Raising the right kind of money [Opinion]

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I was at last weekend’s Mix N’ Mentor Beirut, and after sitting in on two fundraising mentorship sessions it became clear that there are several misconceptions around the fundraising process.

Venture capital is sometimes seen as the holy grail of money by entrepreneurs, but it’s not necessarily the right kind of money for your business.

There are two financing instruments you can use to obtain capital - debt or equity - and what you need can depend on your business model and the stage your company has reached.

Your business model is the process your business undertakes to generate revenue: how will you make money from providing X service or selling Y product?

Business models in tech can be subscription-based, where you provide access to a library of content in return for a monthly fee, or from one-off sales where you sell your app-development services for a fixed price. You could make a commission off sales between two independent parties - a marketplace - or you might simply be selling advertising space on your website or app.

In order to build your business to that point, you need to generate money to finance your operations and pay your employees. And if you are at the idea stage, you need capital to start your business.

But sometimes cash flow from operations is not enough for a business to really reach its potential.

The right kind of money

Choosing the right financing for your business depends on several factors, including how much money will you need to raise in order achieve your vision, what your current cash flow situation is, and how long will the funds you plan on raising last before you need to raise more capital.

As a general rule: if you are generating enough cash to sustain the business and have a little bit extra, but still need money to invest in growth, go for debt.

If you are a tech business with a business model that is not clear but have a vision to build a big company, and have identified investors who can add value and be patient while you build the business, go for equity.

Debt

Pros:

  • You won’t give up any equity in your business, so you are the final decision maker and are only accountable to yourself and cofounders (and the society you work in and employees you employ of course).

  • You are only required to pay the principal + interest. So if your business skyrockets and generates millions in revenues or exits to a larger partner, you are not required to pay a portion of the proceeds.

Cons:

  • You are required to pay back the amount, or you may face liquidation. In the Arab word, liquidation is a complicated procedure and not paying back your debtors can land you in jail.

  • It affects your cash flow since you have to commit to a repayment schedule. This means any repayment will be at the expense of reinvesting in the business for growth.

  • Sometimes debt can come with a set of restrictions on where you can spend the money.

  • You will have to back the debt with assets or find someone to guarantee your loan.

  • Usually limited to businesses that already generate revenues and own some assets.

Equity

As a general rule of thumb, raise enough money to last you 18 months and expect the process to take 6 months. Giving investors anywhere between 10 to 30 percent for each round of funding is normal, as is owning only 35 to 50 percent of your business by your 3rd round of financing.

Pros:

  • You are not required to pay back investors so it will not affect your cash flow. Also, if the business goes under, you are not required to pay back their investment.

  • In the case of most angel and venture capital firms, they are willing to be more patient on returns than debtors (7 to 10 years, if not longer).

  • Aligns interest. You are partners so growing the business is a positive thing for both you and your investors. Good investors will go out of their way to make sure you grow your business. They have a vested interest in the success of the business.

Cons:

  • There is pressure to grow the business and reach scale. You have partners you are accountable to.

  • You are bringing in partners who have a say on where your business can go since they are co-owners. This can be a good or bad thing, depending on the investor.

  • It’s difficult to put a value on your company in the early days. How do you value your startup? As a tech business, you might not be generating revenue yet, but already have several million users, how to you put a monetary value to those eyeballs?

  • You will need to understand what investors are expecting and how they operate. Oftentimes funds have their own shareholders whom they are liable to, so they might have a vision/timeline that differs to yours. They will need to liquidate from 5 to 7 years of investment, and the pressure they will place on you to help them liquidate will start to mount.

  • The fundraising process is time consuming, finding the right investors takes time and requires diligence from the founder. This is time you could have used to build your business.

  • You must regularly keep investors up to date.

  • They might have a say in things such as approving budgets and approving future debt or equity financing plans.

  • It costs money to draft shareholder agreements and requires you to be well represented by a lawyer who understands the jurisdiction you operate in.

Convertible loans

If not calculated properly and mapped out on a cap table you could face significant unforecasted dilution when convertible loans convert into equity.

Pros:

  • Legally easier and cheaper than equity financing.

  • Defers the questions of valuation to a future round of equity financing in case you and your investors do not agree on a number (however, it only defers to the negotiation, it does not get rid of it, eventually the convertible loan will either convert or will reach maturity. For more on this, take a look at these search results).

  • Good for a bridge between two rounds of equity financing, where your future round is in sight and investors are lined up.

Cons:

  • It is still a loan, and sometimes investors will have clauses in the agreements that allow them to call the loans rather than convert to equity.

  • If you pile on different loans at different discounts, it can be difficult to track your company's capitalization table, and you might underestimate the amount of dilution you face.

Understand what options are available for you and take the time to ask people who have benefited from these various forms of financing to identify the right path for you.

Ultimately there’s no one answer, and you can raise a combination of debt and equity over the life of your company, depending on what stage your business is in. 

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