, or those with minority founders can be found in most regions.
Grants are a great form of financing in that they essentially provide you with free money. No equity needs to be given up and the money never has to be repaid.
Grants are also helpful for companies that are not yet appealing opportunities to venture capital investors. Grants are generally given out on specific criteria very different to the criteria of a venture capitalist — for example, revenue and growth may not be as important to the government as social impact or research. The funds a company secures through grant funding can be invested in product and sales to get the company to a state at which it is venture fundable.
What is the downside?
Bootstrapping is not the best decision for every startup; it’s particularly effective in businesses where there is low competition.
Grants generally come hand in hand with a long application process and strict reporting requirements. While it is marketed as free money, the truth is that companies need to work very hard to get grant funding. Applicants often write essays, build business plans, and draft proposals simply to be considered. And once accepted, they often need to keep meticulous records of their progress to remain in good standing or to get the next instalment of the grant.
This is often work the company would never have done were they not applying for the loan, and it is a distraction from the company’s core business.
Grants are also quite unpredictable. What grants are available for what industries varies greatly over time and region to region. Grant funding may not be available to your business. Who will get a grant, and when they will receive the money is also sometimes quite hard to predict, making it a risky financing source to rely on.
Government subsidies and tax incentives
A tax incentive is a reduction in a company’s taxable income or return on taxes paid by a company based on a number of possible factors. For example, if a government is looking to encourage growth in a particular sector (for example, technology), they may offer tax incentives to companies working in that industry. A subsidy is a monetary allowance paid by the government for a specific purpose. The types of government subsidies available to a company can vary greatly depending on the industry or region.
Why government subsidies and tax incentives?
Subsidies and tax incentives are ways of financing a business that don’t require a company to give up any equity and control. They tend to be much more predictable than government grants, being given out to more companies and requiring shorter application processes, if any application process at all. This form of financing can sometimes be so substantial that it affects a company’s decision on where to locate its operations — which is often what the government intended.
Regions that don’t typically attract startup activity tend to have more aggressive government incentive programs, an attempt to make up for other shortcomings in the startup ecosystem. For example, Silicon Valley may not need as many government incentives to attract companies as other regions in the US due to its mature startup ecosystem.
Canada is a great example of a region that uses government incentives to attract startups, via its popular tax incentive program called the Scientific Research and Experimental Development program, SR&ED for short.
Most high tech startups operating in Canada qualify for the credit, which provides support in the form of tax credits and refunds to companies that conduct scientific research or experimental development in Canada. Depending on which province the business is located, companies can recover up to 64 percent of qualifying expenditures such as salaries, contractor fees, and materials spent on research and development.
For many startups that means hundreds of thousands, and sometimes millions of dollars back from the government each year. This program has been a large contributor to Canadian companies maintaining their operations in Canada while they grow and has even attracted many international firms who have set up operations in the country.
What is the downside?
Government subsidies and tax incentives are not always an option depending on your region or industry. These programs can also encourage behaviour not in the interest of the company. While it may be cheaper to operate in a region offering these incentives, perhaps that company would have been better off operating in a more expensive environment with a more developed startup ecosystem and support network. Specific requirements of these programs may also encourage you to run projects that you would not have otherwise run, were it not for the funding.
You’ve probably heard people refer to “bootstrapped” startups before. Bootstrapping is when an entrepreneur starts a company with little capital and attempts to found and build a company entirely from personal finances or from the operating revenues of the new company.
Bootstrapping is a great way for you to maintain full control and ownership of your company as you grow. That means that in the event of a sale, you the entrepreneur will get a larger piece of the pie. Bootstrapping encourages strong business fundamentals. We are rarely as careful with other people’s money as we are with our own. When a company needs to live off its own revenues it tends to prioritize initiatives that make money and operates more efficiently.
What is the downside?
Bootstrapping is not the best decision for every startup. Bootstrapping is particularly effective in businesses where there is low competition, and no need to rapidly expand in order to protect against competitors taking ownership of new markets.
But bootstrapping is often not a viable strategy in winner take all markets, land grabs, or businesses where there are network effects, meaning every additional user creates more value for other users.
Without the funds to invest in product or expand rapidly, a company may lose to better-funded competitors who are able to establish themselves faster. Bootstrapping may also lead a company to prioritize short term gains over long-term value. The company may take on service contracts that pay the bills this month (but are gone the next month), or avoid high-risk projects or research driven projects that don’t have an immediate impact on the bottom line.
Finally, bootstrapping is not always an option; there are some businesses with large enough startup or infrastructure costs that they simply wouldn’t be possible without outside capital.
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