Stories about millions raised, massive exits and how hard it is for various types of companies or founders to raise money from VCs tend to misguide founders by pitching the pipedream that raising equity is the only way to finance a business. In reality, non-equity business financings have outpaced equity financing for more than 50 years. But that’s not newsworthy.
When was the last time you read a story about non-equity vehicles like inventory financing, customer discounts for advance payments, margin sharing arrangements* [see example below], factoring, straight loans or loans paid back with a percentage of revenues instead of a fixed payment? None of these options involve selling part of your company.
Founders who don’t have friends and family with the risk capital, confidence or knowledge to invest in a completely new business so they need to be as creative about finding product/market fit as they are at financing their dreams.
Non-equity financing arrangements often seem expensive at first glance. Investors who take the risk to put up money for unproven concepts deserve returns that reflect the risk for doing so. Factoring rates run as much as 5% per month or 60% per year. Margin sharing arrangements* can eat up 50% of your profits. However, if your business is growing, you can afford to give up some profit today to seed the growth for bigger profits and more traditional financing tomorrow.
These alternatives have one huge advantage over selling stock in your company: they’re temporary. Equity investors, whether you like them or not, are forever…at least until you exit. Once you pay off a lender or sell the inventory paid for in a margin agreement or deliver the agreed upon multiple of a revenue share loan, you have complete control over your company again. If you don’t plan to exit or don’t plan to do what it takes to sell your company for the type of multiple that VCs are looking for in the time frame they need to sell in to sustain their business, you are not “venture backable”. In that case pursuing venture or angel financing is a waste of your time.
That doesn’t make you a bad founder. It means that your company is not venture backable.
Equity investors are looking for a business that will be sold for many times their investment within 5–10 years. (My equity investment hurdle is 10X within 10 years.) If you are successful in raising outside money, the more you raise, the more control VCs will demand over the company to protect their investors. Additional board seats, the ability to control when, if and for how much you sell your ‘baby’ and, yes, whether you remain employed by the company are typical terms and conditions of later rounds of equity financing.
If you’re building a business to pass down to your family members or employees, equity capital is probably not for you. If you are thinking about building a business that will take over the world, make sure you fully understand what that will cost…and not just in dollars and cents.
Tony Wilkins is a longtime early stage investor and “Founder-to-CEO” executive coach. His superpower; helping people improve outcomes by shortening their learning curves and avoiding avoidable mistakes.
*Margin sharing arrangements.
Here’s an example of what I’m talking about. Grace has a product that is selling pretty well. In fact, she can’t keep it in stock because she doesn’t have the money to buy larger production runs.
We agree to a 50/50 margin sharing agreement. I will pay for a run of $10,000 worth of products. We will split the margin on this production run only.
The cost to produce the product is $10 and she sells it all day for $40. Now she has 1,000 units in inventory to sell. Every month, we review what she’s sold. First month, she sells 100 units and sends me a check for $1,000 to cover the cost of the inventory used this month.
Now, we split the margin. She sold 100 units for $40 so the top line revenue was $4,000. However, after shipping costs, returns and Amazon’s cut, the net sales for this first month is $2,500. The 100 units cost $1,000 so our margin is $1,500 which we split. When we agree on the numbers during our monthly meeting, she sends me a second check for $750 (which is half of the $1,500 margin) and she keeps $750.
If we are successful in selling all 1,000 units, she will make $7,500 and repay my $10,000…all from the products she sold. I will make $7,500 and celebrate getting my $10,000 back and helping her get more product into the marketplace. The worst that can happen is that magically, we don’t sell anything, we learn something and I’m stuck with $10,000 worth of Grace’s products, which are the collateral for the advance.
Hope that’s helpful.
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I heard a Warren Buffet quote once that made me laugh out loud; “I try to invest in [mature] businesses that are so wonderful that an idiot can run them. Because sooner or later, one will.”
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