The last few months have demonstrated the kind of volatility we can’t exactly plan for, but for which we can and should prepare.
The impact of Covid-19 is multi-faceted, and a collective effort is called for to come out the other side. And there will be another side. In fact, right now, while many might face problems, there are also opportunities. Strong startups will survive.
As startups grow, gain recognition and commercialise, capital raising becomes a critical component of success. The funding landscape is constantly changing and investment options are diversifying. Venture capital (VC) still dominates startup funding, but other methods like crowdfunding are gaining traction.
Deciding what will work for your startup will depend on a balance between your business objectives and vision, your financial needs, and external and market pressures.
Today we are covering a few of the options available to startup founders seeking funding, giving a broad overview of equity, debt and crowdfunding.
If you missed it, you can check out Part One of this guide which covers bootstrapping, personal networks and angel investors.
For a deep dive into startup capital raising, you can RSVP for Wednesday’s launch to get a free copy of our capital raising guide, developed by Stone & Chalk and venture capital partners.
Equity
When startups raise equity funding, they issue new shares to investors in exchange for capital injections. Negotiation in an equity round centres on the company’s valuation and the rights and entitlements of the investor.
Valuation determines how many shares the investor will receive in exchange for the capital invested and therefore the investor’s percentage shareholding after the raise.
If all investors stay in and gain equity on investment, as external investment goes up the founders’ share goes down (diluting ownership and sometimes control). But as the valuation of the company will increase (with any luck) over time, ultimately the value of your stake will also increase.
Typically companies will start out with the equity split evenly between the founders. At the pre-seed stage it’s common to sell up to 20% of the equity to an incubator or a personal network. At the seed stage, an angel investor will often buy between 5 and 15% of the company.
After this, for companies that make it this far, comes Series A – the first round of Venture Capital funding. At this stage an early-stage Venture fund might purchase 25% of the company. A Series B or late-stage VC funding round might see a second VC fund come on board to purchase another 20%.
Say in this example the company founded by two people was notionally valued at $50,000 when it was founded, and it was valued at $10m after series B. While the founders’ percentage share of the company has shrunk from 50% each to 20.4% each, the notional value of their shares has risen from $25,000 each to $2.04 million each.
Debt
Whereas equity-based fundraising exchanges capital for a stake in the company with which an investor recoups investment, debt-based fundraising follows a classic borrow/return model, where money lent now is repaid to the lender later at a predetermined rate.
Most debt funders require an established cash flow or the use of fixed property as collateral. Valiant Finance offers a simple tool for qualifying your ability to access debt across more than 80 lenders in the market.
Note though, the majority of startups, especially those in the early stages, will not have the option to raise a debt round because they aren’t attractive borrowers.
Raising debt at Series A stage is however becoming increasingly common in Australia through specialist venture debt funds which look for startups with consistent and clear cash flows and a clear investment plan which can lead to profitability in the medium term.
Raising through debt rather than equity can preserve existing shareholders’ stakes and maintain ownership. It can also be cheaper to raise debt than to secure bridging funding between rounds, and faster to close than equity. Business debt can also create tax deductions.
But on the downside, the repayment can be a huge burden on a company yet to generate profit. Debt can also impact profitability and valuation, impacting future equity raises. A debt raising requires the company to be confident of future cash-flow.
A company’s creditworthiness is the highest immediately after raising a new round of equity. If startups are raising a combination of equity and debt, they should consider engaging with a lender once they have a few equity term sheet agreements so that the debt financing syncs with equity fundraising.
However, if raising debt is the sole financing option, the best time to engage with lenders is during periods of sufficient liquidity and operating runway to increase bargaining leverage.
Crowdfunding
Crowdfunding is capital raised through the presale of products, experiences and/or donations of money from the public. The most common way this occurs is online, through social media and other crowdfunding platforms. Crowdfunding campaigns have two key components: raising capital and promoting your product or service.
Reward-based crowdfunding platforms are a popular way for startups to pitch an early-stage idea and to validate a new product or service. Examples of reward-based crowdfunding platforms include Pozible, ReadyFundGo, Kickstarter and Indiegogo.
Equity Crowdfunding is a newly regulated way for everyday investors, people new
to investing, or mums and dads and millennials, to invest in startups and early stage companies. Unlike other models of crowdfunding, equity crowdfunding gives investors an equity stake in the company.
Equity crowdfunding’s main advantages over conventional equity-based investment lies in speed of acquisition and the value created from having a large community of advocates.
Investor-led crowdfunding is an attractive option as startups and founders do not incur fees. Instead, investors in a syndicate pay a fee on top of their initial investment so as not to impinge on limited early stage funds.
Conducting commercial due diligence and risk analysis of investment opportunities better protects investors. Increasing confidence in the investment in turn aids completed raise rounds.
Founders may also benefit from investor expertise to further accelerate growth. Examples include Jelix Ventures, Eleanor Ventures and Scale.
- This is an edited extract of the Stone & Chalk capital raising guide for startup founders. To get a free copy of the guide and attend the virtual launch event on Wednesday July 1, RSVP here.
The free guide is available here.
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