Different types of funding for scale-ups
June 15, 2022
The topic of fundraising inevitably crosses the mind of a founder at some point. “To do, or not to do” is often the question. If the answer is “to do”, a litany of follow-up questions arise.
When is the right time? How much money do I need? Who should I go to for money? What types of fundraising options do I have? The list is long and can be stressful to consider. At RocketX, we’re fortunate to speak to founders daily. We hear these questions being asked on a recurring basis and thought it was time to contribute to the conversation (in written form). This piece will focus on the types of fundraising options out there. We’ll clear up some opacity around the subject such as financing instruments, consequences, and timing.
Please note, however, that the sources of funding examined below are not rigid in their stage – some are useful in various stages – so be sure to consider them and your situation carefully – and if you have any questions, please reach out, so we can assist you!
Funding for Incubation stage
The incubation stage sees a startup seeking immediate funding that will help transform an idea into a functioning business, as well as advice, mentorship, and training. This is a stage of initial development. From a funding perspective, it comes along with the financial backing that acts as fertilizer to catalyse very early-stage growth.
An angel investor is an individual (typically with a high net worth) who provides capital – as well as expertise and access to a professional network – to a startup in exchange for equity or convertible debt. Such investments are considerably risky, with the potential rewards being equally lucrative.
For founders, the upside to such an investment is a drastic decrease in financial risk – angel investors often don’t expect their money back should a business fail. The downside, however, is a loss of control – just how much depends on the initial investment itself and the type of angel investor or angel syndicate (a group of angel investors). Some angels require a very high degree of control and input, whereas others would rather sit back and touch base every so often.
“If an angel investor controls more than 49% of your business, this effectively eliminates your primary decision-maker status,” an article from the European Business Review reads. “If you want executive freedom, this one disadvantage of angel investor finance can outweigh the multiple benefits.”
In general, when giving equity away in exchange for growth capital, you are by consequence diluting yourself. If you plan to raise money again down the road, you’ll yet again dilute. Diluting too much reduces your chances of raising money in the future because new potential investors recognize that you have an ever decreasing stake in the business. It could be argued that an ever decreasing stake results in a reduced incentive in shepherding the business, and therefore investors typically like to see that the founding team has a majority stake at all times, especially in earlier rounds (naturally, a later stage business will have a lower probability of fitting these criteria). Ensuring that you do not give too much equity away in early funding rounds is important and should be a component in the decision-making process when considering a deal.
Venture capital (VC)
Venture capital is arguably the most well-known source of funding. Like angel investors, venture capitalists place high-risk, high-reward investments into nascent businesses in exchange for equity. VCs often times play more operational roles than angel investors, typically also acting as guides or mentors. VC’s raise money from outside parties (limited partners, aka LPs) and aggregate it into a fund, which is then used to invest in businesses. Since these firms are capital allocators on behalf of their LPs, they generate a fee for managing the fund. In order to justify their management fees they need to generate a high return on invested funds, and therefore are very selective in their investments and can be rigorous in their post-investment requirements.
“On average,” according to renowned investment firm JP Morgan, “VC firms will invest a larger amount of money than angel investors, but VC investors will also get a higher equity stake in the company.”
A large investment is an undeniable benefit to any incubation-stage business. However, warns Sifted, there are numerous downsides here, among them “the onerous legal terms, high growth expectations, intense pressure at a board level, lots of financial insecurity and the constant need to perform at an exceptionally high level. Plus you always need to be fundraising to continue to increase your valuation and have the funds to fuel further growth.”
Grants and subsidies
Businesses in verticals critical for solid economies, such as biotech, healthcare, agriculture, or deep tech, would be wise to seek out and tap into governmental grants and subsidies. The two forms of funding are similar to one another, with a grant being a sum given to businesses for a specific purpose. Subsidies, meanwhile, can include cash, but also come in alternative forms, such as tax breaks.
“In order to accelerate the required technological and societal changes, governments award grants [and subsidies] mainly to activities that involve research, development and demonstration of new technologies and concepts,” according to a blog by the Circular City Funding Guide. "In addition, grants are often available for educational programs, awareness campaigns, and capacity building.”
Friends & family
According to MT/Sprout, 80% of businesses in the Netherlands alone receive initial funding from “people within their own network”
“They know you, they most likely know your idea, and they may be more inclined to take a chance on you than an angel investor, venture capitalist or bank,” adds a Sifted article on startup funding. “Plus it can actually be a positive signal to future investors, that you have a network of friends and family who have already supported your startup idea.”
Additionally, businesses can raise funds from family offices, which tend to have slightly different priorities than general equity investors. Family offices manage the investments of one or multiple families. Family offices tend to invest their own money, meaning there is less pressure from external investors, which can be beneficial to your business. The catch? They can be difficult to find – much less source funding from.
“Family offices don’t always want to be found,” another Sifted article reads. “Not every wealthy individual wants details of just how much cash they have to splash bandied around in the public sphere. Others are wary of being inundated with companies hoping to get hold of their capital.”
Early stage funding
After acquiring initial funding, establishing product-market fit, and gaining traction, startups move into the early stage of their lifecycles. Here, they begin to forge a path for the future. Securing funding in this stage can be essential for a business to hire the right people, further develop their product or service, grab market share, and build out a more robust operating model.
The concept of crowdfunding is extraordinarily popular in both the business and cultural world, in large part due to the rising popularity of platforms such as Kickstarter, Indiegogo, and SeedInvest Technology.
Rather than seeking an individual investor, crowdfunding hinges on multitudinous smaller investments from a larger pool of investors. It can be equity-based, with investors receiving equity in return for capital; rewards-based, which, according to Sifted, offer a “non-financial incentive…. such as early access to a product” or service; or debt-based – a model of crowdfunding that sees businesses paying back early investors at an agreed-upon interest rate.
While crowdfunding is an attractive and relatively simple way of raising growth capital, a large pool of investors means that businesses using such means run the risk of giving away too much equity, and therefore losing operational control. An unsuccessful crowdfunding campaign typically sees all money returned to investors, with the business receiving nothing.
Tried and true, a bank loan is what it is: a lump sum given to a business, which is paid back in instalments, with interest. Such loans are typically given to organizations that can provide evidence of historical and future stability, either in the form of cashflow or a solid business plan – depending on a business’s current state, age, vertical, or organizational type.
“For instance,” says the Dutch government, “if you are an existing entrepreneur you need to submit annual accounts and a description of your business activities [to apply for an SME loan]. If you are a starting entrepreneur or if you are taking over an existing company, you need to hand in a solid business plan including a financial plan. In all cases you need an overview of your personal budget.”
A downside? Bank loans often require personal guarantees, with business owners or founders using their assets as collateral.
Later stage funding
In the later stages of a business, the focus shifts from acquiring startup funding to that which can fuel long-term success. This is next-level stuff, and as such, the stakes and the rewards are higher.
Private equity (PE)
Private equity is similar to VC – itself a subsidiary or form of PE – in the sense that private equity firms invest capital raised from numerous parties into private companies.
“Unlike VC firms,” reads a Pitchbook blog, “PE firms often take a majority stake—50% ownership or more—when they invest in companies. Private equity firms usually have majority ownership of multiple companies at once.”
PE firms also predominantly look to mature companies in more traditional industries, where there are different types of risks, though the line between VC and PE firms is blurring.
Revenue-based financing (RBF)
With revenue-based financing – also known as venture debt – businesses receive a loan that is repaid with revenue, plus a margin. Funding here runs the gamut in terms of investment size – “from $10k to $10M, with a fixed flat rate of 6-12%,” according to Dealroom’s blog on the subject.
“Revenue-based financing is accessible only to revenue-generating startups which need capital to accelerate their growth,” the blog continues. “So it is definitely not an option for a deep tech pre-revenue startup, but works well for e-commerce and SaaS businesses, both startups and SMEs … Furthermore, the financing approval is data-driven and takes one to three days, compared to the months needed to raise VC funding.”
While often cheaper than private equity or bank loans – and carrying less risk to those on the receiving end of an investment, as no personal guarantees are required – RBF capital is also usually provided in smaller amounts than VC, with the option of future investment rounds remaining open but not guaranteed. RBF acan also require monthly payments – a potential challenge for any businesses. It is important to remember, however, that RBF is non-dilutive, meaning you’re receiving funding without giving up equity – a major benefit for many businesses, which can obtain cashflow but not risk losing operational control.
Debt factoring involves selling unpaid invoices to a third-party factoring company, in return for receiving an advanced payout of a percentage of the invoices’ value. After they are sold, the invoices are the full responsibility of the factoring company. Factoring companies also charge“factoring fees” – a percentage of each invoice’s value – typically in the range of 1-3%.
“With fast access to capital and flexible qualification requirements, debt factoring is a popular way for B2B and service-based businesses to mitigate cash flow issues,” a Fundera blog on the subject states.
Subscription trading sees companies selling off future receivables, and is specifically for companies with recurring revenue, such as those offering SaaS platforms or other subscription services.
Because subscriptions are considered an asset with fixed income – such as rent is with real estate – companies are able to trade them off their balance sheets for an advanced on expected cashflow, in return for a discounted value. Should a company close a deal, for example, and know that in 12 months’ time it will receive €30,000, it can sell off receivables for immediate access to cash that it can use to grow.
Going public through an Initial public offering (IPO)
Going public through an IPO is often touted as the true mark of a company’s success. This is partially true. Rather than looking at an IPO as the goal itself, though, it’s more prudent to view it as a financing tool, that, like all other forms of fundraising, brings with it both benefits and pitfalls.
An IPO enables founders and early employees to “cash in” on stock shares that can now be publicly purchased and sold. This is a direct means of liquidating capital – no easy feat. On the other hand, IPOs often drastically change a company’s dynamic, bringing with it various methods of compliance that must legally adhere too – publishing annual accounts, for example, or the repayment of shareholder lenders. Additionally, company shares becoming publicly tradable also bring with them the potential for loss of business control.
IPOs, too, are only an option for those select, lucky few of businesses; in fact, an article published by Tech.eu reveals that in 2021, only “28 [European tech] companies that went public … raised at least €100 million each.”
Some last words...
The understanding of various types of funding is as essential as securing the funding itself. Without this knowledge, founders are more apt to make mistakes that have long-lasting – and perhaps even critical – implications for their businesses. Knowing when and how to secure each type of funding is equally important. Our hope is that you can use the above descriptions to develop this understanding, then use it to take the first step in your funding journey.