Sources of Capital

Sources of Capital

Introduction

Several relevant sources of capital are available to a startup in order to meet the company's needs in its various phases. Sources of financing are classified primarily into equity (usually in the form of shares), which is capital invested in the company in consideration for part of the ownership and debt. Many financial instruments are constructed from a combination of the two, such as convertible debentures, which combine debt and options for equity.

There is a direct link between perceived risks and required returns; the risk, the higher is the rate of return expected by investors. The risk incorporated in receiving equity in consideration for an investment is higher than the risk involved in debt (debentures), since shareholders receive only the residual claim, whereas debenture holders have a superior, contractual claim to principal and interest. The younger the company, the greater is the resemblance of any debt it issues to equity, since its debt offers no much better security for a return on the investment.

This section describes the various sources from which startups may obtain financing in the various stages of their development. The first sources will generally tend to invest in the company's equity. In practice, the securities which investors in startups receive are usually preferred shares that are convertible into ordinary shares.

The main sources of finance which are available to startups (see Figure 6-1) are venture capital funds, various institutional investors such as pension funds and insurance companies, and private investors (high net-worth individuals, also referred to as "angels") who operate alone or together with others through investors' clubs and companies. The investments are made in three ways: directly in the startup; through entities which provide added value, such as venture capital funds which screen potential investments, make and manage them, and assist in managing the money of investors of different types; and funds of funds, which assist institutional investors in screening and dispersing investments among several venture capital funds. Obviously, public capital markets (particularly investors on stock markets) are another important source of financing for startups—both directly, by public offerings on stock exchanges, and indirectly, by investments in various investment funds.

Figure 6-1. Sources of Financing for Startups

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Family and Friends

This is the first source of financing sought by most entrepreneurs after using their own funds. Investing personal funds or the funds of family and friends also serves as a signal to outside investors that the entrepreneur places great faith in the company.

Private Investors (Angels)

Private investors, also referred to as angels because of their concern for faithful but penniless entrepreneurs, are a common source of preliminary financing. A typical angel is a person who is familiar with the industry (such as an entrepreneur who "made it") and who contributes to the company not only money, but also added value and connections. There now remains only a vague distinction between an angel and a mere private financial investor.

Angels invest in startups in their early phases with the hope of receiving a high rate of return due to the high risk involved in the investment. In the last decade, many angel clubs have developed which bring together several angels to assess opportunities for investments and to aggregate the amounts of money required for them, thereby making the investment more efficient.

Seed and pre-seed investments are available both from individual angels and from angel associations. These investors typically allocate $10,000–200,000 per project, which are invested in the early phases of companies. There are considerable differences among different angels: Some are merely financial investors who are at times entirely unfamiliar with the startup's line of business, and some have vast experience in the company's specific field of activity. In the United States, angel investors contribute more than $15 billion per year to startups.

Information on angels may be obtained from other entrepreneurs, from attorneys and CPAs, and from Web sites which provide information on sources of financing. Angel associations may also be contacted for this purpose. For a further discussion of investments by angels, see Chapter 11.

Venture Capital Funds

In order to finance ventures after their initial establishment, entrepreneurs usually turn to bodies which specialize in high-risk investments. Venture capital funds concentrate capital which is designated for risky investments and provide their investors with investment-screening services in consideration for part of the profit they generate for them. For an in-depth discussion of the structure and manner of operation of venture capital funds, see Chapter 10.

Many venture capital funds now invest in companies in their early phases. Some of the funds also provide added value services similar to those offered by incubators. Nevertheless, it should be kept in mind that the investment process of venture capital funds is generally very long, and funds prefer to invest only after the business and technological models are clarified. Therefore, funds may prove a good source for seed financing, but not for pre-seed financing. Moreover, funds which declare themselves to be "seed investors" are not always capable of providing an infant company with the type of intimate support it requires.

Corporate Investors

Corporate investors have supported the development of business ventures long before the first venture capital funds were created. Even now, following the development of the venture capital fund, a substantial part of the investments in companies is made by corporate investors (either directly or by investing in funds). The investments are made in the development of new ventures inside the company or in new companies that develop promising technologies which complement the investing company's business (see Chapter 11 on corporate in-house startups and incubators). Some of the investments culminate in the acquisition of the company (for instance, the Chromatis-Lucent transaction, in Chapter 14).

Most of the direct investments made by corporate investors are not limited to mere capital, and are aimed at a strategic cooperation in the development of technologies and the acquisition of know-how or in the distribution of a product. This cooperation is often accompanied by the acquisition of 5–20% of the new venture, a level which does not require the investing company to report the investment using the equity method. Strategic cooperation can help new companies introduce their product to the market quickly. The position held by the strategic partner in the target market and its marketing channels can complement the technological know-how of the venture. On the other hand, caution should be exercised in the face of strategic partners who are more interested in gaining access to the technology than in seeing the company succeed by itself. In certain extreme cases, such partners would rather bury the technology than support its development in order to prevent competition with their own technology. Ties with a single strategic partner can also block opportunities for contacts with other players in the market.

In conclusion, cooperating with market leaders can bestow many advantages, but these advantages also entail many risks, and the partner's intentions and character should be carefully scrutinized before any technology is exposed to these potential partners. In addition, it is best to avoid giving the partner advantages over other potential competitors in the acquisition of the company, in case this issue becomes relevant (some companies condition their investment on clauses such as a right of first refusal to buy the company or a priority in the negotiations), to avoid shutting the door on future opportunities.

Other Venture Capitalists

In recent years, investment banks and many institutional entities have started participating in investment rounds, usually together with funds, and their readiness to join relatively early rounds has increased over the years (although most of the direct investments are still made in the later stages). Institutional investors seek opportunities to invest in companies which could provide them with a higher rate of return than that offered by the rest of the market. The phenomenon has become so prevalent that many institutional investors have started making direct investments. In many cases, a venture capital fund will suggest that its investors participate in the investment round independently, since the fund is either not interested in, or is incapable of investing very large amounts of money in, a single company even if it believes in the company's potential. Other venture capitalists that are particularly visible are investment banks that have created venture capital funds under their management. For a more detailed discussion of these investors, see Chapter 11 on financial institutions which invest directly in funds.

Financing by Debt

Beyond the initial stages, startups can resort to financing by way of debt. The term debt usually signifies a short- or long-term line of credit. The lenders can be banks, venture capitalists, or bodies which specialize in providing credit. The borrower receives the right to use the money for a pre-determined period of time in consideration for the payment of interest. The terms of the loan are set in the loan agreement. To guarantee the repayment of the debt and the interest, the loan is backed by the cash flow itself (an unsecured loan) or collateral (a secured loan).

An unsecured loan is given when the creditor ascertains that the company's cash flow will suffice to pay the interest and the principal. Common indicators for measuring the borrower's ability to repay the debt are his or her EBIT and leverage (debt/equity ratio). A secured loan is typically guaranteed by a marketable asset. Financing by debt (without an equity component) is usually inaccessible to early-stage startups, which are based on high-risk growth and which lack many tangible assets, unless their startups have a good chance of securing long-term contracts with customers. At later phases of the company's life cycle, it becomes easier to resort to financial instruments containing a significant debt component. The types of financing by debt that startups commonly use are as follows:

  • Mezzanine loans— As mentioned above, startups face difficulties in securing traditional financing from banks. A popular solution is the "mezzanine loan." This type of investment lies between debt and equity (hence the name). The incentive for entrepreneurs to use this instrument could be their desire to avoid dilution, on the one hand, and an inability to obtain ordinary bank loans, on the other hand. From the investors' point of view, this loan offers a higher degree of security than an ordinary investment in equity since their right is senior to that of the shareholders.

    The main source for mezzanine loans are commercial banks, insurance companies, and specialized entities which are associated with banks, although mezzanine loans are also offered by several funds which specialize in this type of loan. Mezzanine loans are generally given only to companies that have already started or are about to start making sales, since the repayment of the loan depends on the company's ability to generate cash flows. The criteria used by lenders to screen investments are similar to those used by venture capital funds.

    Generally, the securities issued in this type of investment are either high-yield convertible debentures or are accompanied by an equity kicker in the form of warrants. The rate of interest could be more than 10% above similar loans and range between 15% and 30% with the actual interest rate depending to a large extent on the equity component of the loan and naturally on the perceived risk of the loan. If the company is expected to have a negative cash flow in the first stages after the loan is granted, the payment of interest might be deferred for several years after the debenture is issued, with the interest accumulating during the first period. If the company defaults on its payments, the terms of the debenture could provide for changes in the loan terms. Such changes may include: accelerate the debenture's maturity; increase the interest rate; add warrants for additional shares (or a discount in the conversion price in the case of convertible debentures); add rights to control the board of directors, or add rights to force an issuance or sale of the company.

  • Bridge loan— A bridge loan is typically a loan (for less than one year), designed to provide the company with sufficient funds to finance its current activities, pending an investment round that is expected to take place at a forthcoming time. Bridge loans are common at times close to IPOs from various financial institutions and are also common as a mechanism for funding between financial rounds, without the need to set valuation.

  • Other uses of debt— In the various stages of a startup's life cycle, the company may use other sources of debt financing. For instance, many companies enable the long-term leasing of most of the equipment required by the company. The company may also obtain short-term loans for working capital needs, or obtain a line of credit from banks to be used as required.