When a startup founder is ready to transform their idea into a viable business, they almost always look to equity financing–whether that’s in the form of checks from friends and family, an angel syndicate, or in rare cases, a early stage Venture Capital fund. This thought process is justified. In the embryonic stage of the startup lifecycle, exchanging equity for capital is often the only legitimate option to amass enough cash reserves to build an initial team, create an MVP, and hit the market, as debt investors will want security over non-existent assets and personal loans/credit cards can quickly become dangerous liabilities. Equity financing is also a proven (and expected) option for creating runway and providing growth capital for business expansion through a potential IPO or acquisition.
However, equity financing has its weaknesses–dilution of ownership stake, relinquishing board seats and autonomy of decision making, and irrational growth expectations, amongst others–and make raising a follow-on, or even first-time round less appealing to entrepreneurs who have creatively bootstrapped their way to post-revenue status. Every founder feels protective over their startup baby, and the thought of having a “growth at all costs” investor take over the helm is irksome. Removing the vagaries and potential biases of founders’ opinions, it’s an industry truism that only a fraction of startups looking to attain equity funding will ever achieve that goal.
Continued from part one... Q1 hedge fund letters, conference, scoops etc Abrams and his team want to understand the fundamental economics of every opportunity because, "It is easy to tell what has been, and it is easy to tell what is today, but the biggest deal for the investor is to . . . SORRY! Read More
What’s interesting though, is that demand for equity financing transcends the allure of other useful financing instruments to the point that it has become intoxicating for any founder expecting to reach unicorn status as quickly as possible. Take, for instance, this generally relatable financing example. New home buyers are always happy when their bank lender is willing to extend a mortgage that will provide reasonable financing terms on their dream house. Rarely do those new home buyers then leverage the accumulated equity in the property plus all of their assets to go out and take mortgages on ten additional properties, making a bet that they can 10x their annual earnings within a year simply to cover the many mortgage payments. As an aside, this situation did occur, and as you all know, it was one of the main precursors to the 2008 financial crisis. When it comes to the startup ecosystem, this mentality has become increasingly normal for the hottest new companies who go from a $10M series A to a $100M series B within three months, inadvertently forcing founders to 10x their monthly burn, headcount, and revenue run rate simply to meet the requisite moonshot growth expectations.
Just this month, well known venture industry and NYT reporter Erin Griffith published an excellent op-ed analyzing the growing founder malaise towards traditional VC fundraising and the potential pitfalls of taking on equity financing when it’s not the appropriate long-term option. In the piece, venture capitalist Josh Koppelman of First Round Capital candidly remarks, “I sell jet fuel, and some people don’t want to build a jet.” Everyone knows what happens when you put potent jet fuel in a slow but steady single-engine prop plane—it stalls out and explodes.
Fortunately, alternatives have emerged to dislodge the binary outcome of either banking VC jet fuel or sputtering out entirely. This piece will shed light on the other financial options.. These providers have emerged to both complement and supplement the old guard of financiers, with most focused on helping post-launch startups meet short- to mid-term cash flow needs—without injecting so much capital as to force their trajectories towards the sun (or seabed). The advent of the cable car did not kill off transportation by horse—it simply served as a flexible alternative to meet local demand. Much like a startup idea, it was edgy, scalable, and pragmatic. Alternative financing upstarts today provide flexible, non-dilutive financing to entrepreneurs whose capital needs are not met by a time-consuming equity fundraise or difficult-to-obtain and restrictive institutional debt financing.
Breaking down alternative financing options for the startup economy (what’s alternative financing, anyways?)
Alternative financing is an umbrella categorization of non-standard financing solutions to supplement plain vanilla equity and institutional debt. For the startup economy, these solutions range from the more traditional: term loans, lines of credit, asset-backed loans, convertible debt, receivables/payables financing to the more creative: hybrid equity funding invoice/SaaS factoring, crowdfunding, microloans, grants/tax credit financing, revenue-share agreements, to the “wild west” of fundraising instruments--crypto/tokens.
Why so many options? If the demand is there, you better believe a savvy capital provider will attempt to manufacture a solution. Plus, the more arcane the structure, the lower the initial competition, and the higher the margins and ability to grab market share. These solutions are not only rising in popularity and easier to obtain, they’re also well-suited for the “torso” of the market—companies with varying levels of traction, a proven user acquisition strategy, and a readiness to grease the wheels on the marketing machine.
Flexible Financing to Drive Growth Without Dilution
When it comes to early- to mid-stage startups, some customizable financing instruments have emerged as clear winners in a competitive market where flexibility is the ultimate selling point. In addition to an emphasis on ease of use, the demand for many of these offerings is spiking thanks to quick access to liquidity and an a la carte menu of fee structures to decide between, from interest rates to transaction fees to revenue share agreements.
This is a unique segment of the market, where high growth rates and monthly revenue volume upwards of $500k-$2m remains unattractive to institutional banks offering single-digit APR debt. While $24 million a year in revenue might seem impressive, a revolving line of credit or an AR line on that sum at 8%/yr will gross just $192,000 prior to cost of capital, which could wipe out at least 50% of that margin. Again, low six figure fees might appear attractive to your average “Joey finance,” but they’re nothing for abank turning billions in volume a year.
In our overextended bull market where cash seems to be omnipresent, here are four of the most prevalent alternative financing categories providing liquidity geared towards growth, without the friction points of traditional debt and equity instruments.
Financing for User acquisition and General Ad Spend
Acquiring users through digital advertising channels has become an essential growth strategy for the modern startup, especially for the B2C side of the market. However, with the ubiquity of these digital channels comes massive competition over eyeballs, and with that, ever-rising costs. High profile VC Chamath Palihapitiya of Social Capital aptly captures the mind boggling capital allocation and shaky unit economics of the digital ad spend craze in the firm’s 2018 annual letter: “When the VC industry invests capital into fast-growing startups today, the plurality, if not the majority, of invested capital will go into user acquisition and ad spending, for better or worse (usually worse). Startups spend almost 40 cents of every VC dollar on Google, Facebook, and Amazon.”
The absurdity of this data point—40 cents of each dollar of expensive venture funding spent on top digital channels—is hard to comprehend, yet if each $1 of ad spend generates $1.50 in sales, perhaps it’s justified. An ideal workaround to the “Facebook Ads piggybank in exchange for 25% of your company” conundrum would be to create a funding mechanism that eschews equity. Alternative financing providers have jumped into the digital ad spend party to do just that, and working capital hungry startups have heeded their call en masse. Clearbanc is a notable capital provider that offers “an alternative to selling valuable equity and control to VCs by offering capital based on new data sources traditional banks aren’t looking at.” After a review of sales metrics provided directly from Facebook Ads and Stripe dashboards, Clearbanc will make a lump sum cash offer to startups to be used on ad spend. Funds are then recouped via a fractional revenue share agreement until the loan is paid back, plus a discretionary fee. Clearbanc has funded over $100 million to 500 different companies in 2018. More importantly, this model allows working capital to be rapidly reinvested into a growth strategy that has been pre-vetted via real time sales data, theoretically de-risking the bet.
Until the digital ad spend feeding frenzy subsides, one has to imagine structuring non-dilutive financing for marketing budget-heavy startups will be an extremely popular option.
B2B2B/C Paytech and B2C Microloans
2018 was huge in terms of growth of existing players, as well as considerable VC and debt capital injections into new entrants of the payments/consumer financing vertical. This vertical is not a source of fundraising so much as a provider of cash flow and liquidity solutions to support SMBs with accounts payable financing and consumers with “financial wellness” tools. Many industries—digital media, for instance—are plagued by excruciating multi-month payment cycles between the various parties involved, to the point where the ubiquitous two-week pay cycle feels like a luxury. These lugubrious fund flows lead to inevitable cash flow crunches as well as unhappy “payees,” ranging from large vendors all the way down to individual contractors working for gig economy tech companies.
It would be logical to separate B2B2B/C and B2C financing as they represent different business models, but a slew of new companies have taken a hybrid approach, packaging these strategies into the pleasant-sounding moniker of “financial wellness.” This quasi-Buddhist appropriation refers to a combination of financing solutions to improve working capital and streamline payments for businesses, provide increased financial control and access to short term financing to individuals, or both. Providers like Tipalti and FastPay focus on the “B”, offering AP financing/payment processing on behalf of businesses to other businesses; others, like Earnin and DailyPay, provide liquidity to individuals on behalf of employers by offering accelerated payouts of earned income to hourly and contract employees (Qwil services both business models); and some, like Oxygen and MoneyLion, market a variety of banking services and microloans directly to individuals. Even Goldman Sachs, who historically considered consumer banking anathema to its core business, has entered the booming consumer lending market this past year with the innocuous-sounding platform, Marcus. While B2C lenders typically make their money via a traditional interest rate model, B2B2B/C providers usually charge a fixed discount rate based primarily on the outstanding duration before recouping funds.
This segment of the alternative financing market has grown rapidly as SMBs look to non-bank, non-dilutive working capital sources. B2B2C fintech strategy also allows these SMBs (and even some F500 companies) to promote financial wellness towards non-salaried employees—who are often grossly underserved from an employee benefits perspective—as a means of retention and differentiation in contractor-heavy industries where turnover is inherently high. Multi-party AP financing is a crowded market, yet these providers have been able to thrive for two key reasons: 1. Allowing businesses to avoid long, dilutive equity fundraising cycles due to better access to working capital 2. Allowing businesses to incentivize their vendors, employees, and contractors with financial perks, primarily in the form of better payment terms.
Niche, Vertical-Focused Invoice Factoring & Cash Flow Financing
One of the oldest forms of financial engineering, invoice factoring, has been revolutionized over the past decade, becoming a bespoke solution for the most niche of use cases in the past five. Put simply, invoice factoring is when a business sells its receivables (invoices) to a third party (factor) at a discount to access immediate cash flow. The invoice is then collected in full by the factor (discount + fee) when it comes due.
So, what is the catalyst driving adoption of this solution? Traditionally a resource intensive process (paper invoices are cumbersome), factoring now utilizes software to ingest sales data and verify invoices. The speed at which invoices can be converted into cash flow has reduced SMBs’ reliance on VC and bank debt to manage working capital and, more specifically, scale growth.
With invoice factoring and accounts receivable financing, businesses can avoid long payment cycles, collecting and reinvesting money earned almost immediately. Traditionally, industries selling big ticket items and hard assets (industrials, machinery, transportation, etc) have been plagued with notoriously long net payment terms, but often for good reason, as large purchase orders involve many moving parts and take months or years to fulfill. What’s baffling, however, is that these restrictive payment cycles exist within startup-centric industries like software where sales and payments occur in real-time.
Current payment tech has opened up a world of opportunity for frictionless, crossborder, near instant transactions. Consumers can pay, receive, and transfer funds across accounts and between individuals with the tap of a button. Businesses can move huge sums of money around the world denominated in one currency to be received in another within minutes. A glaring incongruity exists between capability and implementation/adoption by the biggest companies around the world, often without merit or justification. Fortunately, capital providers have taken notice and have structured factoring and AR financing solutions that run the gamut of possible use cases. Have digital verification that a counterparty owes you money at a future date? You’re in luck—there’s undoubtedly a niche alt financing shop that will provide you with immediate liquidity
While founders often shudder at the idea of taking a haircut on money they’ve already earned just to get it faster, in reality, it’s one of the most efficient, and often cheapest methods of boosting cash flow without having to give up a chunk of precious equity or relinquish your firstborn as collateral for a bank loan. For revenue-generating startups with a reliable, consistently profitable acquisition strategy, taking a discount of 50-200bps on accrued receivables for a source of short-term working capital is a viable alternative for growth financing. The proof is in the pudding: C2FO, Fundbox and Bluevine have raised hundreds of millions to turn SMB invoices into cash. FastPay, Braavo, and Qwil combat the needlessly long payment terms of digital media titans like Apple, Google, and mobile ad networks to fuel the growth of app developers, who ironically achieve this growth by reinvesting all profits into ads served by these same companies. Payability factors sales for Amazon merchants so they can stock up on new inventory; Lighter Capital finances current and future receivables tied to subscription-based business models. The list goes on.
Hybrid Equity Financing:
Lastly, there’s the malleable “equity derivative” financing instrument. Hybrid equity offerings are a direct response to a fallacy that has pervaded media coverage of the startup ecosystem, and this incessant propaganda has transformed said fallacy into an absolute truth to many an aspiring entrepreneur. It’s a combination of two romantic ideas that find their roots in religion, prophecy, and zealous idealism: the Holy Grail and the Manifest Destiny. Put simply, the current manufactured truth of the startup ecosystem is that raising truckloads of venture capital will inevitably lead one down the gilded path towards unicorn status, resulting in immeasurable bounty for all involved.
Unfortunately, as Erin Griffiths deftly conveys, successfully reaching this startup Nirvana is an extremely rare achievement. This realization, despite being discouraging to high-achieving founders, has led to some net positive effects in the form of creative financing instruments that offer most of the benefits of equity financing, but without the potential drag of handing over an ownership stake. Capital providers like Indie.vc have a simple, yet empowering thesis: “We believe deeply that there are hundreds, even thousands, of businesses that could be thriving, at scale, if they focused on revenue growth over raising another round of funding.”
Their approach to financing includes a typical convertible note offering with a very atypical redemption clause. If the startup choses to raise a follow on round or sell, the note will convert into a preferred equity stake with pro rata rights to maintain % ownership. However, if the startup opts out of a future fundraise due to ample runway and/or profitable growth, indie will begin incrementally returning their equity option to the founders in exchange for a fixed monthly percentage of gross revenues via a revenue share clause. Indie will return up to 90% of their equity option which can be achieved once indie has collected 3x the original purchase amount.
Others, like Earnest Capital and Purpose Ventures employ similar hybrid equity/rev-share offerings focused on the same thesis of helping keep founders focused on scaling their businesses, not getting consumed by the often perpetual process of raising more capital. While there’s not yet enough data to validate if this hybrid approach can fuel sustainable growth without the need for follow-on fundraising, this creative financing instrument is certainly compelling for founder’s attempting to avoid multiple rounds of dilution.
Conclusion: All Capital is Not Created Equal - Choose Relevance over Ego
While statistically there’s been no noticeable shift away from equity fundraising--almost the opposite, as US VC activity hit just under $100 Billion in 2018, it’s highest total since the dot com boom--the number of deals this gargantuan pool of capital was allocated to hit its lowest level in 6 years. The era of mega-rounds is alive and well, fueling the aforementioned sexy notion that excessive capital will undoubtedly fuel longevity and outsized returns. In reality, the data point that more resources are flowing into less deals highlights how, even in this time of financial abundance, where easy money is being shoveled into the insatiable furnace of Facebook’s ad machine, there’s a dearth of seats at the table for hungry founders in need of capital. Ironically, this funding environment is a perfect example of a Veblen good at scale;
Demand to take part in pricey venture rounds is frenzied, thus inadvertently bidding up prices ever higher due to an appearance of exclusivity. In case anyone forgot, the typical way to profit from a long investment is to buy low, sell high, yet sometimes the outlandish price tag of a good just makes it that much more alluring!
Fear not though; alternative financing, though not quite as sexy, has quickly found its place as a reliable and often times more relevant source of working capital for founders wont to hunker down and simply finish what they set out to do - grow revenues and generate value for stakeholders.
Johnny Reinsch is founder of Qwil, an instant pay platform that serves freelancers and small businesses. Formerly, he was an M&A attorney.