10 May 2017
At Gustavino Capital, we have been surprised by the trend we have seen in early-stage companies who identify the need for a capital injection as the main impediment to their ability to grow their business.
Having been involved in countless projects as an Executive, Investor, Advisor and Entrepreneur, my view is that many budding entrepreneurs are buying into the US VC model as their only guide to growth, and that this can be quite destructive to their ventures.
There are several other funding sources that should be explored before raising venture capital (VC), and the reason for this is that a lot of companies seek VC when their business model is not mature enough to gain advantage from this form of capital injection and what it entails.
Below are six alternatives to VC in order of the most to least preferred (in our opinion):
1. Customer driven (i.e. pull through) revenue which can prove your business model: This is probably the most challenging and overlooked source of funds. While it can be one of the most difficult sources of funds to acquire, it is potentially the most effective, as it doesn’t result in equity dilution and can have the most profound impact on company valuation upon successful completion of product or service delivery.
2. Cash flow from operations: A simple principle of corporate strategy is to invest profits into areas that will create high returns on investment. First analyse how you can maximise cash flow, then deploy that cash flow into high-value investments. Profit (and the discipline to determine early what is profitable), not revenue, is the key to growth.
3. Founder’s equity: Without putting yourself into a highly risky financial position, you should look to invest any outside capital you have into the business. This will allow you to retain ownership and avoid dilution from other capital providers, as well as providing an important signal to future equity contributors that you believe in the business.
4. Friends and family: Much like founder’s equity, raising funds from friends and family shows that you and your trusted advisors believe in the business. This option also means you can avoid giving up control to third parties with potentially conflicting interests.
5. Venture debt or mezzanine debt: When traditional bank loans are not sufficient, alternative debt providers are an option, albeit at higher interest rates. Venture debt is typically backed by assets of the business, while mezzanine debt is often a high-interest rate debt that may be convertible to equity in some business scenarios.
6. Bank loans and lines of credit: Bank loans, especially those supported by R&D grants or other government lending programs, are often a good source of funding. These typically must be backed by inventory or accounts receivable, however, and often require a personal guarantee (if you won’t back yourself, why should your investors consider you investable?).
So many founders, business owners and entrepreneurs will consistently point to the need for outside capital injection to solve their growth issues. Having been involved with many high growth companies, I can say that in my experience up to 80% of these companies should have spent more time looking at their corporate and business strategy first and clarifying the pathway to growth and exit.
Taking on this disciplined approach will make ventures more attractive to VC and any other form of investment in the future. I would even go out on a limb as to say that more value can be added to a venture during this phase than is commonly understood by most venture participants, and that a lot of money can go to waste for investors that are uneducated in the high growth business models.