The Relevance Of Non-Equity Based Financing
Updated: Jan 12, 2020
As I have reiterated time and time again, startup founders are some of the smartest people I get to meet. Armed with razor sharp wit, and bursting at their seams with bubbling enthusiasm, these bright minds can give many a run for their money.
However, as gifted as they may be, most of them end up tripping over the same Achilles heel:
Figuring out the right funding model is often arduous and perplexing; and even if one manages to decide on an appropriate one, it leads to yet another backbreaking journey to find just the right investor. Then, even if a founder does find a great investor to back up the business idea at hand, it is a brand new puzzle to solve when it comes to assessing how much money it really needs at a given stage. Many promising unicorns have been lost to the mad rush for funds, so being mindful of how much one really needs is critical to building a sustainable business.
At the same time, the founders and their teams must know exactly how much equity they can afford to shell out for the much-needed cash in the bank. It's all a complex set of quick and tough decisions that shape the future trajectory of a founder's dream business. With the stakes running high, and time running out, oftentimes these decisions can turn out to be far too hasty and rushed for them to be smartly thought-out.
By the time they realize it, they have likely parted with too much of their equity for little money in the bank, and must go on a wild goose chase after quick profits to make these funding decisions worthwhile.
One way to avoid a lot of the headache that comes with fundraising is to opt for a non-equity based model. While this model does not rid a founder of all their funding woes, it does do away with a large chunk of it. For starters, you no longer have to worry that you will lose control of your business, or not have enough left for the next funding round. Nor will you be left kicking yourself when the value of your enterprise grows manifold while you are left with only a little slice of the equity pie! While some types of this funding model may be more expensive than equity-based funding in the short run, they are usually more likely to yield better results in the long run, especially in the case of a successful startup.
How Does Non-Equity Based Funding Model Work for Startups?
As the name suggests, a non equity based funding model basically entails raising funds without giving any part of your business (or equity share in the venture) away to the person or entity advancing the funds.
Naturally, this model must (usually) also guarantee a decent return to the investor, but that return is not calculated in terms of an equity share.
This means that the founder(s) retains full control of the business, and once the investor is paid back the stipulated multiple via a mode that was mutually agreed upon, the business will no longer have any obligations to the person/entity providing the funds. The clear benefit of this model is that it allows a greater degree of autonomy to the founder(s), allowing them to attain the goal they had envisaged for their business without any meddling from an outside investor who is unlikely to have similar passion or insight for the venture. It also allows the business to grow more sustainably, as it need not go on a reckless quest for growth to satisfy their investors' appetite for greater value on their equity holdings. Even though some forms of non-equity based funding may require the venture to pay more upfront, it also makes it possible to build a robust foundation for the business going forward.
The non equity based funding model is more relevant than ever today, necessitated as it is by the continuing trend of a Series A Crunch and many VCs' growing distaste for hyper funded startups since the likes of Uber and WeWork fell from their high horses. Thus, following this approach not only makes sound business sense, but also helps you keep up with the times, manoeuvring your way around the investors' tightening purse strings.
There are several types of non equity based funding, and some of the key ones have been summarised below:
While many founders are often unwilling to go for debt financing, it is actually a rather safe way to raise funds for your business if you are confident in its ability to make money. If a startup is sure to earn a certain level of profits regularly, it can easily take on some debt on the business. However, since repayments can get disturbed if projections are not met adequately, a startup should carry out a thorough study of their own financials and risk management capacity before they decide to take this route.
Debt financing can take several forms, including term loans, line of credit and invoice factoring. Each one of these types corresponds to the varied needs of new businesses.
Term loans are the most straightforward of the lot, while also being the most expensive in terms of interest. They involve a certain sum of money being provided to the business as a lump sum amount. The business then needs to pay back the given amount over an agreed period and stipulated number of instalments.
Line of credit, usually a revolving one, works very differently than a term loan. It typically charges a lower interest rate and makes a certain amount of money available to the business upto a given limit, just like a credit card would for an individual user. A line of credit is extended on the basis of cash flow, credit, and collateral. Even though they can be hard to maintain, they are a convenient way to get access to funds readily.
Invoice factoring, on the other hand, follows a completely different system, and charges a rate somewhat higher than in the case of a credit of line. These are easy to get, and relatively cheaper than term loans, and particularly useful if you are looking to increase your cash flow. Usually, customers tend to pay about a month or more after generating invoices, but small new businesses find it hard to wait that long for the payment. To solve this problem, they use invoice factoring, whereby their factoring company (a bank or a non bank financial company) gives them upto 85% of the invoice amount upfront and the rest once the customer pays up. The factoring entity charges a fee for this service.
Revenue Based Financing
This model of funding is one where an investor provides funds to a startup, but not against any equity or interest. Instead, the startup and the investor reach an agreement that the latter will be paid back a certain percentage of the business's total revenue or sales over a given period till the investor makes back a predetermined multiple of the given amount. The payment stipulations can vary, they can either be based on unit sales, or total revenue.
This model, involving timely royalty payments is simple & straightforward, allowing an investor to make money without burdening a growing business.
As the business has to give up only a portion of what it sells or makes, it is less likely to be driven to loss by this model. A revenue based financing model rises above its few flaws by efficiently accounting for the needs of the business; and responding to the seasonality of sales which is applicable to many products and services being sold today. If a startup earns higher revenues during a particular period, it has to pay a higher royalty to its investor; simply because it can afford to do so. If sales aren't that good, the payouts will also be proportionately low. This model definitely takes care of both sides, adequately meeting the needs of both the business and its backer.
Crowdfunding is a particularly popular way of raising funds nowadays, with startups pre-selling their unique products and services to beta customers for a lowered price, in order to fund their initial round of production. Platforms like Kickstarter and Indiegogo allow new businesses reach hundreds of thousands of potential backers (and customers) by charging a small fee on all the funds that they manage to raise by preselling.
Crowdfunding comes with an added bonus of marketing the new product or service to a prospective user base,usually on the lookout for innovative solutions to their everyday needs
It allows an entrepreneur to reach massive numbers of people via these platforms, educating them about the existence of their product, generating interest and all-round awareness, while also making some money with it. Indeed, crowdfunding can be a little hit or miss for some startups, owing to the massive volume of ideas and things that are pitched on these websites everyday. However, some of the fantastic success stories that have emerged from these platforms attest to the power of their massive reach.
Oculus VR is a great example of what a startup can achieve through such campaigns. This virtual reality tool was pitched to the public via a crowdfunding platform when its founder was a mere 20-year old, and went on to raise over 2 million dollars. Later, it was purchased by social media giant Facebook for 2 billion! With the likes of Allbirds and PopSocket also being a part of the exclusive club of companies that made it big from crowdfunding, this avenue of easy fundraising does offer a great deal of hope to fledgling founders.
Grants, Awards and Benefits
Great many startups are powered by smart and innovative concepts, and these pioneering ideas are often brilliant enough to earn awards, grants and benefits from governments, or philanthropic organizations.
Getting these grants can help these startups to fund their early expansion and grow to a stage where they can afford to take on an equity round more comfortably.
These are some of the major ways to raise funds without giving up any equity. With such a wide variety of repayment models available within this category, startup founders should be able to find an appropriate funding model quite easily without having to give away any part of the business they have built so lovingly. For those who cannot really bootstrap their businesses, non equity based funding can prove to be a rather decent alternative.