Today, we’re here to examine the traditional equity funding model and discuss why startups are moving towards non-equity funding models. We believe that non-equity funding is the future for startups, and here are a few reasons why.
First off, it’s essential to understand traditional startup funding. The conventional mainstream approach is the equity funding model. Most startup accelerators follow the equity funding model. They assume that an investor of any type (be it an angel investor, corporate investor, or venture capital firm) will want equity in exchange for their investment.
Why do traditional accelerators focus on equity-based funding?
Accelerator programs today teach founders to structure their startups under the equity funding model. Under the equity funding model, accelerators prepare startups for investor readiness. This can be beneficial because if the founder needs to raise money to grow the business, the business is structured to make it easier to start talking to venture capital firms or corporate investors.
Improper structures for a business that has already been running for years can be costly to fix. These inadequate structures cost the business time and money when fundraising, so startup accelerators tend to help founders avoid that by encouraging them to structure their business in a VC-friendly way.
Why equity funding is flawed
On the surface, the equity funding approach isn’t wrong. Whether or not the startup needs to raise money, it doesn’t hurt to make sure startups prepare to take investors up on an offer should one arise. Who says no when an investor wants to throw money at you?
As it turns out, saying no is often one of the most brilliant things a founder can do. Giving investors a stake in your company can often complicate the running of the business just as often as founders believe it can make all the difference.
One reason is that venture capital and corporate investors want to invest is to make money for themselves; helping your business make a profit is only a goal so long as they profit, too.
Once a deal is made, investors will breathe down founders’ necks to encourage a return on investment as soon as possible. And if the startup doesn’t perform, they keep asking why. The result is a back-and-forth tussling with investors. These investors usually don’t understand the business as intimately as the founders.
The main ask is when can they see a profit. Profit for investors means a revenue number that allows them to exit (not actually real profit while the business is still in your hands).
Founders often find themselves wasting time justifying how they run the business instead of running the company and creating value for who truly matters (the customers, not the shareholders).
The other reason is that startup financing is a massive industry of its own, and accelerator programs know this. That’s why the programs emphasize fundraising. They don’t teach that you must protect as much of your equity as possible, especially when corporate accelerators try to get founders to sign away as large of a chunk of your company as possible in the earliest stages since you have weaker bargaining power.
The better accelerators out there teach founders to protect their equity from the beginning, but the irony is that most accelerators themselves ask for equity from the start.
Have you seen the show ‘Shark Tank’? They don’t call it that without reason. The namesake for Shark was an investor with sharp wit and experience aiming to make a great deal for themselves. The startups are the small fish and easy prey for sharks making great deals for themselves by leveraging their financial position. They know that early-stage startups struggle to get themselves off the ground and offer unfair terms to capitalize off the weakness.
In actuality, the fact is there is so much money out there set aside for investing in startups that any founder would be a fool to ignore it. You don’t have to give away equity to get funded.
Equity fundraising requires giving away your startup’s most valuable asset (its shares) and complicates how the business grows strategically.
Non-equity based funding – the future of startups
Non-equity-based funding is less talked about because traditional accelerators, corporate investors, and venture capital firms often (wrongly) believe that they don’t have much to gain from doing so. Why help founders raise money if they don’t get a share of the action?
The non-equity camp has existed in secret in various startup circles, championed in select networks. But these people are typically too engrossed in running their own business to share their know-how, so the non-equity approach remained out of sight at business-savvy family dinners or within circles within circles (like at Silicon Valley house parties or among elite startup clubs).
Non-equity based funding: Ways to raise money without giving away equity
1. Investor Debt financing
Investor debt financing, also known as investor loans, are a simple way to borrow money from investors. The investor source is typically an angel investor (individual investors specializing in hyper-early stage startup investing). Still, sometimes startup loans can come from government and institutional sources as well. Loans can sometimes, but rarely, come from corporate social initiatives. With investor debt financing, a legally binding loan agreement specifies the loan’s repayment terms. Some angel investors may even loan money with a non-legally-binding term sheet.
Tips for founders
Look for friendly repayment terms, preferably one without interest. Some investor debt loans have friendly terms that state the loan can be written off if the startup fails to generate revenue, with other terms to comply with in lieu.
Bank loans are a form of investor debt financing even though they charge interest where angel investors might not, the interest rate will typically be much more affordable than giving away equity in your startup (assuming you’re growing sustainably with a clear vision).
2. Revenue share with investors
Revenue share involves a legally binding agreement with the investor to share a certain percentage of revenue (not profit) generated by the startup after the investment. The investor only makes money when you do through the revenue sharing model.
3. ARR lending
ARR lending, short for annual recurring revenue lending, is a powerful financing option. It was pioneered in the ’90s by venture capitalist Arthur Fox. In the early 2000s, ARR lending grew in hype as founders started to avoid traditional VC funding to not only keep their equity but avoid pressure from VC firms to deliver excessive and unsustainable early growth.
A principle amount is agreed upon by the loaning and borrowing parties. There is typically no set repayment date, with loan repayment based on a percentage of monthly or annual revenue (hence its name). This is a powerful financing option, allowing the business a fighting chance to stay cash-flow positive while repaying the loan (whereas other models can be less flexible).
Borrowing terms are typical US$50,000 – $3 million with interest rates around 10% or more. The borrowing entity may be a bank, business development company (BDC), private equity firm, or non-equity venture capital firm.
3. Bootstrapping Strategies
Bootstrapping is a self-funding strategy that avoids taking investors or loan money altogether. Bootstrapping involves using revenues from paying users to sustain the startup’s operating and growth costs. Below are some bootstrapping strategies used by startup founders.
3A. Lifetime deals with micro-investors
Typical to software startups (also known as SaaS / software-as-a-service startups), offering lifetime deals on a software subscription is a great way to encourage early sign-ups. Before the company can establish its reputation, it needs to acquire early adopters by solving their real problems using the software. Each user becomes a micro-investor that receives a lifetime software subscription in exchange for their early support. Later on, the SaaS company will transition to a monthly or yearly subscription model with lifetime deals either unavailable or charged at a higher price.
3B. Crowdfunding / Pre-Order Strategy
Crowdfunding is a popular strategy for startups to sell physical products. Crowdfunding finances the production of the product by collecting paying customers before the funds can finance production. Some popular crowdfunding platforms include IndieGoGo and Kickstarter.
A pre-order strategy typically involves collecting pre-orders without a crowdfunding platform.
At the end of the day, whether you choose the equity route and give up control or venture towards the non-equity path and maintain your autonomy, the first step to getting a startup to revenue is with traction.
Growing the customer list first is what gets traction. Once you have the customer acquisition part, the game is simple: getting customers, keeping customers, and increasing lifetime value.