Something that almost all entrepreneurs need to deal with when embarking on a new venture is raising funds. That’s when they start preparing a financial plan, explore different strategies and demonstrate that their venture has value. When you have a vision of where you want to take your company from the early stage though, your financing strategy will go along with your startup growth story. Financing requires having a plan in place to prove a possible return on investment, communicating effectively with investors before and after the investment and developing a collaboration that goes beyond financing. It start with inspiring prospective investors with your startup story, how you got so far and how much further you can go. Putting your startup story in numbers validates what you have in mind or gives you strategies to implement early-on.
Understanding the fundraising options available helps you plan ahead. Financing takes away precious time and puts commitment and expectations on your company, so depending on how fast you want to grow, this may be part of your day-to-day operations. You do not have to grow fast in all circumstances. There is a lot of advice on the subject, but the simplest approach is to first consider the options available to the specific stage of the company, type of business, location and what type of financing fits the goals of the team.
Even before doing this, having the right attitude towards accepting and giving capital leads to better working relationships and therefore returns. As a startup founder, despite what you think, at seed stage your company will have about 90% risk of not generating a positive return on investment to the shareholder. Respecting capital and being grateful when someone believes in you to give you their own money is a great place to start. Your startup may be one in a lifetime’s investment, but risk should also be recognised to show that you have your strategy and implementation under control.
On the other side, as an investor, you may be inclined to take as much of the stake, sometimes a controlling stake, in the company as possible. This does not benefit the startup in any way and as a result, it does not benefit your investment either. Taking a majority stake may make it impossible for the company to raise future investments and to have a exit. Respecting the entrepreneurs’ abilities means leaving them in charge of the company, offer guidance, support and setting rules of reporting and communication, but not micromanaging the startup on a day to day basis.
A good way to start is to understand the scope and benefits of an investment, the time to exit, the additional non-monetary benefits of an investment (for impact businesses for example) to communicate to investors. Also, a start-up or small business investment, to some degree, comes from personal interest and experience, so people are unlikely to invest in sectors that they are not familiar with. Some may even be interested in investing only in an industry where they have worked before. Remember that early-stage investments, on average, are not the most profitable asset class, so many who specialise in this type of investments, for example business angels, also do it out of interest: they enjoy the startup culture, the immense possibilities that startups offer, how they can shape and change industries, and they get excited about seeing how much a company can achieve in so little time. So get them excited about where your venture is going and talk about your vision when justifying an investment.
Before deciding on the right approach, let’s look at the main funding options available:
- Bootstrapping simply means using your own funds to finance your business. Getting as far as you can with your own funds is a great strategy, it shows responsibility and commitment and demonstrates how you are able to invest your money wisely. It also prevents you from giving away too many shares early on as that may complicate your company structure in the future. In many cases it is the only option, as funds are difficult to raise at the idea stage. However, this depends very much on the sector you are in – investors tend to invest in some sectors earlier than in others, depending on the risk and the capital needed for product development. It also depends on your competitors and on the market: even though some businesses are not in urgent need of funds, they may need to develop faster to prevent competitors from getting ahead, or to ensure that they take advantage of market momentum. If there is demand for your product now, it does not mean that it will be the same in a few years once new competitors, fuelled by VC money, have reshaped the market.
- Funds from Friends & Family – a good option to get you started, albeit only available to a few.
- Grants and subsidies are available for research-based projects, sustainable businesses, some types of innovative businesses and other special interest sectors. These are often country- or region-specific, so if your business’s success will strongly depend on the availability of grants, you can plan your location ahead, or in some countries, you can apply for a grant and if the application is successful, you can decide if you want to set up your business there.
- Incubator and Accelerators are varied, some may offer support in terms of business development and network, and some may help you with limited seed funding to get you to the next step. These are most suitable to potentially scalable start-ups. The aim here is to give you the necessary tools to get you started and develop your prototype or minimum viable product.
- Crowdfunding is the funding option of choice for many startups these days. It is potentially available to anyone and it can be faster t
- Crowdfunding is the funding option of choice for many startups these days. It is potentially available to anyone and it can be faster than other methods. Some start-ups decide against it because they prefer privacy. It is important to know that crowdfunding is great for some companies and not suitable for others – and that you need to focus on effective marketing communication. Some sectors are ideal, as they present a concept or product that resonate well with the public – and even though there are all kinds of companies crowdfunding these days, if your business is very technical or very focused on B2B relationships, it will be harder to sell it to a crowd. Another important point to remember about crowdfunding is that it’s not enough to get the company listed on one of these platforms: depending on the campaign and the amount to raise, there may be significant work involved in mobilising investors and potential customers to participate in the fundraising process. As many already know, there are typically four crowdfunding models, with various platforms specialising in each of them:
- Donation-based crowdfunding usually applies when donating money for causes without getting back any return.
- Reward-based crowdfunding involves contributing money in exchange for a reward, usually a product or service of the company the crowd is backing. I personally would not consider this an investment, but rather an advance purchase of a company’s products. For this reason, the campaign here is mostly marketing-based. It is suitable when a company mostly requires financing for its inventory, but less so when you still need considerable money to complete the product’s development, as late deliveries may damage your brand at inception.
- Loan-based crowdfunding makes it possible for anyone to lend money to start-ups or projects and earn a fixed return. There are platform that specialise only in this type of instrument, and others that give the choice between investing in debt or equity. The repayment terms would usually be fixed by the platform. For start-ups this would commonly be convertible debt, which converts into equity at a future point in time.
- Equity-based crowdfunding allows anyone to become minority shareholders, especially some platforms that have an increasingly low minimum investment. Early investors in a start-up often earn a return only when the company exits or in some cases, at a future fundraising round.
- Business angels can pursue a variety of investment strategies. Some may actively invest in start-ups, some may invest through crowdfunding platforms, some may contribute to a private investment round together with other business angels, and some may be able to contribute to a large investment round independently (the so-called super angels). Being an active business angel who invests directly into startups also means having an interest in and understanding of start-ups and the industry they are in – that leads to them sometimes taking an active role and contributing to the company’s early development or taking board seat. Other business angels may prefer investing indirectly through investment funds, syndicates and VCs.
- Banks are less commonly approached by start-ups. Mostly, they are able to invest debt in traditional and well-known business models and local businesses.
- Institutional investors include venture capital, private equity firms, mutual funds, hedge funds and others. Venture Capital firms are by far the most common investors in early-stage start-ups among these (less so in pre-revenue start-ups), as they have the means and strategies in place to benefit from early-stage investments. However, they are not the only ones: occasionally, other institutions and funds invest in early and growth stages as well. This usually happens in particular capital-intensive sectors, or for start-ups in more traditional sectors that may not benefit from the typical VC high-growth strategy.
- Corporate investors are leading industry players. Many of them grow through the acquisition of start-ups, but in some cases they also acquire minority shares, usually when the start-up is more established and the risk is diminished. In this case, the investment is highly strategic and the corporate investor may end up acquiring the remaining shares at a later stage. Some now have a corporate venture capital branch that helps them identify the hidden potential in risky companies and make earlier stage investments possible. Whether this is a good option or not, it depends on the founders’ long-term strategy.
- Stock markets (Initial Public Offering) can be an option for growth stage start-ups as well, listing requirements for growth capital markets are less stringent, and new early-stage stock markets are slowly emerging. The availability of capital through VCs and Private Equity has made this option less popular, since an IPO can be very costly. However, it is still a good medium-term option for some types of companies to pursue a market leadership strategy through acquisitions.
- ICOs (Initial Coin Offering) are the new fundraising trend for startups. At first it allowed entrepreneurs to avoid regulations regarding the sale of securities, now regulations are tightening up and companies have found a way to circumvent the regulations by selling utility tokens instead of equity or security tokens. It is still unclear what exactly the return to the investor here is, but regulations is evolving fast and in the following months or year the investment landscape of ICOs will likely be clearer. ICOs have allowed companies to raise funds much faster and in higher amounts than traditional fundraising processes, but with less attention to the company behind and the risk of the investment. The biggest risk is now establishing exactly the legal regulations around ICOs and the rights attributed to investors by the tokens – with a special attention to utility tokens that do not give right of ownership in the company.
These options are not available to all types of companies and stages. They are also not available under the same conditions in all locations, and actually vary greatly from country to country depending on liquidity, knowledge of startup investments and the economy. Other important factors to consider when planning your financing strategy are also the goals and preferences of the team. The moment you accept an investment, you are also bound to report to others and may have less control over your decision-making, so when this takes place it’s important that you know what you want for yourself and the company, your negotiating power and situation, which could involve:
- Retaining control over decision-making
- Minimising investor stake to account for the possibility of additional financing rounds
- Establishing the urgency of investment in case of lack of liquidity
- Retaining know-how within the company and have control over brand
- How long you would like to operate the company for
- Whether you want to work with and take advice from other people
- Whether you need additional know-how and a network from investors to achieve your goals
- Aligning your personal goals to the development of your company
- Time for reporting and flexibility you want to have in changing strategy
So how do you decide which financing source is right for now? This depends on the type of company (whether it’s a fast growing startup or traditional business), stage, sector and location.
Take the example of off-grid energy startups in Africa, such as M-Kopa, BBOX, Trend Solar, Fenix International, Azuri, PEG, Mobisol. These are highly innovative startups that are entering a fast-growing market. Yet they validated their products in the past 5 years in an immature finance market, where venture capital investments are low and taking little risks at later stages. Despite this, these are hardware technology companies with market entry costs that easily surpass $ 3 million.
So what happened? Solar energy for rural populations can vastly improve living standards of the local populations, in a way that the costly greed expansion will not be able to do anytime soon. The local population was also proven to make higher use of off-grid energy devices because of the pay-as you-go (PAYG) model, whereby customers can be pay a deposit for the portable energy device and then repay the remaining cost of the device in 12 or 18 months. Trust in business transactions is often low: customers like knowing exactly how much they will pay and what they get in return. This attracted a variety of grants, donors and impact investors. The PAYG model later attracted the need for inventory finance specifically adapted to this business model.
Because the early-stage equity market was still almost absent, the market still highly risky and with no exits, debt providers replaced in many cases equity financing after the products were validated. Also now that the companies have reached the expansion stage, but since some have fallen short of profit expectations, large debt financing instead of equity are common.
In the next few years exits and IPOs in the sector are to be expected, the first one is the recent acquisition of Fenix International by Engie: this may change the financing landscape from a grant and debt market to an equity market. Prominent business angels such as Richard Branson and Bill Gates are already invested in the sector and are keeping an eye on its development, while Mark Zuckerberg’ internet.org initiative, aimed at making the internet accessible by everyone, has a large stake in Africa’s development. Companies like Google, IBM and others are setting up initiatives to expand into Sub-Saharan Africa.
With changing risks, competition and exits, the finance providers are also changing. Grants often involve a strict reporting process, which takes time away from the business development in a competitive environment. New incoming market players are often now trying to skip some more traditional finance providers when possible. Grant and impact finance is also limited to defined impact sectors, which change from year to year. For some, off-grid energy is no longer a priority. On the companies’ side, receiving impact finance means not being able to implement other innovative business lines that, even though they contribute to the local economy, do not fall under the definition of impact investments. Therefore, companies are developing into different geographical areas and diversifying into other product lines as they become less reliant on impact finance.
This is to demonstrate how, depending on your sector and location, the type of finance available differs, and can change over time as your sector develops.