This is part 2 of a five part series. Read Part 1 here.
Private equity or venture capital funding
When you are just starting out, it is yourself or/and the proverbial triple FFF (friends, family and fools) and perhaps business angels that contributes to the birth of your startup business morphing from an idea in to a company. Then, you begin to look around for more seed or growth funding. Typically these are venture capital or risk capital funds that are eager to jump on the opportunity of the next uber-big venture. Their profit expectations are usually in the range of 20-30% per annum. Whereas, if they hit it big with your great idea, they may even touch 2-20x return, depending how well you do on the exit. Attracting venture capital is generally applauded and celebrated as an achievement. There are some disadvantages however worth mentioning.
One such disadvantage is a possible oversized loss of equity. An equity investor may require anywhere from 10% to 90% of your company. Depending on the shareholder agreement, any milestones or strict targets, even the most benevolent investor may turn out to be a vulture preying on your company. It is important therefore to always weigh all pros and cons about letting in a new equity holder with special requirements. As the saying goes, investors invest in people, not projects. When deciding on an investment option, the same should be said about startups accepting funding: you should seek out long-term partnerships with people, not just the money, at any perilous cost.
The other disadvantage of attracting venture capital or private equity investor is the diminished management control. When a serious firm or individual bring in a substantial amount of funding to a startup, it typically comes with a requirement of management and expenditure control. It is understandable for someone who puts up large amount of money on a promise alone to want to actually see and control the way the money is spent. The easiest way to yield control and oversight is to require a seat at the management or supervisory boards of the company. Once a controlling seat is given, with it comes a diminished executive power for the top management. It becomes harder to push through major decisions, and expenditure amounts that exceed those stipulated in the shareholder agreement. Each major decision gets to be questioned and not always by the most quick minded likes of people. It may, of course, turn out to be a blessing than a curse. For startups that lack experience or clear vision. But it is usually a hindrance and not a boon.
To sum up, private equity or venture capital investor may very well be of benefit to the young startup founders. But, the disadvantages of oversized loss of equity and a certain loss of management control may be the reasons for seeking other options.
Debt
Another way of financing a business is taking a loan, or issuing a convertible loan against future equity. If you are an established company, for short-term purposes you may issue other forms of debt, such as mezzanine, or you may get long term financing in the form of debenture.
A loan is given by a private, or an institutional investor, such as a bank. A loan however ideally is given against a collateral. A loan is basically a credit. However, credit is something you have to earn first. Taking a loan therefore is usually reserved to companies that already have revenue streams, or have high potential for earnings. Taking a loan to spend on a startup is risky for the taker beyond high interest rates. The most real risk is borne by the founder on repayment. As a founder you may need to pledge your private property or find a guarantor to act in your favour and on your behalf, to satisfy credit collateral requirements. Debt instruments like corporate bonds are regulated securities and also incur costs of issuance.
IPOs – are they relevant at all?
IPOs are also called the exit. This usually is the exit strategy for early equity investors and venture capitalists, as well as founders. But, the IPO route is open to largely mature companies with certain revenue streams and proven track record. A typical IPO-ready company would have to show uniqueness not only in differentiating business idea, or solid management, but also have a proven track record of profitability, revenue growth and guarantee a substantial market capitalisation for a liquid market trading.
Preparing for an IPO is expensive. It traditionally involves heavy legal efforts on drafting the prospectus and finding the right underwriter investment bank to initially back the business. But this process is also no longer being upheld in its entirety. An exemplifying case is a recent going public of a company called Slack. The social network platform followed the lead by Spotify to get the company listed without actually going through the IPO process.
The major downside of an IPO process amounts to expense and time the company needs assume to fulfil all the legal requirements prescribed by each jurisdiction. Both Spotify and Slack in the USA demonstrate that costs are being cut away where logically possible. If your company has gained a recognisability and social following by the virtue of its services, you may not even need to go down the expensive IPO route. It could cost the issuing company anywhere starting with USD 2m to USD 10m to prepare and pay all related fees for an IPO. Although the law is clear on security issuance, with the advent of primary listing, IPO industry is seeing a certain revamping of the process.
The bottom line being: either of the alternatives discussed above are distracting, time- consuming, irrelevant or outright expensive.
Source: https://www.securities.io/what-are-your-alternatives/