Is Venture Capital the Best Funding Option for My Business in the Current Economic Environment?
Welcome to Shark Tank…
You have a great idea about a new business opportunity. You’ve run the numbers and are confident that with an initial investment of $500,000, you can turn a profit in three years and generate $150,000 in operating income per year. But you realize there are no guarantees. Further, you anticipate that there is at least a 50/50 chance the economy will enter a recession within the next two years.
- What factors will be most important in determining if you want to fund your venture through equity or take a loan for the $500,000?
- If you meet all your projections, will you be happier in five years that you used equity to fund the venture or debt?
- If the company goes bankrupt in five years, would you have a different answer?
These are some of the critical questions entrepreneurs must ask themselves when deciding how best to fund their new startup. To help you make the right decision, let’s answer each question sequentially.
What factors will be most important in determining if you want to fund your venture through equity or take a loan for the $500,000?
As an entrepreneur, several key factors will help to determine my preferred capital structure for my new venture:
1) Limit my liability
Since I’m still in the idea stage, have yet to build a prototype or MVP (minimum viable product), I have no customers or revenue to show traction/demand, it is going to very difficult for me to qualify for a bank loan.
Moreover, without at least some proof-of-concept, the bank will undoubtedly want to secure any financing against my personal assets, such as automobile, property, bank account, etc.
Therefore, to limit my personal liability, I will first set up an LLC (limited liability company) so that my personal assets cannot be used to collect on business debts.
(Note: if by the end of this exercise you anticipate raising large amounts of funding from investors, you’ll want to structure the organization as a Delaware C-Corporation since it makes it far easier to raise capital from investors. Priyanka Prakash recently wrote a great article on LLC’s vs. Corporations).
2) Invest my own capital
Next, since I want to maintain as much ownership as possible (particularly in the early days), I’m going to invest my own capital to help fund the business; and invest only what I can afford to lose should the business fail.
Additionally, by investing my own capital, this will prove beneficial should I choose to raise equity funding from investors, since it shows I have skin in the game and are willing to back the company with my own money.
3) Non-dilutive financing options
In addition to my own capital, I’ll do my best to secure non-dilutive financing via small business grants and tax credits.
For example, many small business associations, incubators, and government entities have grant programs as well as no-interest/low-interest loan options. This will give me access to funding while maintaining full ownership; and if I’m lucky, I’ll qualify for a grant which does not have to be repaid!
4) Lease equipment to maximize cash flow
After investing my personal capital, coupled with any successful grants, I’ll use these funds to lease the initial assets required to launch the business.
For instance, instead of purchasing the assets, leasing them will help preserve cash flow and make for more predictable monthly expenditures. Moreover, I will work to negotiate the most favorable terms with the lessor; particularly a low-interest rate since I anticipate the economy will enter a recession within the next two years and interest rates will subsequently drop.
Regarding the structure of the lease, I’ll structure each lease as a capital lease so that I have the option of purchasing each asset for a discounted price at the end of the lease term (more on this below).
5) Secure LOC & Loan
Next, I will leverage the capital lease structure to obtain additional financing from banks. For example, a capital lease is treated as an asset on my balance sheet, against which I can use to secure additional debt financing (while claiming depreciation and interest expense to reduce my taxable income) (Corporate Finance Institute).
Specifically, I can use these assets to secure a line of credit from the bank as a means of establishing access to short-term funding. Moreover, I will use these initial assets as collateral to (hopefully) qualify for a long-term loan, should I require more cash to fund operations and develop a prototype.
6) Proof of Concept
Depending on how much capital I can secure from my various sources (i.e. personal funds, grants, short-term LOC, and long-term loan), I’ll use these funds to develop a prototype/MVP which will allow me to test my theory.
For example, if I can show some early signs of initial traction by generating a few sales and acquiring a handful of paid customers, I will be in a far better position (i.e. greater leverage) when moving to my next source of fundraising: equity financing.
7) Equity Financing
Let’s assume I’ve secured the following funding so far:
Furthermore, I’ve built an MVP selling widgets online, and have managed to generate some revenue over the past three months.
Since I’ve demonstrated some early traction and I’m convinced my idea is the next Uber, I’m ready to scale my business to the next level with the use of $300k in equity financing.
I now pitch my business to a group of private investors and show them how their investment of $300,000 today will help launch our company and achieve profitability in three years, while generating $150,000/year in operating profit.
I also sell them on the attractiveness of investing in my company since there’s a 50% chance the economy will enter a recession within the next two years, thus making my company more attractive on a risk-adjusted basis since private markets are repriced fall less frequently than public markets.
For instance, the current U.S. Fed Funds Rate is a dismal 0.25%, and if the economy enters a recession, the Fed will almost certainly maintain rock-bottom rates in an effort to stimulate the economy (which I can also use to negotiate lower interest rates on my LOC and long-term loan).
Therefore, using my IRR calculation, I show the investors how an investment in my company is a much better use of their cash than keeping it in the bank since it will return much more than 0.25% annually (or even the typical 7–8% annual return for the S&P 500).
For example, my business plan demonstrates how three years from now my company will generate $600,000 in top-line revenue, have pre-tax operating margins of 25%, thus generating $150,000/year in operating profit.
Furthermore, since I have very little financial data to go on, I do some research to look at industry average price-to-sales multiples from similar companies that recently received equity funding. Based on my research, the average multiple for an online retail company is 3.13.
Therefore, in three years, when we are generating top-line revenue of $600k, my company will likely warrant a valuation of ~$1.8MM (i.e. $600k x 3.13). As such, I’m willing to offer investors $300,000 for a 25% equity stake in the company. In three years, when our company’s valuation reaches $1.8MM, their equity stake will be worth ~$450,000 (i.e. an IRR of 14.5%, and MOIC of 1.5x).
Conclusion: After going through each of these steps, my resulting capital structure will be a mix of personal, debt and equity funding.
If you meet all your projections, will you be happier in five years that you used equity to fund the venture or debt?
Ultimately, it depends on the type of business and the goals I am trying to achieve.
For example, funding from private investors (particularly venture-backed funding) is best for high-growth (i.e. venture scale) startups that want to achieve global status –– meaning, the business can realistically achieve $100MM+ in annual revenue, capture significant marketshare in a multi-billion dollar addressable market, and ultimately, provide early-stage investors with a return multiple of at least 100x.
In my example above, since I think my company could be the next Uber, I would likely pursue VC funding for the purpose of gaining access to their strong network and domain expertise. As such, in five years (assuming I meet all my projections), I would be happier I chose to use equity funding since I could never have achieved the same level of growth and expertise on my own.
When seeking equity funding, I would attempt to negotiate the best terms possible, such as maintaining control and ensuring I accept only those investors who can add significant value beyond a simple cheque. Personally, I would rather own a smaller percentage of something big, than a big percentage of something small.
If the company goes bankrupt in five years, would you have a different answer?
If the company goes bankrupt in five years, I’ll be very glad I structured the company as an LLC (or Delaware C-Corp). As for the capital structure, I would be happier if I had utilized more equity financing since bankruptcy will undoubtedly impact my ability to secure future debt financing for my next venture.
For instance, private investors and VCs understand the majority of startups fail; and although the entrepreneur may be a very talented individual, it might just be a result of poor timing. As such, investors are sometimes willing to fund the entrepreneur once again on their next venture.
For example, history is full of entrepreneurs who failed at their first startup, yet their next venture went on to be a huge success (i.e. Reid Hoffman who failed with SocialNet before launching LinkedIn, Nick Woodman with FunBug before launching GoPro, and Ed Williams with Odeo before Twitter).
In my case, while I might fail, if investors still believe I have the grit and determination to build a world-class business, they will likely be willing to back my next venture.
About the Author
Matthew is the founder of Allied Venture Partners, a new AngelList syndicate dedicated to the growth and diversity of Western Canada’s technology ecosystem. To learn more please visit Allied.VC
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