What to consider in taking outside capital

Growing businesses are notoriously capital-consumptive. But while most tend to believe that growth generates capital, it’s more often the case that growth consumes capital.

Early-stage companies, especially those in the tech field, need to fund research and product development work ahead of revenue. To develop, market and sell, companies have to hire teams of people before they’ve booked a dime of revenue. Investment is often required to support infrastructure (office, leasehold improvements, equipment). Even when revenue is flowing, capital is needed to fund accounts receivables and inventory and operating losses.

“Bootstrapping” your business — funding only what you can afford to fund through operating cash flow — is a practical and appropriate philosophy, so long as the business is not losing time to market. That means while you are managing your growth slowly, your better-capitalized competitors may be accelerating development and marketing/sales, beating you to the marketplace.

The types of capital

The major sources of external capital available to entrepreneurs include: friends, family and fools (FFF); federal and state grants; equity investors (wealthy individuals or angels; venture capital); and bank financing. Each has its tradeoffs.

On the positive side, FFF capital tends to be easy to access and valuation/pricing tends not to be an issue. But accessing FFF entails emotional baggage, tends to involve small dollar amounts and provide limited value-added in business terms.

The positive side of grants include no payback requirements, there’s no dilution to ownership and can involve meaningful dollar amounts. But grants also mean that the inherent bureaucracy of state and federal grants can involve a long application and review process (by contrast to other funding sources) as well as greater reporting requirements;

As for near-equity, or royalty-based obligation, the positives include no ownership dilution, the payback level correlates to success (typically sales success) and there’s often limited involvement by the funder. Negatives, however, include a required payment whether or not the company is cash-generative and there’s limited value-added beyond capital.

The positives involved in getting access to equity investors include being able to obtain long-term capital with limited/no near-term cash flow implications and funding is risk capital, which means that if the company fails there’s no obligation to repay. Also, typically, equity investors bring industry, financial and/or operating backgrounds to bear, helping companies “beyond the money.” But on the negative side, capital is, relative to grants and debt, more expensive than other forms of capital and investors often require a significant ownership position of 10 to 40 percent as well as a role on the board of directors. Equity investment also requires more of a business partnership than a strictly financial relationship as well as more complex investment documentation, terms and conditions than other forms of capital.

When it comes to bank financing, there is no equity dilution, the funding is provided at fixed, low-interest rates and there’s limited involvement by bank funders. But early-stage (cash flow negative) companies are not ideal for bank financing, a bank requires collateral, assets and/or personal guarantees and repayment begins soon after borrowing. Payment also is required, regardless of company performance.

Questions to ask

Each of these sources of capital is used at a different stage of a company’s evolution:

• Early stage (early- or pre-revenue): Small Business Innovation Research (SBIR) and other grants tend to support companies that are still in research and/or development. Angel networks and certain venture capital funds support companies at very early stages of development.

• Development stage (meaningful revenue with losses): Angel, venture capital and near equity funds support this stage of development.

• Later stage (significant revenue with profits; late-stage turnarounds; special situations, such as buyouts): Some venture capital funds and private equity funds outside the N.H. region.

Questions you should ask yourself in considering capital include:

• Do I have to pay it back? Grants, particularly SBIR, do not generally require payback. Debt, of course, does. Venture capital tends to require a value-realization event (sale, merger, IPO) to realize value for all equity owners, including founders and management. If, however, a company — having taken equity — does not succeed and there is no value left in the business, the equity investor suffers the same fate as management (capital loss).

• Do I have to give up ownership? Equity is typically the only asset class that requires ownership for the investor, not so for grants and debt.

• Do I have to put up guarantees? Most often, banks require guarantees to securitize their loan. Equity and grant funders do not generally have this requirement.

• Who is bearing the brunt of the risk? In debt and near-equity situations, the borrower bears the brunt of the capital risk, in that payment must be made regardless of the company’s capacity to pay. Equity investors, by contrast, assume the lion’s share of risk (and demand a greater return) for assuming that greater risk.

• Is there an “exit” requirement? All venture capital and most angel investors require a commitment for the company to realize stock value increases through a company sale or IPO anytime between the third and eighth year of the investment. Near-equity, debt and grants do not have any such requirement.

• What is your role in the company? By contrast to grant, royalty and debt suppliers, equity funders are very vocal about the quality, experience and composition of the management team. Often, venture capital investors will require augmentation to the management team and/or replacement or reassignment of certain senior founders of the company. If you are uncomfortable in considering this possibility, then you might consider passing on equity funding.

Michael Gurau is president of CEI Community Ventures, a venture capital fund targeting opportunities in northern New England. He can be reached at mhg@ceicommunityventures.com.