Don’t give up equity before considering other options.
Startup founders often look to venture capital as a way to fund their great idea. Professional investors with institutional money behind them seek out companies with high growth potential in large addressable markets. The tech press goes wild for the next big fundraise – lauding entrepreneurs for raising ever larger sums of cash. What they don’t report are the restrictions and expectations that come with raising VC money.
Venture capital investors are looking for a compelling return on investment and because of the inherent risk associated with investing in early stage companies, expect a 10x or greater return in 5 years. This puts tremendous pressure on new businesses and their founders. An investor has to believe in the project, the founder and a particular industry to justify investing money. Most startups will not meet these criteria, and quite frankly, it’s often not the best option despite the press attention.
Let’s briefly analyze the costs of venture capital. A 10x return translates into an internal rate of return (IRR) of ~60% over 5 years. Essentially a VC investor is betting that the startup can generate 60% returns for her every year! For most founders, paying 60% annual interest for 5 years and having someone else telling them how they should run their business is not particularly appealing. Because of the massive returns VCs need to justify their investment model, they will often force founders to run their business to IPO or be acquired by a competitor, regardless of whether that is an outcome the founder desires or not. If the founder is not running the business the way the VC would like or not meeting projections, she can easily be ousted. In addition, VC money comes structured as preferred equity with a liquidation preference that grows over time. Put simply, in an exit they get paid first and what’s leftover is for the founders and employees (other common VC terms and provisions).
For many startups, it’s necessary to seek alternative sources of funding. One option that the press rarely writes about is invoice factoring. Invoice factoring for startups is much faster and cheaper than venture capital. It allows companies to advance money on their completed invoices within 24 hours. The entire process, from finding a factoring company to setting up the credit line takes far less work and time than securing venture capital.
A founder will retain complete ownership of their business using this form of financing.
It’s also much easier to obtain funds with invoice factoring. The process is much faster than raising venture capital and will free up the founder’s time to actually run their business. A startup does not need to prove how they’ll be able to pay back the funds (because it’s not a loan). Factoring involves advancing money that has already been earned, which the factor collects without notifying the startup’s customers. Thus there is nothing for the startup to do but wait until the job is finished. Companies also do not have the pressure of hitting colossal growth projections like with venture capital investment. They are using the revenue they’ve already earned (completed invoices) and monetizing it to fund their growth.
An added benefit of working with a good invoice factoring company is that as a business grows so does the amount of funds it can obtain through factoring. The startup’s credit line will grow with its sales. The more invoices the startup has outstanding, the more money it’s eligible to receive through factoring.
Venture capital is generally used by startups to raise funding when they may not be eligible for bank financing. However, for startups that have slow paying clients, invoice factoring is a very viable and compelling option. Factoring is cheaper, faster and less restrictive than venture capital. Startup founders also retain full control of their business with no outside investor sitting on their board. The founder’s role is completely secure and they maintain 100% of the equity upside when utilizing invoice factoring.
Venture capital financing can be a good option for startups that need a large sum of money starting out and have no customers (e.g. biotech). However, for early-stage companies that have already secured revenue-generating clients, invoice factoring is often superior – allowing a quick infusion of cash without ownership dilution or restrictive covenants. In fact, it’s why we started Harper.