With most ordinary SMEs, the first question we get asked is ‘how do I pay less tax?’ however with startups, it’s generally ‘how do I raise cash?’
While there are quite a few questions you should be asking prior to either of the above, it is still important to know the options out there for financing your business.
Below we’ve highlighted a few options to consider when looking to finance your startup, and when these might be best suited to you.
Debt
This option avoids diluting ownership (shares) in your business but requires you to pay the money back, along with a sizeable interest portion. Generally, this is not even a consideration for startups as you are too risky to inject debt funding into, so you’ll either have to:
- Secure the debt against assets outside of your business (such as your family home); and/or
- Pay an incredibly high interest rate to make it worth the lender’s time.
Even with these factors considered, a pre-revenue startup will struggle to prove that they can service the loan.
As such, it is incredibly rare to get such debt funding off the ground and we don’t put too much weight on this option… for now.
Equity
Most startups know the deal here. You sell a portion of the shares in the company for cash, but it is the questions that follow that catch people out. What percentage do you give up? How much should investors pay for it? When do investors want to see a return? Are they going to take over?
Thinking about the type of investor you are dealing with and knowing what they want, is pivotal in the process and helps answer the questions above.
We’ve highlighted a few considerations below and stress that not all investors should be painted with the same brush, or fit perfectly in the below categories, but it’s a good place to start…
A bit of both
A ‘convertible note’ allows investors to essentially have their cake and eat it too. They will provide what is initially considered debt, with a prescribed discount rate. This can then turn into a defined equity interest. Most of the above investors would be agreeable to this type of structure, depending on the circumstance.
From there, we see clients looking at other issues such as ‘SAFE’ (Simple Agreement for Future Equity) which allows investors to provide cash without requiring a defined valuation of the business. Although simple on face value, you need to ensure this is established and interpreted correctly, as it can create issues down the track.
In conclusion, it is important to understand that before approaching an equity investor, a founder should decide what they are willing to give up, while also understanding that in exchange for giving up a percentage of their business they will not only receive cash, but potentially a mentor and business partner to help them achieve strategic goals.
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Authors: Gavin Stacey, Principal Business Advisory (picture left) and Adam Hall, Manager Corporate Finance (picture right), RSM Perth.
