Companies need capital to grow and take advantage of opportunities. To the extent that entrepreneurs can bring their own savings to their company and/or grow through profits, they retain absolute control, and don’t give up a share of the ownership. Of course, many entrepreneurs don’t have sufficient savings or profits to finance their business. So what are their options? And what are the advantages or disadvantages of each?
Bootstrap. This means you will finance your company with the positive cash flow the company generates. Of course, the company has to be able to provide cash flow over and above the cost of delivering the product and service. This usually means the company will grow slowly, which may be acceptable. However, slow growth may mean the company misses the market. So even cash flow positive companies often need additional capital.
Grants. Occasionally companies will be able to secure grant funding, such as a Small Business Innovation Grant (aka SBIR). Grants can be very favorable in that they don’t have to be paid back as debt does, and unlike stock, they are non-dilutive. Such grants are highly competitive and very specific. They often come with terms and conditions that may be problematic to the company.
Sell Ownership. This is often the first thought an entrepreneur has in thinking about how to raise the capital needed to launch and/or grow a business (and often the advice they get from everyone else). Selling stock has the significant disadvantage of sharing ownership with others, called “dilution”. If I own 100% of the business, and I sell stock equivalent to 25% of the business, then my share drops to 75%. Of course, it generally has the advantage of not having to pay the capital back within a defined time period, as does a loan. Keep in mind that shareholders do expect to be paid back at some point, and at exponential rates compared to what they invested!
There are several ways to sell ownership in your business:
Sell stock. Plain and simple, you sell a certain percentage of the ownership of your company by issuing actual stock. To do so requires the company be valued. If you need to raise $250,000, and if your investors and you agree that your company before they invest is worth $750,000, then you will be selling 25% of the ownership. (Value before investment of $750,000 plus new investment of $250,000 equals a value of $1,000,000 post investment. $250,000 divided by $1,000,000 equals 25%). Usually stock is accompanied by a number of rights and privileges accruing to the purchaser of the stock (e.g.the right to elect a director, or the right of shareholders to replace an underperforming CEO).
Sell a convertible note. Here the company borrows money from the investor with the intention that rather than paying the money back, the note and any accrued interest will at some time in the future convert to stock. The terms of the conversion often include a maximum price at which the stock will convert or a discount from the price of the stock at conversion. The obligation sits on the balance sheet as a liability until conversion. If the note never converts, at some point it will have to be repaid. If the company is successful, in all likelihood the note will convert to stock, and thus dilutes the interest of the entrepreneurs and early shareholders. Generally speaking, convertible notes are simpler than issuing stock.
Sell a SAFE (Simple Agreement for Future Equity). A SAFE is neither stock nor debt. It is a contract which conveys the right to the holder under certain circumstances to convert the investment to stock. Generally speaking a SAFE is simpler than a convertible note. Often investors dislike SAFEs as they typically convey few rights. Entrepreneurs must keep in mind that ultimately a SAFE will likely convert to stock and therefore will be dilutive.
Borrow Money. Loans are not stock, and therefore are generally non-dilutive (although some loans may require issuing options,known as “warrants,” which allow the lender to later purchase stock, generally at a bargain price). The principal plus interest will be repaid to the lender according to some schedule. Traditional loans such as those made by banks generally require net profitability, significant collateral, and often require the principals in the business to personally guarantee the repayment.
Merchant Cash Advances (MCAs). MCAs are very short term loans, designed to bridge between temporary cash flow events. They frequently are issued at very high effective interest rates. Once taken, they are very difficult to pay off and often lead to future cash shortages as entrepreneurs struggle to get away from them.
Revenue-Finance (RF). RF is a special type of growth capital that combines aspects of both traditional loans and equity. While RF is treated as debt on the company’s books, it differs from traditional debt in that there is no stated interest rate, and no fixed payment. Rather the company agrees to pay the investor a percentage of its sales each month. Like equity, the return the investor receives is uncertain as the payment amounts cannot be known in advance, the investor will receive a multiple of the investment, rather than an interest rate, and usually RF is not secured or collateralized. RF contracts are typically structured for a three to five year period.
For example, Sage might invest $100,000 for the right to receive 5% of cash receipts from sales each month until it has received a total of $175,000. While neither Sage nor the company can be sure how long it will take for Sage to receive its full payment of $175,000, at the time of the investment both the company and Sage believe it will be fully paid within 36 months.
Payments are flexible. The payments are a fixed percentage of monthly cash flow. If the company has a big sales month, then it makes a larger payment. Conversely, if the company has a low sales month, its payment will be smaller.
RF is non-dilutive. Once the full amount has been paid, the contract terminates. Sage does not take a share of ownership and the entrepreneur and early shareholders do not suffer additional dilution.
Get Informed Before Making Any Financing Decisions
Companies needing growth capital are wise to be aware of all the options and the potential impact to their business. For more information on the cost of various options, see our blog post Understanding the Cost of Capital.
About Sage Growth Capital
Sage Growth Capital makes revenue-financed investments in companies at any stage who need growth capital. It is our mission to provide a more flexible funding option to growing companies who do not fit traditional equity or lending models. To learn more about Sage Growth Capital or to apply for funding visit: www.sagegrowthcapital.com.
About Revenue-Financed Capital
Revenue-financed capital (RFC), also referred to as royalty financing, revenue share or revenue-based financing (RBF), is a non-dilutive form of growth capital where investors receive a percentage of monthly revenues until a set amount has been paid. RFC differs from equity financing as the investor does not obtain ownership of the company and it differs from debt financing as there is no collateral required and payments are variable. RFC is designed to empower entrepreneurs to grow their businesses with non-dilutive capital that aligns with their sales cycles.
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